Risk management is where most traders fail!
Often people seem to forget that being a trader involves being a risk manager and handle the financial risks involved in trading stocks, options or any other financial instrument.
In order to keep such risk under control, you must be aware of an arsenal of risk management tools and fully understand when and how to use them properly.
Here I am going to explain some of the stocks and options trading risk management tools and how to set them up in order to trade safely.
Risk Management and Stop Orders
The so-called stop orders are tools used by investors worldwide to either limit losses or lock in profits. The main idea behind stop orders is the opportunity for traders to exactly identify points of exit from a position (stop losses or take profits) before entering a trade. Setting stop orders at identified price levels below and above the entry point may result in a simple, yet effective strategy if performed systematically.
Sadly, most traders do not respect such target points giving up to their feelings and emotions. This turns out to be the most popular reason why most traders who approach the financial markets fail.
To better understand how a stop order works, imagine you purchased a stock at $20 and decided to set a stop loss order at $18 in the first place. If the stock drops till $18.01 or rises above $20, the stop loss is not triggered and you can either hold your position or take your profit, whereas if the stock drops at or below $18 the system will follow the instruction you have previously given and a sell order will be automatically submitted.
The same example can be done to demonstrate take profits orders too. After doing all the calculations, let us suppose you decide to set a take profit at $25. When the stock rises at or above $25 an order will be automatically submitted allowing you to get the profit from your trade.
A word of caution is necessary here, in fact you need to be aware that stop orders do not necessarily prevent losses as stock prices fluctuate all the time and may gap far below the stop price. Think of the stop price as nothing more than an activation point. As a result, you are not guaranteed to lock in profits or limit losses just because using stops. These are tools traders can utilize, but have limitations.
Stop Market Orders (MKT) and Stop Limit Orders (LMT)
Basically, there are two main types of stop orders:
Stop orders at the market (MKT), which guarantee that your order will be executed, but cannot guarantee the price at which the order will be filled. Place these orders when you want either enter or exit a trade immediately regardless of the price.
Stop limit orders (LMT), which guarantee the price you receive, but cannot guarantee the order execution. Place these orders when interested in getting into the position only at a specific price.
How to place stop orders in ThinkorSwim
In order to perform stop orders in the ThinkorSwim platform by TD Ameritrade, go straight to the “trade” tab on the top left corner of the software and select the “all products” section.
Let’s imagine you purchased 100 shares of XYZ and now you want to place a stop order related to your trade. First of all, you will have to type in the “symbol” box the ticker you are interested in and then click enter.
Down below the “symbol” box, a menu will pop up with the three following options: underlying, trade grid, options. At the moment, you are interested only in the menu underlying in which you will find information related to the stock.
In the ThinkorSwim platform you can generate a buy order by clicking on the asking price and a sell order by clicking on the bidding price. As we are going to enter a stop sell order, left click on the bid price. You will see appearing the sell order down below on the “order entry tools” window.
If you look carefully at the heading of this window, you will see that the “order” menu on the right side is set by default as a limit order. By clicking on the option “limit”, a drop-down menu pops up with several different types of orders you can choose from: market, limit, stop, stop limit, trail stop, trail stop limit, moc, loc.
How to place stop orders at the market
Select a stop order from the drop-down menu and a second row will pop up in the “order entry tools” window. At this point, in the “price” section of your order you should read the following information:
Your order will be at the market (MKT);
You can set a stop price (STP) at which a sell order will be activated.
For example, imagine purchasing 100 shares of XYZ at $25 per share and placing a stop order at $23. In this particular case, just type in 23 from your keyboard and click enter. By doing so, your order to sell a certain number of XYZ shares at the market will be set and automatically submitted if the stock price drops at or below $23.
How to set up stop limit orders
Select a “StopLimit” order from the drop-down menu and a second row will pop up in the “order entry tools” window. In this case, the system will ask you the limit price at which you want your order to be submitted.
What is really important here is that you set the limit price in a way that it matches the stop price or even be a little bit lower just to allow yourself some room in case the stock price may be falling very quickly when that stop price is reached. In the previous example, you may consider setting your limit order at $22.50.
To sum up, you purchased 100 shares at $25 each and set a “StopLimit” order at $23 with a limit order at $22.50. With this instruction, the brokerage software knows that if your stop price at $23 or lower was ever reached it has to activate the order. However, in this case, it is going to submit a limit order trying to sell shares at $22.50 or higher. You must be aware that by submitting a limit order you do not have any guaranty that it will be filled.
The decision of choosing between a stop order and a stop limit order depends mainly on whether you wish or not to hold the shares. If you would rather get out from your position at any cost regardless of the price, choose a stop order at the market (MKT), instead if you would prefer to hold your shares below a certain price pick a stop limit order (LMT).
Stop orders and time in force (TIF)
Once chosen a stop order or a limit stop order, the next decision is related to the so called TIF or time in force.
The TIF is set at the day as default industry, but in order to place effective stop orders you have to change it in GTC (Good-till-Cancelled) so as to avoid that your order will be cancelled at the end of the day.
Once the order you desire is set, click on the “confirm and send” box on the right corner below. An “order confirmation” window comes up allowing you to check all the order details previously filled in.
After confirming the order, it will be “working” meaning that your brokerage firm is monitoring it and watching for the price. If and when the stock should ever trade at $23 or lower, ThinkorSwim will automatically submit a limit order trying to sell the shares at a price not lower than $22.50.