One thing that is certain in anyone’s trading career is losses.  Even the best traders lose money from time to time.  However, what the best traders have in common is that they are very professional losers.  Knowing how to lose properly is a must in a long and prosperous trading career.  The first thing to know is the proper use of protective stop orders, the second is proper position sizing and the last, but maybe most important tool, is to keep losses small.

Protective stop orders to a trader are as important as the oxygen tank is to the astronaut in outer space.  Without them and their proper use, you are in big trouble.  Protective stop orders in trading are meant to help limit your potential losses.  There is more than one type of protective stop order and it is very important that you understand the difference between them.

Stop Market Orders – This is an order to buy or sell once price touches a particular point.  Once price touches a pre-defined price, the order becomes a market order.  This type of order can be used to enter or exit positions.  Typically, this type of order is used for protection.  While execution of this order is typically guaranteed, the price of the order execution is not guaranteed because the order being triggered is a market order.  The benefit is that if price touches your stop price, the market order will take you out of the position.  The negative is that if the market is moving fast, you may see some slippage and not get filled at your order price.  This certainly is the ideal order however if your goal is to protect yourself.  As a trader, I always use this type of order for protection.

Stop Limit Orders – This type of order combines the features of a stop order with the features of a limit order.  Once a pre-defined stop price is reached, the stop limit order becomes a limit order to buy or sell at the limit price or better.  The benefit of this type of order is that the trader has control over the price the order will be executed at because it is “limited” to the stop price.  The negative factor with this type of order is that it does not in any way provide guaranteed protection, which is what most traders/investors want in a stop order.  For example, if you bought a stock at $41 and have a sell stop limit at $40.50 and price reached $40.50 but there are no buyers, the price will keep declining and your loss will grow with no protection.  In short, if you are looking for more guaranteed protection, the stop market order is a much better choice.  As a trader, I NEVER use a stop limit order for protection.

This is an excerpt from Apr 2009 issue of Trader's Journal. To view the complete article, please click here.