Understanding and Leveraging Buy Stop Orders
A buy stop order instructs a broker to purchase a security when it reaches a specified price. Once the price hits that level, the buy stop becomes either a limit or a market order, fillable at the next available price.
This type of stop order can apply to stocks, derivatives, forex, or a variety of other tradable instruments. The buy stop order can serve various purposes with the underlying assumption that a share price that climbs to a certain height will continue to rise.
Key Takeaways
- Strategic Entry - A buy stop order is an order to purchase a security only once the price of the security reaches a specified stop price.
- Optimized Pricing - The stop price is set above the current market price, creating a gateway for potential gains.
- Prefilled Potential - It is a strategy to profit from an upward movement in a stock’s price by placing an order in advance.
- Risk Management - Buy stop orders can also be used to protect against unlimited losses of an uncovered short position.
Protect Your Positions with Buy Stop Orders
A buy stop order is most commonly thought of as a tool to protect against the potentially unlimited losses of an uncovered short position. An investor might open a short position to bet that the security will decline in price. If that happens, the investor can buy cheaper shares and profit from the difference. The investor can protect against a rise in share price by placing a buy stop order to cover the short position at a price that limits losses. When used to resolve a short position, the buy stop is often referred to as a stop loss order.
The short seller might place their buy stop at a stop price or strike price either lower or higher than the point at which they opened their short position. If the price has declined significantly, and the investor is seeking to protect their profitable position against a subsequent upward movement, they can place the buy stop below the original opening price. An investor aiming to protect against a significant upward movement will place a buy stop order above the original short sale price.
Turning Bullish with Buy Stop Orders
Another strategy leverages buy stop orders to profit from anticipated upward movements in share price. Technical analysts often refer to levels of resistance and support for a stock—acting as a price ceiling and a floor. Some investors anticipate that a stock climbing above the resistance line, known as a breakout, will continue to rise. A buy stop order set just above this line can be very advantageous for capturing these profits. A stop loss order can further protect against a subsequent decline in share price.
Example of a Buy Stop Order in Action
Consider the price movement of a stock, ABC, that is poised to break out of its trading range between $9 and $10. A trader betting on a price increase places a buy stop order at $10.20. Once the stock hits that price, the order becomes a market order, and the trading system purchases the stock at the next available price.
The same type of order can be used to cover short positions. Suppose the trader has a large short position on ABC, betting on a future price decline. To hedge against the risk of the stock’s movement in the opposite direction (an increase in price), the trader places a buy stop order that triggers a buy position if ABC’s price increases, offsetting potential losses.
Related Terms: market order, stop order, short position, stop loss order, strike price, technical analysts, resistance and support, breakout.
