You decide you want to buy a security yourself, rather than have your 401(k) provider do it on your behalf. So you select an individual stock, or a share in an exchange-traded fund, or a bond…whichever. Then you open an account, you fund said account, and finally you place an order for the security in question. Nothing could be easier, right?
Not quite. The above scheme works only if the security you want to buy is liquid enough that it gets traded regularly. Place an order to buy or sell any of the 30 stocks that comprise the Dow Jones Industrial Average, and unless you place any conditions on it, it should be filled imminently. (That’s called a market order – you agree to buy/sell the stock at whatever price it’s currently trading at.) Select a thinly traded issue that’s sold over-the-counter, however, and you could be waiting for a while to find a buyer or seller.
Thus folks who participate in the stock market will make their orders conditional. For instance, ensuring that the order activates only when the price reaches a certain level. With XYZ trading at $10, a buyer could place an order that takes effect the moment the price falls to a level he designates – say $9. (Or a seller could place an order that activates only when the price reaches $11 or some other price of his choosing.) That’s called a stop order. Taking the first example, once XYZ falls to $9 (assuming it ever does), the investor’s stop order activates and becomes a market order. At that point, any seller willing to sell at $9 can do so, now that he has a buyer.
That being said, in practice a buy stop order is set for a price above the market price, not below. If that makes no sense, it will in a minute. The idea is to minimize possible losses. Take the above example of a buyer with a stop order in place and a stock trading at $10. The buyer sets the stop order at $11, let’s say, and knows that he doesn’t have to worry about getting shut out should the price increase far beyond that. If the buy order wasn’t a stop order, but rather just a standard market order, the buyer might be forced to sit there helpless as the price reached $12, $13, $14 and beyond.
If the buyer were to have set the stop-order price below $10, there’s a chance he’d be waiting on the sidelines indefinitely. The idea behind a (buy) stop order is for the buyer to acquire the stock at a price he can live with, not to set an unreasonable standard that the market has no interest in meeting.
(To learn about other strategies to cut losses, see Investopedia's article "Limiting Losses.")
Correspondingly, a (sell) stop order of course cuts losses in the other direction. A stockholder who wants to liquidate his XYZ holdings will set the stop order at, say, $9 with the stock trading at $10. Set it lower than $9, and the stockholder will lose more money than he’d be comfortable losing. Set it at $11 or $12, and he could end up holding onto the stock indefinitely, which would seem to defeat the purpose of placing a sell order in the first place.
There’s another dual-sided reason for setting (buy) stop orders above the current market price and (sell) stop orders below: primarily, to lock in the profit on a stock a buyer shorted. If you borrowed 1000 shares of XYZ from your broker at its previous price of $12, buying it back later at any price less than $12 (excluding transaction fees, of course) will net you a profit. Buying it back at $10 is swell. Buying it back at a stop-limited $11 is worse but still positive. Fail to place the stop order at $11, or place it too high, and you could lose your profits.
So that’s a stop order. A related concept, the limit order, means that the investor is buying (selling) a certain number of shares at a certain price or lower (higher). Combine the two types of orders and you get a tool created specifically to limit downside – the stop-limit order.
Here’s how it works. Again, we’ll use buying for our example. (Hold this article in front of a mirror to see how it works for selling.) The important thing to remember is that a stop-limit order specifies two prices – the stop price and the limit price. With a stop-limit order on XYZ, currently trading at $10, the buyer can set a stop price of $11 and a limit price of $12. The moment XYZ rises to $11, the order goes live as a limit order. If XYZ then continues rising to $12 before the order can be filled, it’ll stay open until the price again sinks to $11. Thus the buyer’s possible losses are lowered. The big difference between a stop order and a stop-limit order in this case is that in the former case, the shares sell as soon as possible, and at the best possible price for the buyer; with the latter, the shares sell only if the limit price is reached, which might not happen immediately.
With stop-limit orders, buyers protect themselves from prices too high for their tastes. And sellers need not worry about prices that are disarmingly low. Specifying stop-limit rather than market orders is an effortless way to minimize the downside for the defensive investor.