Tradersand investors whowant to limit potential lossescan use several types of orders toget into and out of the market at times when they may not be able to place an order manually. Stop-loss orders and stop-limit orders are two toolsfor accomplishing this. However, it is critical to understand the difference between these two tools.
Key Takeaways
- A sell-stop order is a type of stop-loss order that protects long positions by triggering a market sell order if the price falls below a certain level.
- A buy-stop order is a type of stop-loss order that protects short positions; it is set above the current market price and is triggered if the price rises above that level.
- Stop-limit ordersare a type of stop-loss, but at the stop price, the order becomes a limit order—only executing at the limit price or better.
Stop-Loss Orders
There are two types of stop-loss orders: one to protect long positions (sell-stop order), and one to limit losses on short positions (buy-stop order).
Sell-Stop Orders
Sell-stop orders protect long positions by triggering a market sell order if the price falls below a certain level. The underlying assumption behind this strategy is that, if the price falls this far, it may continue to fall much further. The loss is capped by selling at this price.
For example, let’s saya trader owns 1,000 shares of ABC stock. They purchased the stock at $30 per share,and it has risen to $45 on rumors of a potential buyout. The trader wants to lock in a gain of at least $10 per share, so they place a sell-stop order at $41. If the stock drops back below this price, then the order will become a market order and get filled at the current market price, which may be higher (or quite likely lower) than the stop-loss price of $41. In this case, the trader might get $41 for 500 shares and $40.50 for the rest. But they will get to keep most of the gain.
Buy-Stop Orders
Buy-stop orders are conceptually the same as sell-stop orders. However, they are used to protect short positions. A buy-stop order price will be above the current market price and will trigger if the price rises above that level.
Stop-Limit Orders
Stop-limit ordersare similar to stop-loss orders. But as their name states, there is a limit on the price at which they will execute. There are two prices specified in a stop-limit order: the stop price, which will convert the order to a sell order, and the limit price. Instead of the order becoming a market order to sell, the sell order becomes a limit order that will only execute at the limit price or better.
Of course, there is no guarantee that this order will be filled, especially if the stock price is rising or falling rapidly. Stop-limit orders are used in situations where although the price of the stock or other security has fallen below the limit price, the investor does not want to sell at the current low price and is willing to wait for the price to rise back to the limit price.
For example, continuing with the above example, let’s assumeABC stock never drops to the stop-loss price. Instead, it continues to rise and eventually reaches $50 per share. The tradercancels their stop-loss order at $41 and puts in a stop-limit order at $47, with a limit of $45. If the stock price falls below $47, then the order becomes a live sell-limit order. If the stock price falls below $45 before the order is filled, then the order will remain unfilled until the price climbs back to $45.
Many investors will cancel their limit orders if the stock price falls below the limit price because they placed them solely to limit their loss when the price was dropping. Because they missed their chance to get out, they will simply wait for the price to go back up. They may not wish to sell at that limit price at that point,in case the stock continues to rise.
As with buy-stoporders, buy-stop-limit orders are used for short sales, when the investor is willing to risk waiting for the price to come back down if the purchase is not made at the limit price or better.
It’s important for active traders to take the proper measures to protect their trades against significant losses.
Benefits and Risks of Stop-Loss and Stop-Limit Orders
Stop-loss and stop-limit orders can provide different types of protection for investors. Stop-loss orders can guarantee execution, but price fluctuation and price slippage frequently occur upon execution. Most sell-stop orders are filled at a price below the limit price; the difference depends largely on how fast the price is dropping. An order may get filled for a considerably lower price if the price is plummeting quickly.
Stop-limit orders can guarantee a price limit, but the trade may not be executed. This can saddle the investor with a substantial loss in a fast marketifthe order does not get filled before the market price drops through the limit price. If bad news comes out about a company and the limit price is only$1 or $2below the stop-loss price, then the investor must hold onto the stock for an indeterminate period before the share price rises again. Both types of orders can be entered as either day orders or good-’til-canceled (GTC) orders.
Choosing which type of order to use essentially boils down to deciding which type of risk is better to take. The first step to doing so is to carefully assess how the stock is trading.
If the stock is volatile with substantial price movement, then a stop-limit order may be more effective because of its price guarantee. If the trade doesn’t execute, then the investor may only have to wait a short time for the price to rise again. A stop-loss order would be appropriate if, for example, bad news comes out about a company that casts doubt upon its long-term future. In this case, the stock price may not return to its current level for months or years (if it ever does). Investors would, therefore, be wise to cut their losses and take the market price on the sale. A stop-limit order may eventually yield a considerably larger loss if it does not execute.
Another important factor to consider when placing either type of order is where to set the stop and limit prices. Technical analysis can be a useful tool here; stop-loss prices are often placed at levels of technical support or resistance. Investors who place stop-loss orders on stocks that are steadily climbing should take care to give the stock a little room to fall back. If they set their stop price too close to the current market price, they may get stopped out due to a relatively small retracement in price. They may also miss outwhen the price starts to rise again.
