The Finance Professor: Manage Risk Like a Pro

A stop order is an effective trading technique to limit losses on a stock. A stop order is an order you place with your brokerage that's executes a market order once a stock falls to a predetermined stop level (see stop price ).

For example, let's say you bought Google(GOOG Quote) at $500 per share, and your research indicates that Google can get to $600. However, you want to be able to cut your losses should the stock drop, let's say, 10% to $450. So you place a stop order (it can be a day order or good-till-canceled order ) to sell Google at $450.

Another version of a stop order is called a stop-limit order (or stop-loss order). Here, a stop order is triggered, but instead of a market order being initiated, a limit order at a limit price is then placed for your account.

Sometimes I use "hard" stops and enter actual stop orders. However, most of the time I use "soft" (or mental) stops, which means that when a stock drops a certain percentage, I closely re-examine my position and determine if my original thesis for buying the stock was incorrect. If so, I then sell the stock. However, if the stock is down due to a weak market or a motivated (read: panicked) seller, then I stick it out and hold for better prices.

More-sophisticated trading techniques to manage risk include hedging with derivatives and pairing by short-selling a comparable stock. I'll cover these in more depth in another installment.