To traders, profits are the life blood of business. Without them, business ceases and traders leave the market. Successful traders use stop loss orders to protect profits.
What Is A Stop Loss?
A stop loss order is an order to buy or sell a security at a predetermined price. This differs from a limit order in that a stop loss typically protects unrealized profits or limits loss on the downside. For example, if a trader is long a stock from $100 and the stock now trades at $103, he has paper gains of $3/share. Also, if he wishes to “lock in” $2 worth of profit, he places a stop loss order at $102. If the stock trades at $102, the trader automatically exits the position. This ensures the trader realizes a certain gain.
Conversely, if a trader enters a new position, he places a protective stop loss order, minimizing losses. A trader that buys stock at $100 that wishes to lose only $2 places a stop at $98. If the stock trades at or below $98, the trade exits automatically, controlling losses.
Analyzing Stop Losses
Stop losses are paramount to successful traders. However, the do not always act as planned. For example, slippage is an unfortunate reality of trading. This occurs when trades execute at worse prices than the trader anticipated. This happens when no other trader wants to take the other side of your trade, so you get the next best price. Sometimes this is $.01, other times $1, or more.
For this reason, savvy traders estimate slippage based on the liquidity of the stock. They take smaller positions if they anticipate large slippage upon exit. Controlling losses is the first of foremost rule of profitable speculation. Stop loss orders are specifically made for this purpose.
Stop loss orders save traders from themselves. They take the emotion out of active trades. An old saying goes, “Stops in, emotions out.” They help traders by minimizing losses, or locking in certain profit.