A stop order can be used not only to limit a loss but also to lock in any accrued profit on a trade, and a trailing stop order can be a one-way ratchet to riches.
A stop order is one of the order types offered by most if not all online brokers. Contrary to popular belief, the attachment of a stop order to an already-open trade need not be limited to stopping a loss. As a way of stopping a loss, and ultimately securing a profit, a stop order is one of the most important tools in the trader’s toolbox.
What Are Stop Orders?
A regular stop order (also known as a stop-loss order) can be attached to an open “long” trade, to close the trade automatically if the price of the asset falls to a specified level, the idea being to bank a small loss before it becomes a big loss. A stop order attached to a profitable position can be set at a level that will lock in some of the accrued profit.
A trailing stop order can be set at a specified distance below the current price, and it will increase in line with a rising price — like a ratchet — to secure a lower loss or more profit as the position becomes more profitable.
A guaranteed stop order will definitely execute at the specified price level whereas a non-guaranteed stop order will not definitely do so, but this need not be a problem in a liquid market.
A stop order can also be attached to a “short trade” that profits when a price falls. In this case, the stop order would be placed above rather than below the current price, like this:
Stop order on a short trade (source: IG.com)
Should You Use Stop Orders Right Now?
Here is a real-life recent example of a stop order in action. It was on a Volatility Index trade, but this doesn’t really matter for the purposes of the example.
Soon after the trade was opened at a price of 19.24 (1), a protective stop order was set just below the level at which the price has found some support (2). If this support level was ever breached, the stop order would close the trade at a manageable loss before it became an unmanageable loss. Once the trade moved firmly into profit, the stop level was adjusted to the level shown at (3), which meant that henceforth £56 of the accrued £154 profit was secured.
A stop order scenario when trading the volatility index (source: IG.com)
Note that this demonstrates a manually trailed stop order; a “trailing stop order” would achieve the same aim automatically.
Stop Orders and Price Targets
The whole point of a stop order is to close a long trade when the price falls to a specified target price or to close a short trade when the price rises to a specified target price.
Where Can You Use Stop Orders Today?
Most if not all online brokers let you use stop orders, including these two brokers:
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