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Wednesday, September 3, 2008

Swing Trading - How to Use Stop Orders to Boost Returns

Sell Stop

A sell stop order is an order to sell a stock at a predetermined price that is below the market. For example, if a stock is currently trading at $25.00, a sell stop may be entered at $24.00. Once the stock trades at $24.00, your stop becomes a market order and may be executed at, above, or below $24.00 - depending on market conditions.

The most typical uses of sell stop orders are to protect profits or limit losses. When you first buy a stock, determine how much you are willing to lose on the trade, and enter a sell stop below your purchase price. Depending on your style, it may be 2%, 3%, 5% or 10% below your buy. As your stock advances, protect your profit by moving up the sell stop price.

Since most buy prices are arbitrary (i.e. not based on any scientific formula), so are the stops calculated as a percentage of them. It is much more important to buy right than to have the "right" percentage stop loss.

Another pretty useless feature in my opinion is trailing stops - stops that are adjusted with the market price of the stock. If you place your stop too tightly or incorrectly you are running the risk of being stopped out of a rising stock on a pullback only to watch it climb right back up. It is much more practical to use logical stops, i.e. stops placed right under certain logical levels below which the stock is highly unlikely to go. Percentage wise, logical stops may be larger but you are less likely to get whipsawed. Besides, if a stock violates a logical stop it is likely indicating that something is wrong and the advance may be over.

Buy Stop

A buy stop order is an order to buy a stock at a predetermined price that is above the market. For example, if a stock is currently trading at $44.00, a buy stop may be entered at $45.00. Once the stock trades at $45.00, your stop becomes a market order and may be executed at, above, or below $45.00 - depending on market conditions.

The most typical uses of buy stops are to protect short positions or buy breakouts.

Protecting short positions works in reverse of protecting your buys: you place a buy stop above the market to limit your loss if your short moves against you.

Using buy stops to buy breakouts

It is not advisable to place GTC (good till cancel) buy stop orders when buying breakouts. An after-hours announcement may cause a stock to gap up at the open. If you enter a buy stop at, say, $45.00 and the stock opens at $60.00, your order will be executed at the market. If the gap up is excessive and begins to fade, your purchase may be at the high of day, leaving you with an instant loss.

However, you can use intraday buy stops to buy breakouts. Once you see where a stock opens, there are two key ingredients to watch for: price and volume. If you are satisfied with the volume but cannot watch the price throughout the day, place a buy stop 10 cents above the pivot.

Stop Limit Orders

Your stop order becomes a market order once the stop price is triggered. In a fast moving stock, your buy or sell may be executed significantly above or below the price you entered. To protect yourself, you may use a buy (or sell) stop limit order.

A sell stop limit order has two components: a trigger - a stop price at which your stop becomes a market order and a limit price below which you don't want to go. For example, a sell stop $26.00 limit $25.00 means that if the stock trades down to $26.00 you want to sell but will only do so as long as the price remains at or above $25.00 (selling at $25.00 or better).

A buy stop $46.00 limit $47.00 means that if the stock trades up to $46.00 you want to buy but will only do so as long as the price remains at or below $47.00 (buying at $47.00 or better). Using stop limit orders can protect you against excessive gaps (up or down) but may also leave you behind if the stock trades just a few pennies outside your limit.

Slav Fedorov is a full time stock trader and founder and managing member of TradingZoom, LLC - a provider of proprietary trading data that swing traders can put to work right away. http://www.tradingzoom.com/

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