A trade order instructs a broker to enter or exit a position. At first, placing trades may seem overly simple: push the "buy" button when entry conditions are met, and push the "sell" button when it's time to get out. While it is possible to trade in this simplified manner, it is not very efficient, as it requires constant monitoring and it exposes traders to unnecessary financial risks.
Traders who use only the buy and sell buttons may experience losses from slippage and from trading without a protective stop-loss order. Slippage refers to the difference between the price the trader expected and the price at which the trade is actually filled. In fast-moving markets, slippage can be substantial and the difference between a winning and losing trade. Certain order types allow traders to specify exact prices for trades, thereby minimizing the risks associated with slippage.
Protective stop-loss orders, on the other hand, limit trading losses by creating a "line in the sand" past which traders will not risk any more money. These orders automatically close out losing trades at pre-determined price levels. By utilizing advanced order types, a protective stop-loss order can be placed in the market as soon as a trade is entered. This can be especially important to active traders in a fast-moving market when a stop-loss could be reached within seconds of being filled on an order.
Modern trading platforms allow traders to use a multitude of order types to add precision and protection to their trading methodologies. Knowing when to trade is only part of trading; successful traders must also know how to trade, and which order type is appropriate for a given situation. This introductory guide will explain the various order types - from basic to advanced - and provide examples of how each is used by today's traders.
Introduction To Order Types: Long And Short Trades
A basic concept that must be understood before learning about specific order types is the direction in which a trade can be established. Trades can be entered in two different directions, depending on the anticipation of a rising or falling market. Long trades are the classic method of buying with the intention of profiting from a rising market. Long trades can be conducted through all brokers and do not necessarily require the trader to have a margin account (assuming the account has funds to cover the transaction). The losses from a long trade are considered limited (even though these losses could be extensive). This is because if a long trade is entered at any level, price can only go as low as $0 if the trade moves in the wrong direction.
Short trades, on the other hand, are entered with the intention of profiting from a falling market. This is accomplished by borrowing a stock, futures contract or other instrument from a broker and then selling them. Once price reaches the target level, traders buy back the shares (or contracts), or buy to cover, and replace what was originally borrowed from the broker. If price drops, the trade may be profitable (depending on other factors such as slippage and commission); if price rises, the trade will be a loss. Short trading requires a margin account with a broker, since the trader must borrow shares/contracts from the broker in order to complete the transaction. Not all trading instruments can be sold short, and not all brokers offer the same instruments for short sale.
Long Trade = profit from a rising market
Short Trade = profit from a falling market
Trading short positions is an important part of active trading because it allows traders to take advantage of both rising and falling markets. Unlike long trades, where losses are limited, short trades have the potential for unlimited losses. This is because a short trade loses value as the market rises, and since price could theoretically continue rising indefinitely, losses can be unlimited - and catastrophic. Trading with a protective stop-loss allows traders to manage this risk.