Trading for beginners: when use the Stop order to limit a loss or lock in a profit
Stop orders are usually often used to help protect an unrealized gain or to limit potential losses on an existing position. Below, we’ll discuss how to use them in your portfolio to protect long equity positions.
What is a stop order?
Stop orders often come in two main varieties: standard stop orders and stop-limit orders. To better understand how stop orders work, it’s helpful to think of the stop price as a trigger. For example, once an execution occurs at your designated trigger price, your stop order becomes a market order to buy or sell that stock at the prevailing market price. Note that stop orders are inactive and hidden to the other market participants until the trigger price is reached.
1. Stop orders (also known as stop-loss orders) and stop-limit orders are very similar, the primary difference being what happens once the stop price is triggered. A standard sell-stop order is triggered when an execution occurs at or below the stop price. When this occurs, a market order to sell is sent to the marketplace and your position will be closed out at the next available price.
Example: If the current price of a stock is $90 and you want to protect against a significant decline, you could enter a sell-stop order at $85. If an execution occurs at $85 or lower (at the same place where your order resides), your stop order is triggered and a market order is entered to sell at the next available market price. Because the stop order is now a market order, all characteristics of market orders apply.
In most cases, your stock will be sold at a price that is close to the market price at the time the stop order is triggered. However, you must remember that a stop order becomes a market order, so in cases where the stock is dropping rapidly, the stock is halted and reopens for trading or when the stock gaps down in the morning (lower than the prior day’s closing price), your execution price could be significantly lower than your stop price.
2. Stop-limit orders are most often used to sell a security at a specified limit price once the security has traded at or through a specified stop price. Therefore, it has two components: the stop price and the limit price, which may or may not be the same.
Unlike standard stop orders, with a stop-limit order, you must enter both a stop price and a limit price. In most cases, the limit price on a sell stop-limit order will be equal to or below the stop price. As the stock begins to decline in value, if the stock trades at or below the stop price, the order will trigger and become a limit order to sell at the specified limit price.
Because the order is now a limit order, execution cannot occur unless the position can be sold at the limit price specified (or better). If the next available price after the stop price is reached is below your limit price, your order will not be executed unless the price increases back up to your limit price. All other characteristics of limit orders apply as well.
To increase your chances of execution on a stop-limit order to sell, consider placing your limit price below your stop price. The farther below the stop price you place your limit price, the better chance you have of executing your order in a rapidly declining market.
With any type of limit order, including stop-limit orders, you aren’t guaranteed execution because the stock may trade below the limit price before the order can be filled. This often occurs when a stock is reopened for trading after being halted due to a significant news announcement, or when the stock opens for trading in the morning at a price that is much lower than the previous day’s closing price. When this occurs, a stop-limit order may trigger and be entered in the marketplace as a limit order, but the limit price may not be reached.
Example: The current price of a stock is $90. You place a stop-limit order to sell 100 shares with a stop price of $87.50 and a limit price of $87.50. If an execution occurs at $87.50 or below, your order will be triggered and become a limit order to sell at $87.50 or higher. If the market is falling fast, your order may not be filled at all if the next trade occurred at $87.45 and the stock continued to decline. However, if you entered your order with a stop price of $87.50 and a limit price of $87 and the next trade after the $87.50 trigger was at any price above $87, your order would typically be executed.
Keep in mind that , your order can’t be executed at a price that is inferior to the best available price, even if your limit allows for it. Therefore, in a slowly declining market, your order might be filled at $87.50 or better if market conditions allow for it.
With the courtesy of Charles Schwab