How to Devise an Effective Order-Entry Strategy in Trading - dummies

How to Devise an Effective Order-Entry Strategy in Trading

By Michael Griffis, Lita Epstein

During trading hours, you can be reasonably confident that a market order will be filled at or near current market prices. But if you’re like most people, you won’t spend all your time watching the market. As such, you need another strategy for entering and exiting positions. You can use one or more of several alternative approaches to better control the terms and prices that you’re willing to accept.

How to use limit orders

If you’re buying a stock, choose the maximum price that you’re willing to pay, and pay no more. That means you will use limit orders, which enable you to set the highest price that you’re willing to pay for a stock, making that your limit price. If you’re selling short, choose the lowest price at which you’re willing to sell, and set that as your limit price.

Limit orders are effective for opening a position, but they’re problematic for exiting a position. For example, if you need to exit your position because the breakout has failed, you simply need to exit the position without trying to finesse the price. Failed trades recover infrequently, and they often get worse. You have no reason to be patient when things are going against you.

Similarly, whenever you have a profitable trade and you’re trying to protect your profits, a limit order rarely is your best choice for exiting the position. You’re better off exiting the position by using either a market order or a stop order after you’ve identified a reversal pattern.

How to use stop orders and stop-limit orders to enter a trade

Stops can be effective for opening a position. If you identify the stock that you want prior to an actual breakout, you can enter a buy stop at a price above the breakout point. These orders can be entered on a GTC basis, so that even if the trading range lasts a while, your order is poised to trigger a transaction whenever the breakout occurs.

Most brokers limit the length of time orders can remain open, so make sure you know your broker’s GTC policies and remember that NASDAQ doesn’t have provisions for handling stop orders. If you’re trying to use stops when trading NASDAQ stocks, your broker must provide the mechanism for triggering these trades when your stop price is hit. Make sure your broker can handle the stop orders you want to use.

The downside to this approach is obvious — you’re unable to confirm the breakout. If the breakout fails and you’ve triggered a buy order on the breakout, you now hold a position that’s losing money.

Although it is generally recommended that you wait a few days to confirm the breakout, using this strategy at times may be more appropriate than others.

For example, if you’re convinced that the market is in a bull market phase, the stock’s trading range is long and tight, and you can identify an obvious breakout, then entering a GTC buy stop order at a price that’s a bit higher than the breakout price is probably okay.

However, you need to be much more tentative when the market is only in a bullish transition or pullback phase, or when you’re monitoring second and subsequent breakouts. When that’s the case, make sure the breakout is confirmed — that means the stock remains above its breakout price for a bullish breakout — within a few days before entering your order. If you have any doubt, wait for confirmation.

Another problem with this approach is that after the stop price is reached, your order is triggered and it becomes a market order to buy or sell. You’re in the exact situation you’d be in if you’d entered a market order while the market was closed. You have no control over the fill price after your stop is triggered.

For example, say the stock price gaps higher as it breaks out of its trading range and surpasses your stop price by two or three dollars. Your order is triggered and will likely be filled at a price that’s much higher than your stop price, and much higher than you had anticipated. If the stock price falls below your fill price, you’re now holding a losing position.

The only way to avoid this problem is by using a stop-limit order, which means when your stop price triggers the release of your order, the order becomes a limit order rather than a market order and is filled only if the stock price pulls back below your limit price. Again, remember to confirm that your broker permits stop-limit orders on NASDAQ stocks.

You can also use a stop order or a stop-limit order to open a short position. You specify a sell stop or a sell stop-limit order while designating your trade as a short sale. Again, you must confirm that your broker supports these types of orders for NASDAQ stocks.

How to use stop orders to exit positions

After your buy or sell order is filled, you need to enter your stop-loss instructions. You need to protect your open positions and simultaneously stay clear of short-term traders trying to run the stops. Running the stops is a little game played by short-term traders where they try to find and execute open stop orders before driving the stock price in the other direction.

It can be lucrative for them and infuriating and expensive, for you. You can try to avoid being run over when they’re running the stops by keeping your stop prices away from the most obvious location. For example, if a breakout occurs at $35.75, don’t put your stop-loss one cent below at $35.74. Move down a few cents, to $35.69, or even $35.63, to stay away from obvious stop-loss spots.