So, I hopped on a plane for Chicago, eager to learn everything I could about the stock market, at this high end trading school. I stayed at a very nice hotel near the lake, and the Chicago Board of Options Exchange, where the course would be taught. This area of Chicago was the nicest I had ever experienced in a big city. Immaculate streets, charming restaurants and cafes, friendly people. A far cry from the Chicago of today, with its appalling statistics of violent crimes.
The CBOE building was huge, with very high security, despite the fact that this was about three years before the horror of 9/11. I registered at the classroom, and took my seat with only six other students. The instructor gave us an outline of the course, then began to explain our failures and misconceptions. As he went on with numerous examples, we all groaned, knowing we had all made the mistakes and clung to foolish ideas. “Buy and hold” was a big one. Many of us had been taught to invest in “blue chip” (highest quality) stocks, and keep them indefinitely, because they would always go up. While that method may have worked at certain times, it could also be very dangerous. Some investors may have tried to protect themselves with “sell stops,” but these are far from foolproof, as you will see.
Stock trading was broken down into three types: Long term investing (buy and hold), where one bought stocks and forgot about them- with or without sell stops; “Position Trading,” where one would buy and hold stocks for a few days, maybe up to two weeks, usually but not necessarily with sell stops; And finally, “Day Trading,” where one would buy and sell a stock- or stock options- possibly within a few hours, but NEVER longer than one day, always with sell stops. Day trading was the vastly preferred method of this school, upon which our instruction was focused.
For one thing, one could never get into trouble if they got out of every stock by the end of the trading day. Let’s say you bought 1,000 shares of “XYZ” one morning, and it gradually was rising during the day. You are up ninety cents, or $900 profit. Your personal trading rules say you are to sell before the market closes; however, you are “confident” that in this instance it would be a mistake, because the stock “looks like it will continue to rise tomorrow,” so you hold it. To play it safe, you put a sell stop at the price where you will not make less than say, $.70 per share, or $700. That evening, a huge scandal at “XYZ Corp.” is revealed on the news, where its CEO absconded with millions of dollars.
You are concerned, but not worried, because you have the sell stop in place. But a sell stop is “a trigger to sell” when a stock or option reaches a certain price; however, it does not guarantee that the stock will be sold at the stop price. You, and a hundred thousand other investors, may have stops in place on “XYZ,” and all will trigger an order to sell at the same time! “XYZ” could then open drastically lower than its closing price the day before. Your sell stop may not kick in until you have lost A LOT of money! Sure, that may not happen, and “XYZ” could continue to rise the next day. Or not. Either way, if you sold at market close, you would have made $900, and slept well.
This is not to say sell stops are useless; to the contrary! Let’s say you choose to buy a stock or option (for precise reasons I will explain) one morning, at say $10 per share. Your personal trading rules determine the amount of risk you are comfortable taking, so let’s say yours is two percent. You would then concurrently place a sell stop at $9.80, meaning that if this stock dropped to $9.80, and you bought 100 shares, you would lose $20.00, or $200 if you bought 1,000 shares. This would occur in the same day you bought the stock, and that is the most you could lose, barring a doomsday occurrence. Your potential for profit can be essentially unlimited, though! Let’s say your analysis tells you that this stock has a reasonable potential to go up $.75 that day. You might also place another stop which would trigger a sale when the stock rose $.75, which would net you a $750 profit. One also has the ability to change their stop orders at any time. If your chosen stock is rising higher and faster than you thought, you can raise the protective sell stop as the price rises, while also raising the stop which will trigger a sale when you reach a certain profit. Unless you have the ability to stay glued to your computer screen all day long, this is a much safer way to both limit your losses AND protect your profits. I once watched a stock rise all day, but I had no stops in place. A customer came in, and we chatted in the warehouse for some time. When I went back to the computer, I learned that my stock had reversed direction, and all my profits had vanished, and then some. Well placed stops would have kept this a profitable trade. The instructor then began the lengthy procedures for choosing stocks.
“Bulls make money, bears make money, but pigs are slaughtered!” – Old Wall Street saying.
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