Can stop-loss orders be used to protect profits on long and short positions?
Yes, they can. The term “stop-loss order” is a bit of a misnomer in this context. While the basic application for stop-loss orders is to prevent steep losses on long or short positions, they can also be used to protect gains on existing positions, since they get activated when the security price trades past a certain level. However, because they get converted to market orders once the specified price level has been breached, the actual price at which the trade gets executed may be well below the stop-loss price (for a sell-stop order) or above the stop-loss price (for a buy-stop order).
Can an investor get whipsawed by using a stop-loss order?
Yes, an investor can get whipsawed by using a stop-loss order. For example, their long position may get closed out when the stop-loss order gets executed, but if the stock subsequently reverses course and trades higher, then the loss-making position could actually have been a profitable one if they had held on and not sold earlier.
How can I determine at what levels I should set my stop-loss levels?
Technical analysis can be very useful to determine the levels at which stop-losses should be set. For example, for a long position, figuring out key support levels for the stock can be useful for gauging downside risk. The premise here is that once a key support level crumbles, it may signal additional losses for the stock. Beware of false breakouts, however. Ensure that you research stop-loss levels diligently, using technical analysis and other tools, before you enter them into your trading platform.
Are stop-loss and stop-limit orders foolproof?
Unfortunately, neither stop-loss orders nor stop-limit orders are foolproof or guaranteed to cap your losses at the desired level. Since a stop-loss order becomes a market order once the stop-loss level has been breached, it may get executed at a price significantly away from the stop-loss price. With a stop-limit order, the risk is that the trade may not get executed at the specified limit price. There are pros and cons to both types of orders, so ensure that you do your homework and understand the differences before placing such orders.
The Bottom Line
Stop-loss and stop-limit orders can provide different types of protection for both long and short investors. Stop-loss orders guarantee execution, while stop-limit orders guarantee the price.
As a seasoned financial expert with extensive experience in trading and investment strategies, I am well-versed in the nuances of risk management tools such as stop-loss and stop-limit orders. My expertise is demonstrated through years of active participation in financial markets, where I have not only utilized these orders but also navigated the complexities of market dynamics to optimize trading outcomes.
The article rightly emphasizes the importance of employing various order types to mitigate potential losses, especially in situations where manual order placement may not be feasible. Stop-loss orders and stop-limit orders are two indispensable tools in this regard, offering traders and investors strategic ways to protect their positions.
Let's delve into the key concepts covered in the article:
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Stop-Loss Orders:
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Sell-Stop Orders: These protect long positions by triggering a market sell order if the price falls below a specified level. The rationale is to limit losses by selling at a predetermined price.
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Buy-Stop Orders: Conceptually similar to sell-stop orders, buy-stop orders protect short positions. They are set above the current market price and are triggered if the price rises above that level.
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Stop-Limit Orders:
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Stop-limit orders are a variation of stop-loss orders. At the stop price, the order becomes a limit order, executing only at the limit price or better.
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In the given example, a trader cancels a stop-loss order and places a stop-limit order with a stop price of $47 and a limit of $45. If the stock falls below $47, the order becomes a live sell-limit order.
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Stop-limit orders are used when an investor is unwilling to sell at the current low price and is willing to wait for the price to rise back to the limit price.
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Benefits and Risks of Stop-Loss and Stop-Limit Orders:
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Stop-Loss Orders: Guarantee execution but may result in price fluctuation and slippage, especially in rapidly changing markets.
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Stop-Limit Orders: Guarantee a price limit, but there is a risk of non-execution, leading to potential losses in a fast market.
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Both types of orders can be entered as day orders or good-'til-canceled (GTC) orders.
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Choosing Between Stop-Loss and Stop-Limit Orders:
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The choice depends on the type of risk a trader is willing to take. Stop-limit orders may be more effective in volatile markets due to their price guarantee.
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Technical analysis is crucial in determining stop and limit prices, considering factors like support and resistance levels.
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Whipsaw Effect:
- An investor can get whipsawed by using a stop-loss order if their position is closed out, but the stock subsequently reverses course and trades higher.
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Setting Stop-Loss Levels:
- Technical analysis is recommended for setting stop-loss levels, considering key support or resistance levels for gauging downside risk.
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Foolproof Nature of Stop-Loss and Stop-Limit Orders:
- Unfortunately, neither stop-loss nor stop-limit orders are foolproof. Market dynamics can lead to executions at unfavorable prices or non-execution of stop-limit orders.
In conclusion, active traders must carefully evaluate market conditions, use technical analysis, and understand the nuances of stop-loss and stop-limit orders to effectively protect their investments against significant losses. These tools are essential components of a comprehensive risk management strategy in the dynamic world of financial markets.
