Stops, Limits and Market Orders and Other Tools of the Trade
The Mechanics of the Trading Process
Now that you have decided to manage your own portfolio, you need to be your own mechanic. Just like working on your own car there are certain tools of the trade you need to understand and the better you are at working with these tools the more you will be able to keep your portfolio running like a fine tuned engine.
Before We Start
I have been out of the trading business for a while tending to some personal issues so this “returning to the fundamentals” is as much for you as it is for me.
I am going to present this exactly as I went about setting up my own trading portfolio after being out of the market since 2008. I was a very active trader from about 2004 through 2008 and had learned the “tricks of the trade” well enough to be earning an average of $1,000 per day in the market.
As previously reported, however, I made some bad trades, got on the wrong side of the market and lost everything. I now have a new nest egg to manage and need to relearn the fundamentals. Just like getting back on a bicycle after not having ridden one for many years, there will be some bumps and bruises but I intend to wear a helmet and encourage you to do the same. Start slow, avoid the curves but do get back on the bike and build your portfolio back to where it was before the collapse of 2008.
So here goes, trading 101:
Choosing a Broker and Opening an Online Account – There are several very good options available and it is worthwhile to check out the features and benefits of each one before making your final selection. For a beginning trader, I recommend one of the following three options because they provide all the basis tools you need to get started and are price competitive. They also offer some free trades to get you started. Any one of these most popular discount brokers is fine or if you prefer you can go with the online version of one of the big houses. Google discount brokers or online brokers and you’ll find plenty of information to help you decide.
- TD Ameritrade
Funding Your Account – How much to put into your active portfolio
- Allocation Strategy – Make sure you have a plan for how much you intend to put into the market and stay with your plan. For a younger person who is looking primarily for growth, you can put more money into the market than someone like me who needs to protect by base at all costs.
- Liquidity – Make sure you keep enough money in cash to cover at least 6-9 months of living expenses. If you don’t have that money available, then you probably should not be getting involved in trading in the first place.
- The Actual Process – the brokerage companies make this very easy. You can send them a check or you can simply authorize and electronic funds transfer from your bank account. I prefer the latter because it is faster and easier.
Placing the Trade
- Market Orders – DON’T – A market order means you are at the mercy of your broker, the market and the online trader. The order will fill at whatever level is available and there can often spell disaster. Your order could split to multiple price levels and not execute at the price you expected.
- Limit Orders – With a limit order, you are telling your broker to place an order at a set price or below. Your order is routed to the Limit Order Book to be matched. Everyone in the market can see your order. The primary benefit of a Limit Order is that you are guaranteed to only trade at a given price. You know what price you'll buy or sell at. The risk in a limit order is that in a fast moving market, your limit order may not hit. For example, if your target security is currently trading at $85 and you put in a limit order to sell at $84 just below the market, it may not come back to $84 and you will miss the market because your order will not execute.
- Stop Orders – A stop order turns into a market order when the last traded price touches the stop price. With a stop order, you are telling your broker that when the stock hits a specified price (your stop), executive it immediately at whatever price they can get for it. Your stop order is not published to the market until it hits the stop price - it stays on the brokerage books until then. (It does not get published out to the market).You use a stop order to cut your losses if a stock suddenly turns against you or the market crashes. You are essentially saying, get me out NOW at whatever price you can get for this pig. On the other hand, you risk being” taken out” if there is a temporary pull back and then the stock returns to its normal level later on in the trading cycle. Traders call this “getting stopped out.” Market makers and hedge funds often move the market to take out a large number of stops. That is why you see swings during the day.
- Stop Limits offer the best of both worlds and how I do most of my trades. Simply put, a stop limit order turns into a limit order when the last traded price is the stop price. With a stop limit order, you tell your broker to execute the trade only IF the last traded price for your target stock is at your specified strike price. The main benefit of a stop limit order is similar to the stop order in that you know exactly at what price the trade will execute.The risk is the also similar in that you don’t know if the order will execute or not and you may again “miss the market” if a stock makes a sudden mover in one direction or another.
Now that you have the tool box filled, it’s time to enter the game. Remember to watch your back at all times and the fundamental rule of the game – The other guy is trying to take your money, all of it and they have better tools, more experience and are more ruthless than anyone you would ever care to meet.