Published Tuesday, December 22, 2015 at: 7:00 AM EST
Sometimes, even for stock traders, the best offense is a good defense. For instance, a "stop order" can be a useful way to slam the brakes on potential losses, especially when the stock market is showing volatility. However, a stop order isn't foolproof. It also could trigger a loss greater than you expected or close the door on future appreciation.
There are three basic types of stop orders: regular stop orders, stop-limit orders, and trailing stop orders.
1. Regular stop orders. A basic stop order works pretty much the way the term implies. All you do is specify a price at which you would want to sell a stock if the price is falling. If the stock never reaches that point, nothing happens and you continue to hold the stock until you otherwise choose to sell it. If the selling point is reached, an order is placed to sell the stock at the next best available price.
But this doesn't provide absolute protection in a rapidly declining market. If the downward trend is gradual, your sale likely will be consummated at a price close to the specified sales point. However, if the decline is rapid, the actual sale price may be considerably lower.
To avoid having a stop price that's too low to lock in recent profits, you can cancel the stop order and resubmit it at a higher price. That situation is one reason stop orders need to be reviewed periodically.
2. Stop-limit orders. With this variation, you can set a "floor" on your order. In this case, there are two critical price points: the stop price and the limit price. Just as with a normal stop order, once the stop price is reached, an order will be placed to sell—but only at the limit price or higher. If the next available price is lower than the limit price, your order won't be executed.
Although a stop-limit order protects you in case the stock drops below a certain price, there's a chance the sale won't be carried out. So the order provides price protection but not execution protection. As with regular stop orders, it makes sense to review stop-limit orders in a rising market, adjusting them upward if necessary.
3. Trailing stop orders. The third type of stop order is yet another variation on the same theme. In this case, the order is adjusted as the price of the stock increases, eliminating the need for canceling and resubmitting the order the way you have to do with a regular stop order or a stop-limit order. The adjustment is automatic.
Once a stock price stops rising and begins to fall, the stop price freezes at the highest possible point. If the stock declines past that point, the order is executed, just like a regular stop order. Unlike a stop-limit order, this technique provides execution protection.
Obviously, one of the key components of stop orders is setting the best price points for your situation, taking all of the relevant factors into account. For instance, an astute pricing strategy may protect you from a decline in price while giving you plenty of leeway to get through the inevitable ups and downs.
The pricing strategy ultimately depends on your personal comfort level. In other words, how much are you willing to risk before you're forced to walk away and lick your wounds? It depends on your personal risk tolerance, but some stock market experts have advocated use of a strict percentage method. For instance, you might set the stop order price at 5% or 10% below the current price.
Another factor is the volatility of a specific stock. If you're holding a stock that has fluctuated widely of late, you may not want to set a stop order too close to the current price; a temporary drop could mean that you lose a stock that may rebound quickly. For example, if the stock price has fluctuated regularly by 5% in a matter of days or weeks, setting a stop loss at only 5% below the current price may not be practical. But if it has been more than a year, say, since the price moved that much, a stop order 5% below the current price might be make sense.
Stop orders can be valuable tools in managing risk and keeping losses to a minimum in a volatile market. But if you decide to go ahead and use one or more of these three kinds of stop orders, consider the pricing strategies outlined here. We can provide the guidance you need.
This article was written by a professional financial journalist for Advisor Products and is not intended as legal or investment advice.