A stop order is an order placed to either buy above the market or sell below the market at a certain price.
It is an instruction to your broker to execute a trade at a particular level that is less favorable than the current market price.
In the image above, the blue dot is the current price.
Notice how the green line is above the current price. If you place a BUY stop order here, in order for it to be triggered, the current price would have to continue to rise.
Notice how the red line is below the current price. If you place a SELL stop order here, in order for it to be triggered, the current price would have to continue to fall.
The meaning of a stop order is the opposite of a limit order, which instructs your broker to buy or sell an asset at a particular price that is more favorable than the current market price.
Stop orders are normally used to take the trader out of a trade in the event the market goes against his/her position.
Types of Stop Orders
There are two types of stop orders: stop loss orders and stop entry orders.
Stop Loss Order
A stop loss order can be used to limit risk, by automatically closing a position once it reaches a certain level of loss.
There are a variety of types of stop loss orders, including a basic stop loss, a trailing stop loss, and a guaranteed stop.
Stop Entry Order
A stop entry order is used to take advantage of market movements by opening a long position when the market price rises to a certain level.
Or opening a short position when the market price falls to a certain level.
Breakout traders can use them to make sure they don’t miss any opportunities to enter and exit trades when they can’t monitor the market.
An order sent to a broker becomes a market order when the market reaches the specific price stated. In volatile (or fast) markets, slippage may occur.
When should you use a Stop order?
Using a stop loss order is a good way to manage your positions without having to constantly monitor the markets and be there at the exact moment of execution.
The key is to choose a stop order level that allows your asset to fluctuate in price while still protecting you from downside risk.
When selecting your stop order level, it is important to realize that this is no guarantee of execution.
Basic stop orders can incur slippage when opening and closing positions if there are large movements or gaps in the market.
If your level is reached, your stop order will be filled at the best available market price, which could be totally different from your desired price.
If you choose to use a stop order, and the market movement is only temporary, you may lose out on potential profit.
For example, if you’re in a long position and your stop-loss order closes out your position, and right after, price rises again. 😭
Risks of Using Stop Orders
Stop and stop-limit orders can be helpful if you can’t constantly watch your investments, but they come with risks:
- Uncertain Execution Price: Stop orders activate at a certain price (the “stop price”), but the actual price you get when the trade goes through (the “execution price”) might be different. This is especially true in volatile markets where prices change quickly.
- False Triggers: Sudden, short-lived price swings can trigger a stop order, even if the price quickly bounces back. This could lead you to sell when you wouldn’t have wanted to.
- Price Declines: Sell stop orders can make price drops worse during volatile periods. When a stop order triggers a sell in a falling market, it can push the price down even further.
- Stop-Limit Orders and Missed Trades: Stop-limit orders give you more control by setting a minimum acceptable price (the “limit price”). However, if the price keeps falling past your limit, your order might not get filled at all.