Risk vs. Reward is one of the most important concepts when it comes to our trading. It is important to realize that when we are trading, we are not gambling. Our trading revolves around calculated risks that will make us successful in the long run. It is a beautiful thing that when we trade, we only need to be right on the movement of the stock 40-50% of the time to come out with profit in the long-run. Do not be discouraged if every trade you make does not come out as a winner because you will soon realize that that is not how trading works. To protect ourselves, we have a set of rules for you to put in place when you are trading. They are called stops.
A stop order, also referred to as a stop-loss order, is an order to buy or sell a stock once the price of the stock reaches a specified price, known as the stop price. When the stop price is reached, a stop order becomes a market order. This means it will be executed. We will primarily deal in sell stop orders. A sell stop order is entered at a stop price below the current market price (below the price you bought the stock at). We will use sell stop orders to limit a loss or to protect a profit on a stock that we own. Stop orders are to be strictly followed to ensure that we are not gambling, but trading. When we buy a stock, we will always set a 3% stop right away below the price we bought the stock at. For example, if we buy one share of Facebook at $50, we will stop our stop at $48.50 to make sure that we lose no more than $1.50 on this particular trade (or 3%). If we buy our share of Facebook and the price gets down to $48.50, we will be stopped out of the trade. No questions asked. When we start to trade without stops, we expose ourselves to more risk than we should. Now that we have gone over how to cover our losses, we must also learn how to take profits.
We also have rules for taking profits. A common struggle that beginning traders deal with is when to get out after making a profit in the stock. When we buy shares in a stock, we are looking to make at least 10% on the trade. If we buy one share of Facebook at $50, we are looking to make no less than $5. Just because we are looking to make no less than $5 doesn’t mean that we can’t make any profit even if the stock has reached $55. Let’s say that after a few days of trading, our Facebook share has reached $55. Now that we have reached $5 of profit on paper, meaning we haven’t technically made anything yet because we still own the share and don’t make the profit until we sell it, we will set a 3% trailing stop on our position. A trailing stop works similarly to a regular with one minor difference. A trailing stop order can be set at a defined percentage away from a security’s current market price. This means that if we set a 3% trailing stop on our Facebook position, the stop will move upward as the price of our Facebook share continues to rise. However the trailing stop will not move downward if the price of our Facebook share moves downward. Here’s an example of how that would work. When Facebook hits $55, we will implement our 3% trailing stop which means that the price our stop would be set at would be $53.35 (3% below $55). If Facebook climbs to $56, our stop would move with the price of the stock to $54.32. Our stop is solidly set at $54.32 and will never move any lower than that. Let’s say the next day that Facebook drops to $54 a share. If you realized that we will now be out of our position, you would be correct. With our trailing stop of 3%, we would have been stopped out at $54.32 and ended up making $4.32 on the trade. The trailing stop takes all of the emotion out of taking profits for us which is a good thing. Whenever we make a trade, we must immediately set a stop. If we stick to our rules regarding stops, we will be successful.