By Anthony Trongone, Ph.D., CFP, CTA*

Practical advice often has us heading in opposite directions. For instance, does "absence make the heart grow fonder" make sense or is it "out of sight out of mind"?

Conflicting advice also commonly appears in investing. My favorite contradiction is the one we face when we are in a profitable position: Should we "take our profits" or "let our profits run?" Any trader with experience knows that the correct answer to this question depends on the current trading environment.

Fortunately, with the advent of electronic day trading, we can submit conditional orders. These orders give us the opportunity to benefit from either strategy. After defining three conditional orders that contain aspects of these special characteristics, I will discuss how we can apply this knowledge at the beginning of the trading day.

Finally, I will offer practical suggestions on how to apply three types of conditional orders when opening the trading day with 100 shares of Google:

STOP ORDERS
TRAILING STOP ORDERS
BRACKET ORDERS

CONDITIONS: Coming into the trading day (9:30 a.m.) with a 100-share long position in Google.

In this case, a STOP ORDER TO SELL would be an order to sell at a specific price below the 9:30 opening price. This is the more widespread protective order. If the price falls to your target price, it will automatically activate your sell order.

TRAILING STOP ORDER -- Instead of placing an order to sell at a fixed price, you can designate a specific amount, which would sell your 100 shares below the prevailing market price. Placing a trailing stop order at $2.00 triggers an order to offset your long position at $2.00 from the highest price (highest price - the amount of your trailing stop).

For instance, say that, as the trading day opens, this Internet stock is at $400: As long as the lowest price does not fall $2.00 from its highest price, your order remains active. If GOOG is able to reach $404, without falling $2.00, the new stop price automatically advances to $402 ($404 - $2.00).

BRACKET ORDERS -- These orders allow you to effectively place two sell orders: One above, the other below, the prevailing price. The profitable side of this order has you placing a limit order to sell 100 shares. Because it is above the opening price, it produces a profitable trade; conversely, the unprofitable side has you placing a sell stop order below the opening price. Many people refer to this as an OCA order (one-cancels-all group of orders; therefore, once one order executes, it automatically cancels the other order).

Each of these orders has the advantage of minimizing your downside risk by effectively offsetting your long position if the price falls to your exit (stop) price. However, depending on the situation, each is best at either "letting your profits ride" or "taking your profits". So, let me show you some examples with the return characteristics of all three conditional orders.

In each example, Google opens the trading day at a price of $400. At the opening price, you place one of three orders. What is the result of each conditional order?

Stop loss order at $396
Trailing stop order at $4.00
Bracket order: A limit order to sell at $404, together with a stop loss order at $396

Situation 1a: After opening at $400, GOOG trades within a range of $399 - $408, without slipping $4.00 from its highest price. It closes the trading session at $405; consequently, the profit for each conditional order is as follows:

REGULAR STOP A $5.00 profit, with the order still active
TRAILING STOP A $5.00 profit, with the order still active
BRACKET ORDER Sold at $404, providing a $4.00 profit

Situation 1b: After opening at $400, GOOG trades within a range of $399 - $408 until 2:00 p.m. when it falls to $403. It closes the trading session at $403; consequently, the profit for each conditional order is as follows:

REGULAR STOP $3.00 profit -- with the order still active
TRAILING STOP Selling price at $404 ($408 - $4.00); therefore, a $4.00 profit
BRACKET ORDER Sold at $404, providing a $4.00 profit

In either situation, the regular stop loss allows the stock to rise without offsetting your order. Although the trailing stop allows GOOG to run higher, it gives back $4.00 from its highest price. The bracket order doesn’t give you the opportunity to "let your profits run" because it automatically closes your position at $404.

Situation 2a: At the open, the stock immediately falls to $394 and continues falling throughout the trading day, ending the day at $384. In this case, the three conditional orders offset your position after suffering a $4.00 setback. Despite the differences in these three conditional orders, they react similarly when the stock quickly deteriorates. In this downside situation, each of these orders is equally capable of reducing risk as the price falls to your exit price.

Situation 2b: At the open, the stock immediately rises to $402 but reverses direction as it falls $8.00 to a price of $394. At 2:15 p.m., the Federal Reserve reduces rates, and GOOG rallies to a closing price of $416.

REGULAR STOP $4.00 loss -- closing your position at $396
TRAILING STOP $2.00 loss ($402 - $4.00)
BRACKET ORDER Sold at $396, providing a $4.00 loss

The trailing stop has a slight advantage, but this example demonstrates the security in having a protective order.

Situation 3a: GOOG opens at $400; the day rises to $405, but the trailing stop stays active. As the trading day progresses, its price slowly advances to a closing price of $408.

REGULAR STOP An $8.00 profit, with the order still active
TRAILING STOP An $8.00 profit, with the order still active
BRACKET ORDER A $4.00 profit because the 100 shares are offset at $404

Unlike its counterparts, the bracket order does not allow you to ride your profits, which, in some instances, is a disadvantage.

Situation 3b: After the open, Google slowly rises to $405, with the trailing stop staying active, but, as the day progresses, its price slowly declines to a closing price of $392.

REGULAR STOP A $4.00 loss, with a stop at $396 offsetting the order
TRAILING STOP $1.00 profit, offsetting your long position at $401 ($405 - $4.00)
BRACKET ORDER $4.00 profit, closing the order at $404

Finally, we have a situation in which the bracket order is the most profitable alternative. Although it doesn’t allow you to ride your profits, its advantage comes from allowing you to take your profits before they completely deteriorate. It’s emotionally painful to watch your profits evaporate, making it difficult for you to retain a positive attitude, which often contributes to further losses.

Recent Results

A detailed analysis of this high-flying Internet stock in November 2006 revealed a greater downside risk in the opening 60 minutes of trading. In 119 trading days, the stock, averaging 1.53 million shares, was very active. An average range (highest - lowest price) of $4.82 made it difficult to place a protective order without the position being offset. Certainly, the $17.68 gain made the ride more comfortable.

Overcoming the Challenges of Placing the Best Possible Order

With limitless possibilities, the decision to place the best possible order that will minimize loss becomes a daunting task. Often, the correct decision appears impossible because each instrument has its own personality. And, the fact that stocks often follow the direction of the (move in tandem with) overall market further complicates your decision.

One way to overcome this challenge is to design a strategy specific to the instrument you are trading. To construct the best strategy, an analysis of each trading order is necessary.

Without following a particular system, the best remedy is simply to use a strategy that would leave you less susceptible to emotional trading distractions. My book, Trading in the Footsteps of Sherlock Holmes, offers you specific trading skills necessary to overcoming emotional impulses.

*Reprinted (and modified) with permission from Anthony Trongone, Ph.D., CFP, CTA, Trongone Investment Systems, L.L.C., Director of Executive E-MBA Programs in China and Taiwan at Centenary College in Hackettstown, New Jersey. Dr.trongone@gmail.com