Thursday, 17 December 2009

Stop Orders FAQ

If you're thinking about using Stop Orders in your trading or investment strategy, you might find the following list of Frequently Asked Questions (FAQ) -- and answers -- useful as a starting point:

Q: What is a Stop Order?

A: An order that executes at some future time when the price of a financial instrument falls to the level you specify (Stop Order to Sell) or rises to the level you specify (Stop Order to Buy).

Q: Doesn't this mean buying or selling at a price less favourable than the current market price?

A: Yes, but the theory is that a falling price is likely to keep falling and a rising price is likely to keep rising. The market price will become more and more unfavourable, and so it's better to get out as soon as the price starts to become unfavourable.

Q: What can you achieve using a Stop Order?

A: You can buy at the onset of an uptrend or sell at the onset of a downtrend; you can "stop a loss" before it becomes unacceptable, or you can "lock-in" some profit without prematurely closing a position.

Q: What is a Trailing Stop Order?

A: A stop order that moves automatically, or which you adjust manually, to trail a rising or falling price. It allows you to secure an increasing amount of profit on a profitable position, or establish a new position at an increasingly favourable price.

Q: What kinds of traders use Stop Orders?

A: Day Traders might use Stop Orders to close a position quickly if it goes the wrong way. Swing Traders might use Stop Orders as protection in case the price moves out of its recent trading range. Position Traders might use Stop Orders to "lock-in" long-term profits, and investors might use them as an if-all-else-fails safety net.

Q: Which financial instruments support Stop Orders?

A: This is broker-specific, but typically all positions established in Spread Betting or CFD (Contracts for Difference) accounts allow Stop Orders. Equity and Index ETF (Exchange Traded Funds) positions in regular brokerage accounts typically allow Stop Orders. Fund Managers typically do not allow Stop Orders on their funds.

Q: Are there any dangers in using Stop Orders?

A: The main problem is that sometimes prices "gap" up or down, so your Stop Order executes at a worse price than the price you set. Opening and closing positions frequently using Stop Orders can lead to whipsaw losses.

More Questions

There are many more questions that are too complex to answer here in brief; such as "How close to the current price should a stop order by placed?" and "How can you combine Stop Orders with Position Sizing in order to manage risk?". You will find answers to those question in the book.

1 comment:

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