Using Stop Orders to Enter Positions

March 31, 2009 07:00 PM

Rick has been involved in various aspects of the futures and options markets, including positions as an economist and derivatives market analyst at the Bank of Canada and Finex. In 1996, he founded World Link Futures Inc. to serve the beginning futures trader.

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.

About the Author
Rick Thachuk is president of WLF Futures, Options & Forex Education Network. Contact him via