Stop orders are not to be confused with limit orders. The buy limit order is usually placed below the current market and must be executed at the limit or better. The buy stop order is placed above the current market and may be executed at the price specified on the stop, above or below it, because it is executed at the market after the stop price is touched.

Unlike a sell limit order, a sell stop order is placed below the current market level and, when triggered, may be executed at the price specified on the stop, above or below it, because it is executed at the market after the stop price is touched.

A more complex type of order is the stop limit order. A buy stop limit order becomes a limit order once the current price rises to a specific stop. A sell stop limit order becomes a sell limit order once the current price drops to a specific stop.

Uses of limit and Stop Orders

A buy limit order may be used to establish a new long position or to liquidate an old short position. A sell limit order may be used to establish a new position or to liquidate an old one. A stop order is used to limit a loss, protect a profit, or establish a new position.

Limit orders are very useful when trading slow, choppy, liquid markets. Scalpers of fractions of a point place limit orders all the time. In most liquid markets, trading is so slow and choppy that there is always a second or third chance of getting filled at your favored limit price since the market moves toward and away from that limit in a choppy fashion.

Stop and limit orders are useful tools for portfolio managers who trade hundreds of stocks with big buy and sell orders. They allow the manager time to focus on other work instead of constantly monitoring the quotes to execute a trade.

Never use limit orders in fast, illiquid markets. The chance of getting filled at your limit is slim when a market is moving rapidly. In fast, illiquid markets, always get in and out using market orders.

The Expected return equation in Entering the Market

The expected return equation is one of the most overlooked mathematical formulas used to enter a market. I have spoken to many traders and was amazed how few traders really understand the formula. Traders who do not know how to use the equation are relying on pure hunches to trade the market and, therefore, will not last long. Heres the formula:

Net Expected Return for a specific trade = (Avg gain X Win odds) - (Avg loss X Loss odds)

- Slippage - Commission

where . . .

Avg gain = Average profit made on a winning trade

Avg loss = Average loss on a losing trade Win odds = Chance (%) of a winning this trade. For example, a 50% chance of winning. Loss odds = Chance (%) of a losing this trade.

If the net expected return is a positive number, then you have a good trade or sound entry. If it is a negative number, then you should avoid that trade.

For example, based on one or two technical indicators or chart, you feel that Microsoft has a 4 points upside (Avg gain), a 2 point downside (Avg loss or your stop) with a winning chance of 60 percent to a losing chance of 40 percent, then your net expected return on that trade is

Net Expected Return per trade = (60% x 4 pts) - (40% x 2 pts)- 0.125 slippage

- 0.125 of commission = 1.35 pts

Since the trade generates a 1.35 points expected net return, it is a great trade and entry should be taken immediately.

You may say this mathematical equation looks fairly easy to apply so why isnt everybody getting rich off it? The real skill in applying this equation successfully and, therefore, trading successfully is being able to evaluate your win odds, loss odds, avg gain, avg loss as accurately as possible. A slight misjudgment in any one of the factors would turn a profitable net return trade to a net loss. That is the art of trading: being able to subjectively assign odds in different scenarios and market situations and quantify them through the Net Expected Return Equation.

This is why trading will always remain an art as well as a science.

Using Technical Indicators and Tools to Time an Entry

The most important part of entering the market involves selecting the best technical tools to time your entry.

There are many different technical tools and indicators traders can use to time an entry. A combination of indicators can provide high risk/reward entry points. Technical indicators appear to work best in stocks or markets not widely followed.

The following are simple technical indicators that are widely used.

Support and Resistance of a Price Chart

Support and resistance are extremely popular nowadays and are effective entry tools because of their simplicity. Once price hits a strong support on a chart or a crucial resistance, an entry could be triggered.

Figure 5.1 Stock chart showing support and resistance lines.

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For an example, look at Figure 5.1. Bristol-Myers is a good trading stock to apply support and resistance. When the stock hits a crucial support, it bounces off immediately and initiates an uptrend. And when it hits a crucial resistance it retraces before testing the resistance again. Support and resistance have more significance if they are new yearly low or highs due to psychological buying and selling.

The key idea is to buy support and sell resistance. Support on the chart should be wide and tested numerous times to verify the significance of the support. The more significant the support, especially if price is at a yearly or historic low, the higher the odds the support will hold. This is also true for resistance. It should also be wide in time and tested on several occasions.

Playing Breakouts and Breakdowns-A Popular Strategy

Understanding how support and resistance work helps in playing breakouts and breakdowns. When price breaks above a crucial resistance, it is called a breakout. A breakout will trigger a buy signal. A breakout of a crucial resistance point with good volume is a good entry if the price closes above the resistance. When price breaks below a significant support, it is called a breakdown and will initiate a sell short signal.

Breakouts and breakdowns are popular strategies, but depending on which market you trade, they can be difficult to apply because of many false signals. However, from my own experience, the cup and handle breakout pattern strategy suggested by William ONeil of Investors Daily works very well in a bullish market.