Your Guide to Stop Orders
If you’re new to investing, you may be curious about what a stop order is and how to use it. This defensive investment technique introduces safeguards that help you minimize risk when buying or selling stocks. Review the background of this concept and learn how to incorporate stop orders in your trading strategy.
- A stop order is a defensive strategy with the goal of increasing potential profits while limiting loss by helping you trade an asset at your preferred price.
- Stop orders automatically take effect at the price you set, called the stop price, and can be used to both buy and sell stocks and assets.
- A buy-stop order sets a stop price higher than the market price at which you will buy rising shares.
- A sell-stop order sets a stop price lower than the market price at which you will sell falling shares.
- Stop-limit orders allow you to set a stop price that will trigger a limit order rather than an automatic market order.
- Stop orders work best in slowly declining markets.
- Carefully setting a stop price improves your chances of success with this strategy.
What Are Stop Orders?
A stop order is a trade order that takes effect when a stock or financial asset reaches a certain price point, called the stop price. With a stop order, you increase your chances of buying or selling a stock at your desired price, limit your potential loss, and boost your likely profits.
Stop orders automatically convert to market orders once the asset reaches the established price. The broker will execute the market order at the best available price. When a stop order expires without execution, you break even.
Stop orders only take effect during regular trading sessions, which take place Monday through Friday from 9:30 a.m. to 4 p.m. Eastern Standard Time, with the exception of established holidays. You can decide how long your stop order will last or set a good-til-canceled order (GTC) that remains open until you decide to close it.
Types of Stop Orders
Image via Flickr by Clover Autrey
Before diving into stop orders head-first, it’s important to understand the various types of stop orders and what each entails:
- Basic stop order: A basic stop order triggers a market order. However, this does not guarantee that you will be able to buy or sell your stock at the stop price. Rather, it guarantees the best available price. In other words, the stock price could change again after your order is triggered but before it is completed.
- Stop-limit order: By combining a stop order with a limit order to create a stop-limit order, you can specify a stop price as a maximum or minimum. The broker will fulfill your sell order only if the stock or asset hits or exceeds that price and fulfill your buy order only if the asset hits or drops under your stock price.
- Buy-stop order: A buy-stop order allows you to set a stop price that exceeds the asset’s current market price. It allows you to avoid or limit losses on a specific trade, often used to protect profit when short-selling stock.
- Sell-stop order: A sell-stop order is the opposite of a buy-stop order; the stop price is below the current market price of the asset. You can use a sell-stop order to profit from a long-term holding or limit your losses when shares begin to fall.
- Trailing-stop order: A trailing-stop order refers to an order in which the stop price follows a rising bid price. You can specify a percentage or a number of points by which the stop price will trail the value price. If the asset begins to decline in price, the stop price will hold at its peak. A trailing stop can increase without limit but will never decline. It also prevents the need to enter new orders as an asset price rises.
Difference Between a Stop-Loss and Stop-Limit Order
A stop-loss order refers to a sell-stop order linked to a stop-limit order. It can be difficult to distinguish between when to use stop-limit orders compared to stop-loss orders, especially for traders who are new to these concepts. In fact, a stop-limit order is a type of stop-loss order. Instead of automatically executing at the market price like a stop-loss order, the stop-limit order converts to a limit order at the stock price. It will only execute if the stock remains at the market price or better.
Benefits of Using Stop Orders
In general, markets on a gradual downward trend provide the best environment in which to benefit from stop orders. Stop orders are more likely to fail in gapping or halting markets.
You can use a stop order to profit from a breakout. This occurs when a stock’s price exceeds the resistance line. When this occurs, this strategy posits that the stock will continue to rise. In this case, you would create a stop order to buy with a price just higher than the line of resistance to capture the predicted breakout profits. Consider implementing a simultaneous stop-loss order to shield against a potential price backlash.
Many traders appreciate that a stop-loss order removes the burden of monitoring an asset by automating the trade decision based on their parameters.
Disadvantages of Stop Orders
With a stop-loss order, it’s important to avoid stopping out. This occurs when the order inadvertently becomes activated, resulting in a loss that would have otherwise become a profit. For example, if an asset’s price hits the stop-loss price but quickly recovers and then begins to rise, the order would trigger the sale at the lower price. This stands even if the stock rebounds within a matter of minutes.
In a fast-moving market, a stock-limit order can be used for protection when trading volatile assets. However, a triggered limit order does not guarantee the execution of a trade. This can create a significant loss unless the trader can wait it out until another price rise.
Sometimes, a stop order can be only partially filled. When this occurs, the unfilled orders remain open and often incur additional transaction fees, especially when it takes several days for the shares to become available.
You can often make special order provisions to limit the risk of these situations. For example, an immediate-or-cancel order allows partial fills but cancels the order for the unfilled shares. With a fill-or-kill order, you cancel your order if it cannot be filled at a certain price. An all-or-none order prevents partial fills and cancels the order.
Deciding Where to Place Stop Prices
When setting a stop order, you must first decide on a stop price below the current stock price. Many investors set a stop order at 5% to 10% below the trading price. For example, if the current share price is $100, you could set a stop price of $90 to $95. Others decide to limit potential loss to a percentage of their total portfolio value, often between 1% and 3%.
Placing a stop price too close to the current price can result in an unwanted trigger of your stop order by typical price fluctuations. Placing a stop price too far below the current price can result in losing profits before you are able to exit the trade successfully.
Review the volatility of the asset for which you plan to place a stop order to help you determine an appropriate stop price. For example, if a stock typically rises or falls more than 5% in a day, a stop price 10% below the share price would be more appropriate. Try finding the stock’s average daily price change to inform your stop price.
Some traders take advantage of technical analysis to decide where to place limit and stop prices. If you detect resistance and support levels on technical analysis charts, you can set stop-loss prices at those levels.
Stop orders allow you to defend your holdings against market changes. Understanding how to use these techniques can bolster your ability to make smart trades. The more varied your portfolio becomes, the more important it is to implement stop orders to limit your risk as well as the amount of time you spend monitoring your investments.