This is the long awaited continuation post of my explanation of the basics of trading.
I will now explain stops, limit stops, and trailing stops.
Stops are an important tool for protect your gains. When a stop order is put in in combination of a buy or short trade it simply protects or realizes your profits from said trade. Stops can only be put below the current market price if you are long or above the current market price if you are short.
Let’s say you bought WFC at $10.00 and it went up to $15.00. You think the price could go higher but you are afraid of losing the profit you’ve already made. You can but a sell stop order at $14.00 in which case you will automatically exit your position if it hits that price. In other words you have already realized your $4.00 in profit and you are betting for even more.
Short positions work the same way in reverse. If you shorted WFC at $20.00 and it goes down to $10.00. You will want to put a stop $11.00 to protect your profits. It should be noted that when shorting positions you have an unlimited loss potential so you should ALWAYS use stops. If you enter your position at $20.00 make sure you immediately put in a stop at whatever level you are comfortable at, for there’s no telling how high the stock could go. In a buy order the lowest you can go is $0, there is no ceiling for short orders – the sky’s the limit.
Now stop limit orders are interesting, I haven’t used them yet. They are a combination of a stop and a limit order. If you bought WFC at $10.00 and after doing your analysis you think that if it reaches $15.00 it has the potential of going much higher. The way it works is that the limit price – let’s say $15.00 will activate a sell stop order at another set price, say $14.00. If the price never reaches $15.00, the stop will not be put in. The same goes for shorting – in reverse or course.
Stop limits are particularly useful if you do not have time to actively check your stocks every day. They offer a different dimention of protection.
Finally, Trailing Stops are progressive stop orders which move along with the price. Again we are long WFC at $10.00 and it’s on it’s way to $15.00. Say it’s at $14.50 at this point and going up – but you do not have full confidence it will make it to $15.00. You can put in a sell trailing stop order at $14.75 in which the security will begin to sell at that price and continue changing the price along with it’s movement. You will see sales at $14.50, $14.55, $14.60 and so on. My understanding is that these can backfire quite easily and should be closely monitored.
This concludes the explanation of the basics. Now I can pass on to the fun stuff. Coming up will be technical indicators and chart patterns – the tools that will give you an edge.