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.
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.
With 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.
With 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.
About the Author
Shah Gilani boasts a financial pedigree unlike any other. He ran his first hedge fund in 1982 from his seat on the floor of the Chicago Board of Options Exchange. When options on the Standard & Poor's 100 began trading on March 11, 1983, Shah worked in "the pit" as a market maker.
He helped develop what has become known as the Volatility Index (VIX) - to this day one of the most widely used indicators worldwide. After leaving Chicago to run the futures and options division of the British banking giant Lloyd's TSB, Shah moved up to Roosevelt & Cross Inc., an old-line New York boutique firm. There he originated and ran a packaged fixed-income trading desk, and established that company's "listed" and OTC trading desks.
Shah founded a second hedge fund in 1999, which he ran until 2003.
Shah's vast network of contacts includes the biggest players on Wall Street and in international finance. These contacts give him the real story - when others only get what the investment banks want them to see.
Today, as editor of 10X Trader, Shah presents his legion of subscribers with the chance to earn ten times their money on trade after trade.
Shah is also the proud founding editor of The Money Zone, where after eight years of development and 11 years of backtesting he has found the edge over stocks, giving his members the opportunity to rake in potential double, triple, or even quadruple-digit profits weekly with just a few quick steps.
Shah is a frequent guest on CNBC, Forbes, and Marketwatch, and you can catch him every week on Fox Business's "Varney & Co."
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.