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Some Not-So-Great Tips for Using Stop Orders

Stock Trading to Go posted 10 Great Tips For Using Stop Loss Orders Successfully the other day. I’ll give the listing a middle grade. There are some good suggestions, but there’s also some stuff which range from perhaps too narrowly focused for general use all the way to just completely wrong.

First of all, I don’t agree with the idea put forth before the list of tips that stops are like insurance. Insurance makes you whole on losses suffered. Stops only provide a measure of assurance that they don’t get too large.

Here are the tips I’m good with:

2. Watch for hidden fees.
3. Never assume a stop loss order has been filled successfully.
6. New investors should use only stop market orders.
7. Use stop loss orders to setup a profit vs loss ratio.

In the case of #2, it’s a case where some brokers charge extra for non-market orders. And of course traders should always confirm all order entries and executions, which is #3.

In terms of #6, the comparison is against stop limit orders, which is where when a stop price is reached a limit order is activated rather than a regular market order. The difference is that a limit order will only be executed at the specified price or better. That means your order may not get filled, which you absolutely don’t want happening.

As for #7, I’ll go along with stops enforcing discipline and can help to better trade selection.

Now here are the ones I take issue with.

1. Never use stop loss orders for active trading.
4. For the original placement always give the stock at least 5% of space to avoid market maker abuse.
5. Don’t use stop loss orders for large positions.
8. Keep an eye out for after hours trading gaps.
9. Set the trigger price at common price increments.
10. Use with stocks that have high average daily volume.

Long-time readers of this blog know that I am not a fan of anyone using always or never in terms of trading rules, so you can guess my reaction to #1. That aside, the author is suggesting that because you’re in front of the screen watching the market you don’t need the stop. My contention is that stops help enforce discipline, and what happens if you are distracted by something while you’re trade is on?

Tip #4 is one that doesn’t fit many people’s trading. Short term traders, for example, may never expose themselves to a contrary move that large. I do, however, agree that stops should account for normal volatility.

Now for the really big problem for which I’m going to lump tips #5, #8, #9, and #10 together because they are all based on the same error in understanding. It’s one that appeared in the prior post that’s referenced at the outset of this one. The blogger is under the mistaken belief that a stop order will not get activated unless the market specifically trades at the order price. That is just flat out wrong, as this Investopedia definition indicates (italics mine):

What Does Stop Order Mean?
An order to buy or sell a security when its price surpasses a particular point, thus ensuring a greater probability of achieving a predetermined entry or exit price, limiting the investor’s loss or locking in his or her profit. Once the price surpasses the predefined entry/exit point, the stop order becomes a market order.

I tried to correct the blog author via comment when I saw the initial error, but it never went through (apparently). That site is one with a pretty large amount of traffic, suggesting the perception of authority, so I’m really surprised to see that kind of error being made.