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Home > Education Center
> Using Stop Orders to Enter Positions Using
Stop Orders to Enter Positions
Article By Rick
Thachuk
World Link Futures
A stop order is a type of contingent order that instructs
the floor broker to buy or sell if the market price moves to a certain point, that point
being the stop price. Stop orders are known for their value as a risk managementtool. An
open futures or options position can be protected with a stop order. If prices move
unfavorably (to the stop price), then the stop order is executed and the open position is
closed, thereby ending any further loss on the position.
A customer who purchased one August gold futures contract
at $285, for example, might enter a stop order to sell one August gold futures at $275. If
gold prices decline to the stop price of $275, then the stop order will be executed and
the long position will be closed. Using stop orders for the purpose of risk management is
emphasized in introductory investment books and most beginners are aware of it. However, I
have found that many beginning traders are unaware that stop orders also can be used to
enter a new position.
Why would you use a stop order to enter a new
position?
Consider the case of a commodity that has been trading within a range of 80 to
100 for the last several weeks. The trader believes that if the commodity breaks out to
105, it will continue to rally to 125. But if the commodity breaks below to 75, it will
continue to decline to 55. Many beginners erroneously believe that a limit order or a
market-if-touched order are the proper types of orders to use in these cases. They are
not. The proper order to use is the stop order. It's a good idea for beginners to paper
trade for a while until they fully understand how these various orders work or, if trading
for real, establish a broker-assisted trading account to avoid costly errors associated
with incorrect order usage.
For the example above, the trader should enter a
good-till-canceled stop order to buy at 105 and a good-till-canceled stop order to sell at
75. In the former case, if the market rallies to 105, then the stop order will be executed
and the trader will be long the contract. At this point, the trader should cancel the
outstanding stop order to sell at 75. In the latter case, if the market declines to 75,
then the stop order will be executed and the trader will be short the contract. At this
point, the trader should cancel the outstanding stop order to buy at 105. Finally, note
that once a trader has a position, he then should use a protective stop order in the same
manner as was described in the opening paragraph.
Using stop orders to enter a position is ideal for trading
strategies that rely on contracts breaking out of a price range. Since many contracts
spend a good deal of time range trading before resuming or continuing a trend, a trader
will find many opportunities for using stop orders in this manner. In fact, a trader may
have several stop orders working for him at any given time. As markets break out of their
trading range, positions will be established as stop orders are filled. This way a trader
does not have to watch prices all day to wait and see a breakout move. The stop order is
in place already and will be executed if the movement occurs. |
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