Stop-loss orders involve buy trades being triggered as security price is rising, or sell trades being triggered as security is dropping in price. Stop-limit orders effectively build a limit price requirement atop a normal stop-loss order.
What Is a Stop-Loss Order?
A stop-loss order is an order to buy a security as its price is rising and hits a specified stop price or to sell a security as its price is declining and reaches the stop price. The former is called a buy-stop, and the latter is called a sell-stop.
Most typically investors set sell-stop orders to protect the profits, or limit the losses, of a long position. When the stop price is reached, the stop-loss order converts to a market order and is usually executed immediately thereafter.
What's notable about stop orders is that trade execution is triggered as a security price is becoming less favorable for the trade.
Key Takeaway: The main benefit of a stop-loss order is that it limits losses. There is a fairly high likelihood that the order will be executed, but it could be executed at a much higher or lower price than what is set in the order if the price falls or rises too quickly.
Stop-Loss Order Example
Let's assume that an investor buys 100 shares of XYZ Corp for $70/share, a total cost of $7,000. However, the price of XYZ declines to $60/share, making the position worth only $6,000. At this point, the investor is sitting on a $1,000 unrealized loss. If the investor decides that they are unwilling to accept losses more than $2,000 on their position of XYZ, they can set a stop-loss order to sell the shares at the $50 price level. If the price of XYZ does drop to $50 or lower, the 100 shares will be automatically sold at the best available transaction price, protecting the investor from any additional losses.
Tip: Some investors will use stop-limit orders to establish new positions at price levels they believe represent the beginning of a new trend in the same direction.
What Is a Stop-Limit Order?
A stop-limit order is similar to a basic stop order, but with one added condition. With a stop-limit, the investor not only specifies a stop price, but also a stop limit price. If the security in question reaches the stop price, this will trigger a limit order (instead of a market order for a regular stop order). The trade will only execute once the trigger price is reached and the limit price can be executed.
The benefit of a stop-limit order is that it guarantees a minimum trade price for sells, or maximum trade price for buys. The drawback is that the order might not be executed even if the stop price has been reached. If a stock experiences a sharp price movement, it could move right through an investor's stop limit price, resulting in even greater losses on the position that wasn't divested.
Stop Limit Order Example
Consider an investor who is long 100 shares of XYZ, and has entered a stop-sell order with a stop price of $50, and a stop limit price of $48.50. If shares of XYZ decline to the stop price of $50, the 100 shares of XYZ will be sold as long as a minimum price of $48.50 can be obtained. If the stock price has dropped sharply, and a sell order cannot be executed at $48.50 or higher, the 100 shares of XYZ will remain unsold.
Tip: Stop-limit orders guarantee a minimum price (for sell-stops) or a maximum price (for buy-stops) but it's possible the trade will not execute even if the stop price is reached.
Stop-Loss vs. Stop-Limit: Example
Let's say an investor purchased 100 shares of Acme stock at $80, and that the price has increased to $100. The investor decides to set a stop-loss order at $90 in an attempt to protect some of their profits. Acme shares do eventually decline to $90. At that point, the stop-loss order becomes a market order, and the stock is sold at whatever the best available transaction price is at that moment. Let's assume Acme shares have low liquidity, and the best available price is $88.75. The stop-loss order will result in 100 shares of Acme being sold at $88.75.
Alternatively, the investor could have placed a stop-limit order instead of a simple stop-loss order. Let's assume they set a stop price of $90/share, at a stop limit of $89/share on their Acme stock holding. If the price of Acme shares declined to $90, but the best available transaction price at this point is only $88.75, the order will not be filled since that level is below the stop limit price of $89. In this scenario, the investor's position would be exposed to potential additional share prices declines. The investor's stop-limit order will only divest the shares of Acme if a price of $89 or higher can be realized.
Benefits of Stop-Loss & Stop-Limit Orders
Both stop orders and stop-limit orders will serve to limit losses if the price of a security moves against an investor's position (conditional on the price not blowing right through the stop limit if one exists).
- Stop-loss orders guarantee execution as long as the stop price is reached and there's time to execute the trade before the market close.
- Stop-loss orders can be used by traders to establish new positions at price levels they believe represent the beginning of a new trend in the same direction.
- Stop limit orders guarantee a minimum trade price for sells, or maximum trade price for buys, if the trade executes.
Risks of Stop-Limit & Stop-Loss Orders
Both types of stop orders can result in investors being shaken out of positions they wanted to hold, due to short-term price fluctuations. In some markets, traders are known for trying to take out known stop levels.
- Stop orders might be executed at a price that's less favorable than the specified stop price.
- Stop limit orders may not be executed at all, even if a security price moves through the stop price that an investor set for protection
Stop-loss vs. stop-limit orders are both used to provide protection against the size of potential losses on existing positions. Stop prices usually represent the maximum loss level an investor is willing to accept for a given position. Stop-loss orders guarantee execution if the security hits the stop price, but do not guarantee what price the trade will be exited at. Stop Limits effectively build a limit price requirement atop a normal stop-loss order.
This article was written by
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