In recent weeks, I have written about risk and included concepts like protective puts and stop loss orders as ways a trader might endeavor to cut losses in the event a position moves against her. The articles sparked a question from a subscriber who wanted to know about the difference between stop loss and stop limit orders and how the two might be used by a trader.

The stop loss order is an order to a broker that says if a stock hits a specific price the position is to be closed at the market. Suppose, for example, that we own shares of XYZ trading at $25 a share and we see a support around $24.25. If the stock goes below $24.25, it has broken support and is no longer showing the bullishness for which we initially bought the stock. In such a circumstance we might place a stop loss order at $24.20 thereby instructing our broker to sell our shares in the event XYZ hits $24.20 OR BELOW. Once the stock price hits $24.20 or below, our order goes to the market as a market order. I emphasize the "or below" part because there are times when a stock may gap down and never touch our stop. In the XYZ example, suppose, for example, that the stock closes at $25 a share today and that this evening it announces unexpectedly poor earnings. Tomorrow, the stock opens at $23 a share. Well, it didn't hit our stop price at $24.20, but passed right over it. In that event, our stop is activated, the sell at the market order goes to the floor, and we are sold out of the position at the market which is now around $23. While we did not get the $24.20 we might have expected, but, quite importantly, we are out of the position and that might not be a bad thing since the stock is falling sharply and we want to cut losses.

Instead of utilizing a stop loss order, we might have chosen a stop limit order. Actually a stop limit order is two separate orders combined into one. The first part, the stop is the same as I described in the preceding paragraph. The second part is the limit which places a limit on what we are willing to take. Using the XYZ example, above, we might place a stop limit with a stop at $24.20, limit, $24. Now, we have instructed our broker to sell our shares if the price hits $24.20 or below, but only if we can get $24 or better. In the situation where the stock gaps down the following morning, our stop would be hit because the price is now at $23, well below our stop, but we would not be sold out of the position because our order was to sell at a limit of $24.20 and since the stock is selling well below our limit, we would not be filled and would still own the falling stock. In general, then, if we are placing a stop so we can get out of a position that is moving adversely, we would probably want to use a stop loss rather than a stop limit order.

When might we want to use a stop limit order? Perhaps, if we saw a stock that was dealing with a resistance and we wanted to buy shares, but only if it broke above that resistance. Let's say ABC has been trading in a range between $14 and $16 a share and we saw a triple top resistance at $16. If the stock breaks through that resistance, we might want to own shares, but we would like to get in fast on that break above $16. In such circumstances, we might choose to place a buy stop limit order. The order might be buy stop at $16.10, limit $16.50. By that order, we have instructed the broker to place a limit order to buy the stock at $16.75 or better, but only if the stock hit $16.10 or higher. In that event, if the stock broke resistance and hit our stop number, our limit order would go to the floor, and we would buy the stock provided it was at or below our limit of $16.75. Such an order would prevent the situation where the stock broke above resistance, but rocketed past a price at which we were willing to buy.

As you can see, these orders, used properly, can be very valuable additions to a trader's arsenal. In "Trade Your Way to Wealth" , I discuss in detail a number of important orders available to the trader that can be used to help control losses and to protect gains. Knowledge of available orders can be extremely helpful to the trader and I often use them in my own trading.

Good Trading!
Bill Kraft

Our Success Trading service delivers quality trading ideas for the elite investor that has the financial wherewithal and market nimbleness to profit on small moves in a stock's price. Become a member and you will be provided with email and/or mobile alerts intended to provide you with the opportunity to make many, many profitable trades.

Here is a play from the Success Trading Group:

AT&T, Inc. (T)
We like AT&T (Ticker: T) at $25.60 for a new trade position. We have several more stocks on our radar and are looking forward to trading next week.

Have a great weekend and we'll trade next week.
Success Trading Group Team

Our Option Trading Service is for conservative traders that understand leverage principles and enjoy the challenge of options trading. We focus on powerful option trading strategies that place volatility and momentum in your favor. And we pride ourselves on always minimizing our losses!

The Option Trader service utilizes standard trading in Puts and Calls as well as strategies using Leaps, Straddles, Credit Spreads, Calendar Spreads, and Naked Puts. But no matter how sophisticated a strategy may be, we ALWAYS know our downside potential on every trade.

Here's a look at a trade Bill is currently working on:

Halliburton Company (HAL)
HAL remains in an uptrend and bounced up off the trend line on Friday. I am looking at the possibility of buying some LEAPS calls on bounces off the trendline such as the one that just occurred. It looks like HAL is in an uptrending channel so one thing I will consider is buying the LEAPS calls on a bounce off the lower channel line and selling at a bounce down from the upper channel boundary.

Good Trading!
Bill Kraft
Editor of $10 Trader, Option Trader and Trend Trader
"Trade Your Way to Wealth" by Bill Kraft is an Amazon.com best seller!
"Smart Investors Money Machine" is Bill Kraft's most recent publication.
"Trading for Keeps: Making Money with Low Risk Option Trades" a trading DVD by Bill Kraft