What Is a Stop Order?
A stop order is one of the two main order types you will encounter in the market: stop and limit. The key for the stop order is that it is always executed in the direction that the price is moving. For instance, if the market is moving lower, the stop order will be to sell at a pre-set price below the current market price. Alternatively, if the price is moving higher, the stop order will be to buy once the security reaches a pre-set price above the current market price.
There are several types of stop orders that can be employed depending on your position and your overall market strategy. Here's a review of the various types of stop orders and how they function relative to your position in the market (no position, long position, and short position).
- Stop-loss orders should be in place whenever you have an open position to limit your potential losses.
- Stop-entry orders can be used to enter the market in the direction the market is moving, frequently referred to as breakout trading.
- If the market is moving higher, a stop-entry order will make you long; if the market is moving lower, a stop-entry will make you short.
- You can move your stop-loss order in the direction of the trade, using a trailing stop-loss to further limit your losses, or even better, to protect your gains.
- You can use a financial or technical price level to place your stop order.
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A regular stop-loss order is recommended for any live position. A stop-loss order is just what it means—it stops losses. The stop-loss order will take you out of your position at a pre-set level if the market moves against your existing position. Stop-loss orders are critical for when you can't actively keep an eye on the market, and it's recommended always to have a stop-loss order in place for any existing position for protection from sudden market news, data releases, and the like.
For example, let's say you're long (you own it) stock XYZ at $27 and believe that it has the potential to reach $35. However, at price levels below $25, your strategy is invalidated, and you want to get out. You would then place a stop order to sell XYZ at around $25, or slightly lower to account for a margin of error.
A stop-entry order is used to get into the market in the direction that it's currently moving. For example, let's say you have no position, but you observe that stock XYZ has been moving in a sideways range between $27 and $32, and you believe it will ultimately move higher. In this case, you could place a stop-entry order above the current range high of $32—say at $32.25 to allow for a margin of error—to get you into the market once the sideways range is broken to the upside. Now that you're long, and if you're a disciplined trader, you'll want to immediately establish a regular stop-loss sell order to limit your losses in case the break higher is a false one.
Trailing Stop-Loss Order
Continuing from the scenario above, XYZ has broken above the range top at $32, and your stop has been triggered at $32.28 (we'll explain later why your order may not have been filled at exactly the $32.25 order price), making you long in a rising market. Continuing on, the price goes higher and hits your first price objective at $35. You may now want to protect your profits in case the market reverses lower. You can accomplish this with a regular stop loss placed at, say, $34. That means you will lock in around $1.72 on the trade ($34.00 – $32.28 = $1.72) if the market turns around. In this case, you used a stop-loss order to protect your profit instead of limiting your loss.
In the case above, you manually moved up your stop-loss order after the market had moved in your favor. Some online brokers offer a trailing stop-loss order functionality on their trading platforms. These orders follow the market and automatically change the stop price level according to market movements. You can set a particular price distance the market must reverse for you to be stopped out.
For example, you can specify $0.50 for the stock trade, meaning that the market price, currently at $35, must touch $34.50 for your stop-loss order to be triggered. However, if the price continues to move higher, the trailing stop will rise with it, always remaining $0.50 from the highest high the price has reached. For example, let's say the price continues to move higher from $35 and reaches $36.75. Your trailing stop will have followed the price increase and will now be at $36.25 ($36.75 – $0.50 = $36.25). Trailing stops are a great way to protect profits and stay in a position until the market has shown that it has actually reversed.
Where to Place Stop Orders
A common question posed by both traders and investors is where they should place their stop-loss order. There are too many variables to give a one-size-fits-all answer, but a rational method falls into two categories: financial and technical.
A financial stop-loss is placed at a point where you are no longer willing to accept further financial loss. For example, let's say you're only willing to risk $5 on a stock that's currently trading at $75. That means you've chosen a financial stop of $5 per share (or $70 as the stop price), regardless of whatever else may be happening in the market.
A technical stop-loss is placed at a significant technical price point, such as the recent range high or low, a Fibonacci retracement level, or a specific moving average, just to name a few. The key factor is that, if you have a market position, you need to have a live stop-loss order to protect your investment/position.
Earlier, we mentioned that a stop-loss order's execution may not be at the exact price you specified. Let's say you had a stop-loss entry price at $32.25, but it was executed at $32.28, or 3 cents higher than you specified. That difference of 3 cents is referred to as slippage, which is caused by many factors, such as lack of liquidity, volatility, and price gaps on news or data, just to name a few. Slippage can also occur when a regular stop-loss is executed.
Traders should expect some slippage on a stop-loss order execution if any of the above conditions apply. As a result, traders need to be aware of upcoming events and data releases, as these can often trigger extreme volatility and price gaps, potentially leading to slippage on the execution of your stop order.
To illustrate, you might be long XZY stock at $50 with a stop-loss at $49.00. Bad news hits the newswires, and the market price drops rapidly through $49.00. Given the sudden volatility in the market, your stop-loss ends up being executed at $48.95, meaning 5 cents of slippage on your order due to the news. It may be the case that the market continues lower, reaching a close of $47.50, for instance. All of a sudden, that 5-cent slippage may not seem so bad after all. The most important thing was that you had a stop-loss order in place to limit your losses.
Why Do I Always Need a Stop-Loss Order When I Have an Open Position?
Not every trade is a winner. Every position has the potential to move against you, losing you money. A stop-loss order will limit your losses to around a specified level that you define. It's important to note that you should create a complete strategy (entry, stop-loss, and take-profit) to manage your position before you enter that position. That way, you avoid the emotional uncertainty that comes with having an open position.
What Should I Do if My Stop-Entry Order Is Filled?
You now have a position in the market, and you need to establish, at the minimum, a stop-loss (S/L) order for that position. You can also add a take-profit (T/P) order. Coupled together, you now have orders bracketing your position. Such orders are typically linked and known as a one-cancels-the-other (OCO) order, meaning if the T/P order is filled, the S/L order will be automatically canceled, and vice versa.
Where Should I Place My Stop-Loss Order?
You can use a financial stop (how much money am I prepared to lose on this position?) or a technical S/L (what significant technical level will need to be breached for your trade scenario to be invalidated?). Not every trade is a winner, so you need to have a strategy in place before you enter a position, knowing where you'll limit your losses and take your profits.
Should I Ever Move My Stop-Loss Order?
It is recommended that you should move your stop-loss order only if it's in the direction of your position. For example, imagine you're long XYZ stock, with a stop-loss order $2 below your entry price. If the market cooperates and moves higher, you can raise your S/L higher to further limit your loss potential, or possibly lock in profits.
However, you should never move your stop against your position. Using the example above, imagine the market does not cooperate and moves lower against your long position. As it nears your pre-set S/L level, you may lose discipline and want to lower your stop further so you can hold onto the position and avoid taking a loss. This exposes you to further losses and goes against your pre-set strategy for the trade. Maintaining your S/L at your pre-set level means following your original strategy. It's what keeps small losses from becoming large losses.
The Bottom Line
Stop orders are a critical tool in a trader's toolbox. Traders and investors should always have a stop-loss in place if they have any open position. Otherwise, they're trading without any protection, which could be dangerous and costly.
Stop orders can be adjusted in the direction of the trade if the market moves in your favor, but you should never move a stop away from the direction the market is moving. For example, if you're long and the market is moving lower, you should never lower your stop from where you originally placed it. Hopefully, you have put together a complete trade strategy (entry, stop-loss, and take-profit) before you entered the market. This way, your mind and emotions are not in play, just your strategy.