Stop Orders: When and Why
Given the volatility of today’s market, it has become increasingly more important for investors to have exit strategies in place. In order to maximize profits and minimize losses, it is in every trader’s best interest to be aware of risk management tools available to them. One of the simplest, yet overlooked risk management tools is the stop-loss order.
When are Stop orders used?
Before entering a trade, a trader should always know when they are entering and exiting the position. Typically stop-loss orders are used when implementing a short-term trading strategy. These autopilot-type orders reduce the need for a trader to monitor losses, and are therefore particularly helpful for traders to exit a position based on their risk parameters and not on emotion.
As cliché as it is to quote Warren Buffett, I feel that it is appropriate at this time. The Oracle of Omaha has been quoted saying “Rule #1: Never lose money. Rule # 2: Never forget rule #1.” These words of wisdom are true, yet many traders fail to follow them by allowing small losses to become larger losses because emotion influenced their strategy. Large losses can be avoided by having the proper stop-loss order in place. It is important to trade based upon what a stock is doing, not what you want it to do.
Although stop-loss orders offer crucial risk control to traders by reducing losses, they also increase the risk of getting out of a position too early. This is apparent when stocks are experiencing volatility, and was evident during the flash crash of 2010. When the market dropped 700 points in a matter of minutes, many traders took large losses because their stop orders were triggered. Long term holders of positions must be aware of the fact that when a stock goes against them, a stop-loss order may lock in losses. This does not allow the trader to evaluate the position, which may actually be a buying opportunity.
Fighting our instinct to become emotional about our money is a hard task overcome, so SpeedTrader offers many risk control tools to traders. As I said before these orders can reduce exposure to large losses but can also lock those losses in. It is important for a trader to recognize the most appropriate time to use stop-loss orders to cut losses and maximize profits.
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