Subscribe to Money Morning get daily headlines subscribe now! Money Morning Private Briefing today's private briefing Access Your Profit Alerts

Why I'm a Huge Fan of "Mental Stops"

Lots of traders learned this one the hard way…

Today I'm going to share a true work of fiction. Only the names have been changed to protect the not-so-innocent.

It's based on life on the trading floor back in the day and how, if you tip your hand too much, the competition can make your life hell, and make out like a bandit, really fast.

This is what led me to create a really useful trading tool that we use in my Capital Wave Forecast and Zenith Trading Circle services when a little "secrecy" is called for.

Let me show you how it works…

How Stops Usually Work

First, we need to take a quick look at the two most basic types of stop orders.

stop-loss ordersWith a regular "stop-loss" order, an investor designates a stop-loss price. That price is a trigger price.

When the stock hits that price, a stop-loss order becomes a "market order." The investor might get the exact price he designated as his stop-loss price, but, since the order turns into a "market order" when the designated price is triggered (meaning the stock trades at that price or through it), the investor, if he's selling, will be filled at whatever the next bid price is, and he may have to sell at even lower prices if there aren't enough shares at any close-by bid prices to fill his entire order.

trading with stopsWith a "stop-limit" order, the investor attaches a "limit price" to his stop order. The limit price is the trigger price, the same as it is with a plain stop-loss order. But with a stop-limit order, the investor is only willing to sell at the limit price he designates. He may or may not sell shares at his limit price when it is triggered. A stock can trade right through an investor's limit price and keep falling, and he won't get filled. A stop limit is used when you only want to sell at a specific price and won't accept anything lower.

In my trading services, very often, if not most of the time, we use plain old stop-loss orders. I don't like stop-limit orders because you may not get filled at your limit price. We use stop-loss orders because we want out of a position. The trigger price is secondary, because we're not hung up emotionally on the money. We want out, and we want out quickly.

Now, here's the cool part. There's another kind of stop order we use – sometimes.

I call it a "mental stop."

A "mental stop" is the exact same thing as a stop-loss order, with one very BIG difference. It's a mental stop because I want us to keep it in our heads and not actually put down an order with a broker or on any exchange.

I'll tell you why – there was a perfect example this week.

After we just booked a fat 100%-plus profit on half of this retailer put options position, I recommended we use a "mental stop" on the other half of our position and sell if the puts traded back down to $0.24, which if triggered would get us out with a 50% gain on the remainder of our position. Again, a mental stop would mean that if the puts trade down to $0.24, we immediately put down market orders to sell our remaining position.

Maybe some folks put down actual stop-loss orders at $0.24. It could have been us, it could have been someone else, but they traded down to $0.24, and we had to get out.

Now, here's the inside scoop, the real story, on what can happen when actual stop orders get put down on an exchange or are given to "brokers."

How It Really Works in the Trading Pits

In the old days (the early 1980s), when I was a market maker on the floor of the Chicago Board Options Exchange (CBOE), I'd go into a trading pit to trade. I'd trade the actual stock through my clerks, who I'd signal my orders to, and they'd execute them over the direct lines I had to the floor of the NYSE or to over-the-counter market makers I wanted to use, and I'd execute the options trades myself in the pit directly with other market makers or brokers.

I used to "trade size" (meaning big lots), which made me friendly with other big traders who also wanted to trade size. Some of those traders were market makers, and some of them were brokers, and because the CBOE allowed it, some of them were market makers who also had a "book" of customer orders. It looks like a deck of cards with orders written on them.

Here's the not-quite-true story part… based on first-hand experience.

Join the conversation. Click here to jump to comments…

About the Author

Shah Gilani is the Event Trading Specialist for Money Map Press. He provides specific trading recommendations in Capital Wave Forecast, where he predicts gigantic "waves" of money forming and shows you how to play them for the biggest gains. In Zenith Trading Circle Shah reveals the worst companies in the markets - right from his coveted Bankruptcy Almanac - and how readers can trade them over and over again for huge gains. He also writes our most talked-about publication, Wall Street Insights & Indictments, where he reveals how Wall Street's high-stakes game is really played.

Read full bio

Leave a Reply

Your email address will not be published. Required fields are marked *

Some HTML is OK