What Is a Stop Order?
A stop order is one of the main order types you will encounter in the market: stop, market, and limit. A stop order is always executed in the direction that the price is moving. For instance, if the market is moving lower, the stop order is set to sell at a pre-set price below the current market price. Alternatively, if the price is moving higher, the stop order will be to buy once the security reaches a pre-set price above the current market price.
There are several types of stop orders that can be employed depending on your position and your overall market strategy. Here’s a review of these types and how they function relative to your trading position in the market.
Key Takeaways
- Stop-loss orders should be in place whenever you have an open position to limit your potential losses.
- Stop-entry orders can be used to enter the market in the direction it is moving, frequently referred to as breakout trading.
- If the market is moving higher, a stop-entry order will make you long; if the market is moving lower, a stop-entry will make you short.
- You can move your stop-loss order in the direction of the trade, using a trailing stop-loss to further limit your losses or protect your gains.
- You can use a financial or technical price level to place your stop order.
Types of Stop Orders
There are three types of stop orders you can use when trading: stop-loss, stop-entry, and trailing stop-loss.
Stop-Loss Order
A regular stop-loss order is recommended for any live position. A stop-loss order will remove you from your position at a pre-set level if the market moves against you. Stop-loss orders are critical when you can’t actively keep an eye on the market and it’s recommended to always have one in place for any existing position to protect you from sudden market movements.
Example: Let’s say you’re long (own) stock XYZ at $27 and believe it could reach $35. However, at levels below $25, your strategy is invalidated, and you want out. You would then place a stop order to sell XYZ at around $25 or slightly lower, allowing for a margin of error.
Stop-Entry Order
A stop-entry order is used to get into the market in the direction it’s currently moving.
Example: Suppose you have no position, but you observe that stock XYZ has been moving in a sideways range between $27 and $32 and you believe it will eventually move higher. You could place a stop-entry order above the current range high of $32 - say at $32.25 to allow for a margin of error - to enter the market once the sideways range is broken to the upside. Now that you’re long, you’ll immediately establish a regular stop-loss sell order to limit losses if the break higher is false.
Trailing Stop-Loss Order
Continuing from the scenario above, XYZ has broken above the range top at $32 and your stop was triggered at $32.28. Now you are long in a rising market. The price continues increasing and hits your first price target at $35. To protect your profits, you can place a regular stop loss at, say, $34. This locks in around $1.72 ($34.00 - $32.28 = $1.72) if the market reverses. Some brokers offer trailing stop-loss orders which follow the market and automatically adjust stop levels according to market movements.
Example: Specify $0.50 for the stock trade, meaning that at a current price of $35, the market must touch $34.50 for your stop-loss order to trigger. If the price continues to climb, the stop will rise with it, always remaining $0.50 from the peak. If the price reaches $36.75, your trailing stop will be $36.25 ($36.75 - $0.50 = $36.25). Trailing stops effectively protect profits and maintain position until the market demonstrates a reversal.
Advantages and Disadvantages of Stop Orders
Advantages
- Execution guarantee: Your order will execute whether you’re monitoring prices or not.
- Additional control: Gives you more control over buy/sell timing.
- Loss mitigation: Helps limit or prevent losses.
Disadvantages
- Short-term fluctuation risk: Can cause premature selling due to minor market swings.
- Slippage: The execution price may not be the exact price you specified due to market factors.
Advantages Explained
Using stop orders has substantial advantages because they can help you avoid or minimize losses, with an execution guarantee regardless of market monitoring. This adds a control level, enabling timely trades avoiding potential distractions. They serve as a precautionary tool, essential for limiting or preventing considerable losses.
Disadvantages Explained
The drawbacks include susceptibility to short-term price fluctuations that may inadvertently exit your positions. Similarly, slippage can occur—where orders execute at slightly different prices from set levels—caused by lack of liquidity, volatility, and market gaps, akin to any market order’s potential risks. Be sure your brokerage supports the desired stop orders as policies may vary.
Stop Order vs. Limit Order
A key difference: stop orders use the best available market price rather than the exact set price, transitioning into market orders upon reaching the stop price. Conversely, a limit order executes at your specified or better price, reducing likelihood compared to stop orders. If a stock never hits your limit, there’s no execution; a stop order would still execute using the best available price.
Example of a Stop Order
Where should one place their stop-loss order? A common method utilizes financial or technical measurement points. A financial stop-loss sets a limit on financial loss tolerance. For example, willing to risk only $5 on a stock at $75 means setting a stop at $70. A technical stop-loss uses significant technical price points like recent highs/lows or moving averages. Crucially, protecting investments dictates always having a live stop-loss order.
Importance of a Stop-Loss Order When Holding an Open Position
Not all trades are winners. Any position holds potential for unfavorable movement causing loss. Hence, a stop-loss order caps losses at specified levels. Your strategy encompasses entry and exit plans—managing positions, cutting emotional stress.
What to Do When Your Stop-Entry Order Is Filled
Post-order fill, establish at least a stop-loss order, adding a take-profit (T/P) order if needed. Combined, these bracket strategies offer optimal position management, typically linked to operate as a one-cancels-the-other (OCO) order, ensuring automated cancellation post-profit taking or stop activation.
Where to Place a Stop-Loss Order
Use a financial loss cap or technical levels like prior highs/lows in forming stop orders. Each trade’s strategic plan covering pre-determined loss caps and target achievements aligns with market movement predictions.
Adjusting Stop-Loss Orders
Only adjust stop-loss orders compatible with trade directions. For instance, lifting stop-loss levels when market prices rise enhances profit-locking potential while reducing loss possibilities. Always conjectured market-per iterative alignment validates positional adjustments.
The Bottom Line
Stop orders stand as pivotal protection tools in trading, acting as safeguards for reducing exposure to significant market downturn risks. Adjust in sync with favorable market movements consciously. Prior strategic schemes buttressed by clear entries, predefined loss caps, and profit targets mitigate emotional trading biases, fostering disciplined, calculated investing.
Related Terms: market order, limit order, trailing stop, breakout trading, technical analysis.
References
- U.S. Securities and Exchange Commission. “Investor Bulletin: Stop, Stop-Limit, and Trailing Stop Orders”.
