Candlestick Trading Blog

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Stop loss orders are the great insurance policy of the stock market. A stop loss order is an open order to your stock broker saying that if your stock drops to a certain target, he or she should immediately place a market order to sell on your behalf.

Setting a stop loss order is quite easy, although there are several different types. A typical stop loss order simple instructs your broker to sell if your stock drops to a specific price. This does not take into account any gains that your stock might have made after you placed the stop loss order. The other kind is a trailing stop; this is a stop loss order that instructs the broker to sell if your stock price drops by a certain percent; this allows for the stop to follow any increases in the stock price. Such techniques have created many successful traders!

Let’s look at an example of a stop loss strategy. You own a stock that has been trading at $40 per share. Since you’ve been tracking it, there has never a drop in price of more than $2 per share, so you have your broker set a stop loss order for $36. While you were away for a week on vacation, the company received some positive press and the stock jumped to $50, but later in the week the CFO was indicted for embezzling millions from the company and the stock plunged to $25. What was the effect on your stock? Since you placed the stop loss order for $36, your broker placed a market order to sell when that price was met. Instead of losing $15 per share, you only lost $4 per share.

In the same example, what if you had implemented a trailing stop loss order instead? You decided on a 10% stop since your stock has been very stable. At $40, that meant to sell at $36. When the stock rose to $50, your trailing stop rose to $45 and as the stock fell, your broker placed a market order to sell at $45. Instead of losing $4 per share, you still made $5 per share. These types of stop loss strategies and techniques will work well for the first trader but even better for the second.

It is important to note that the example is for illustrative purposes only and that any complex trade such as a stop loss order will increase the amount of commission that you pay. You also need to exercise care with a stop loss order because you are selling on a downswing; set it too close to your price and you may be out of a stock that is on a temporary trend. Set your target too far from your price and you could lose far more than you want to lose. In a case like this, you always want to consider risk reward ratios and act according to how comfortable you are.