The idea behind stop orders is to try to minimize losses in times of stock market turbulence. In almost forty years of stock market investing, however, I’ve never used one. In fact, I don’t know any professional trader or portfolio manager–or any amateur, for that matter–who has.
The details of what each kind of order does may differ a bit from broker to broker, so it’s important to read an exact definition on your brokerage website before you transact. Generally speaking, here’s what they are:
what they are
Stop orders come in several flavors.
—stop loss order. The user selects a stop price below the current quote of a stock he owns. If the stock declines to the stop price, a market sell order is entered. (The order entered is a market order to ensure a sell transaction happens. That might not be the case with a limit order.)
One important aspect of the stop loss is that trading after the stop has been triggered can be significantly below the stop level.
—stop limit order. Here the limit is typically placed above the current price, because the user wants to buy (to, for example, limit losses on a stock that has been sold short). Once the stop is reached, a limit order for the stock at the stop price is placed. That order will be filled before the stock can go higher.
One can also place a stop below the current price, combined with a limit sell order at the stop. But this gives no guarantee the stock will be sold.
—trailing stops. I don’t get these at all, although I understand they’re popular with trading-oriented individuals.
—-the stop price and the limit price can be different. Once the stock reaches the stop price, the limit order is placed.
For example. the stock is trading at $50 when the trailing stop is initiated. The stop is at $45, triggering a limit order at $40. This protects the seller against a “flash crash”-like temporary dive, which he’s vulnerable to with a stop loss order. The analogue on the buy side would be a stop at $55, triggering a limit order at $53.
—-the “trailing” part is that in the case of a sell order, the stop and limit are adjusted upward if the stock begins to rise (trailing behind along the same trajectory as the stock). In the case of a buy order, the stop and limit trail along with the the stock if it begins to fall. In either case, the stop and limit remain unchanged if the stock starts to move in an unfavorable direction.
An example (simplified a bit): the stock is trading at $50. You place a trailing stop sell order with the stop at $49 and the limit at $48. The stock rises to $55. The stop rises to $54 and the limit to $53. The stock then declines to $54. This triggers the stop, which activates the sell order at a limit of $53 or better. You sell at, say, $53.50. If the stock’s initial move is to fall to $49, the limit order at $48 (or better) is placed.
my problem with stops
It isn’t that they take a bit of getting accustomed to. It’s that the user makes relatively complex trading plans in anticipation of a market environment that may develop in a much different way than the plans have envisioned. Their virtue, which is that they automate a trading plan in advance, is also their vice–that they can prevent you from applying human judgment based on the most current information at the time this may matter the most.
Maybe it’s just that I haven’t used these tools, but it seems to me that the door to unintended consequences is opened pretty wide by their employment.