Understanding Stop Orders: Part 1

Understanding Stop Orders: Part 1

The ability to place stop orders is an essential function of any trading platform. Before considering whether to use this versatile tool, it’s important to understand how it works.

There are actually four major types of stop orders. Each of them can be applied to either long or short positions, but for simplicity, we’ll describe each one from the perspective of someone holding a long position.

Stop Loss Order

The Stop Loss Order is the most basic stop order, and is simply a way to guarantee that you will exit your position if the price moves too far against you. When you enter the stop loss order, you specify a trigger price. If at any time the price of the stock drops to the trigger price, then your broker will immediately replace your stop order with a market order to close your position.

Let’s say that you buy a stock for $25/share, and you want to get out if the price drops by 3% or more. Since 3% of $25 is $0.75, you would enter a stop loss order with a price of $24.25.

Because this type of stop order converts to a market order, you are guaranteed of exiting your position as long as there is sufficient liquidity in the stock. However, as with all market orders, there is no guarantee regarding the price at which your order will be filled. Consider a case in which the stock gaps down, with an opening price of $23.75. Your stop loss order will be triggered, because $23.75 is less than your trigger price of $24.25. Your market order will likely get filled at a price close to $23.75, depending on how quickly the market is moving. That would make your actual loss on the position close to 5%, even though you set your stop order price at a 3% loss.

Stop Limit Order

If you want to avoid being at the mercy of a market order, you can use a Stop Limit Order. As with the basic stop loss order, you will specify a trigger price which determines when your stop order gets converted. In the case of a stop limit order, however, the resulting exit order is a limit order rather than a market order.

Let’s use the example from above where we buy a stock for $25/share and want to exit if the price drops by 3% or more, but we also don’t want the stop order to result in a loss of more than 4%. Once again we would set our trigger price at $24.25. We would also set a limit price of $24, which is 4% below $25.

If the stock price drops to $24.20, our stop limit order will be converted to a limit order to sell the stock at $24.00. That limit order will likely get filled almost immediately, at a price near the current price of $24.20.

If the stock price gaps down to $23.75, our stop limit order will still be converted immediately to a $24.00 limit order. In this case, the stock price would have to rise back up to $24.00 before our limit order would get filled. If the price continues to fall, then our limit order will remain unfilled and we will continue to lose money on our position.

Trailing Stop Loss Order

Trailing Stop Loss Orders are a convenient way to protect some of your profits on a position. Let’s say that your $25 stock has increased in value to $27/share. Using the original Stop Loss Order with a trigger price of $24.25 means that you could lose your $2/share of profit, plus another $0.75 or more before the Stop Loss Order is triggered.

One way to solve this problem would be to manually cancel your old Stop Loss Order and enter a new one with a trigger price of, say, $26.25. A more convenient way is to use a Trailing Stop Loss Order, which automatically adjusts the trigger price depending on the price of the stock.

Whereas the Stop Loss Order specifies an absolute price for a trigger, the Trailing Stop Loss Order specifies a relative trigger price, for example -$0.75. At any given time, the effective trigger price for the Trailing Stop Loss Order is $0.75 less than the stock’s high water mark since the stop order was created.

Consider a case where we again purchase a stock for $25, but we do not immediately enter a stop order. The next day, the price drops to $24.50, reminding us that we want to have some protection in place, so we enter a Trailing Stop Loss Order with a relative trigger price of -$0.75. As soon as our order is entered, our effective trigger price is $24.50 – $0.75 or $23.75. During the rest of the day, the stock reaches a high price of $24.75, making our effective trigger price $24.00.

The following day, the stock opens at $24.60, and then rises to $24.70. Our trigger price does not change, because we have not exceeded the previous high water mark of $24.75. Later in the afternoon, the price rises to $26, which would bring our effective trigger price to $25.25.

As with the Stop Loss Order, if at any time the stock price falls below the trigger price our stop order will be immediately converted to a market order which will be filled at the current price.

Trailing Stop Limit Order

The Trailing Stop Limit Order can be thought of as a combination of Trailing Stop Loss Order and a Stop Limit Order. Like the former, it specifies a relative trigger price which changes with the stock’s high water mark, and like the latter it generates a limit order when the stop is triggered. To be useful, the limit price must also be relative to the stock’s high water mark, and it is usually specified in a similar manner. For example, if we set the relative trigger at -$0.75, we might set the relative limit price at -$0.80. That means that our limit order will probably get filled even if the stock price falls a few more cents after triggering the stop.

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As always, you will likely find it instructional to explore your own trading platform to see what capabilities it offers and how the interface works. If you have questions, either contact customer support or experiment cautiously with small positions.

In the next installment, we’ll discuss some of the pros and cons of actually using stop orders.