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Stop Loss Orders in Stock Trading
from: Maxx Trading GuidesTo use a stop loss order, you must totally understand market orders so you don't get confused. A market order is simply instructions from your stockbroker to either buy or sell a certain stock. When a stop loss order is placed, it instantly becomes a market order when a pre-determined price is reached. At that point, the usual rules of a market order take effect, which mean the order is more likely than not going to be executed.
The gamble is that you don't know the price. Since you've set a predetermined price, and the stock has reached that point, it doesn't guarantee that by the time a stop loss order is placed it will be at the price you've predetermined. Here's the tricky part of a stop loss order: your stock may reach your price, however, due to the stock market's ongoing fluctuation, by the time the stop loss order is placed, the price may have increase or decreased.
Most investors use a stop loss order in two different situations. First, he may use a stop loss order to reduce the amount of loss he may suffer. Let's say you've purchased 500 shares of stock from Target, a discount store chain, and at the time of purchase you place a stop loss order on the total amount of stocks. You then predetermine that you won't sell any of your 500 shares from Target until it gives you a total profit 75% higher than the purchase price.
Let's assum the 500 shares from Target cost $95 each, for a total of $47,500. Based on your projection, you're not allowed to sell these stocks until you make a total profit of $78,375. So, after 5 months of owning 500 shares of stock from Target, you earn that total profit and you sell your 500 shares of stock from Target, however, by the time the transaction occurs, each stock drops in profit by 25%, therefore, you just saved yourself from losing a return on your investment.
The second reason an investor may choose to place a stop loss order is to protect their profit. As the investor, you've decided you're only willing to lose a certain amount of your initial investment, so you place a stop loss order on your purchase.
For example, you decide to buy 25 shares of stock in Company X priced at $1.00 each, for a total investment of only $25.00. You set up a stop loss order on this stock purchase by deciding you're only willing to lose 20% of the original investment. Therefore, if the stocks go down in price and you've lost $6.25 on the original investment, you're able to sell you stock to ensure that you don't lose any more profit due to the decreasing price of the shares.
The main advantage of the stop loss order is that you don't have to monitor your purchase on a daily basis. Since you've set a predetermined amount, when it's reached, the action of buying or selling takes place. Therefore, if you hold a demanding full time career and you don't have time to watch the stock market every day to keep up with each of your purchased stocks, this can save you from a major loss if one of investments drops drastically in price.
However, the main disadvantage is that when your stop price is reached, buying or selling takes place, even if you've changed your mind and you want the investment to remain the same. This can be detrimental if a stock has shown no losses over a period of time. An example would be if you purchased 30 shares of stock from Company V and you place a stop loss order on it at the time of purchase.
As time goes by, you discover that Company V's stock has shown no losses but has instead had a steady gain. However, the stock has reached the stop price, so you must now sell a profitable stock. This means that in the long-run, because you had no choice but to sell this particular stock, you're losing money on your investment.
This stop loss order can provide a huge saving of your profits, however, if you use this when it really isn't necessary, you could end up losing more money than you have gained.
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