Stop Order
Tue, Apr 15A stop order is a directive to either purchase above the market price or sell below it at a specified price. It instructs your broker to execute a trade at a level that is less advantageous than the current market price.
In the image above, the blue dot represents the current price. The green line is positioned above this price. If you place a BUY stop order at this level, the current price must continue to rise for the order to be activated. Conversely, the red line is below the current price. If you place a SELL stop order here, the current price must continue to decline for the order to be triggered.
A stop order functions in contrast to a limit order, which directs your broker to buy or sell an asset at a price that is more favorable than the current market price. Stop orders are typically utilized to exit a trade if the market moves against the trader's position.
There are two main types of stop orders: stop loss orders and stop entry orders.
Stop Loss Order
A stop loss order is designed to limit risk by automatically closing a position once it reaches a predetermined level of loss. Various types of stop loss orders exist, including basic stop loss, trailing stop loss, and guaranteed stop orders.
Stop Entry Order
A stop entry order is employed to capitalize on market movements by initiating a long position when the market price rises to a certain level, or by opening a short position when the market price falls to a specific level. Breakout traders can utilize these orders to ensure they do not miss opportunities to enter and exit trades when they are unable to monitor the market.
When an order is sent to a broker, it becomes a market order once the market reaches the specified price. In fast-moving or volatile markets, slippage may occur.
Utilizing a stop loss order is an effective way to manage your positions without the need for constant market monitoring. The key is to select a stop order level that allows for price fluctuations while still safeguarding against downside risk.
When determining your stop order level, it is crucial to understand that there is no guarantee of execution. Basic stop orders may experience slippage when opening and closing positions, particularly during significant market movements or gaps. If your specified level is reached, your stop order will be executed at the best available market price, which may differ significantly from your desired price.
If you opt to use a stop order and the market movement is only temporary, you might miss out on potential profits. For instance, if you are in a long position and your stop-loss order closes your position, only for the price to rise again immediately afterward.
While stop and stop-limit orders can be beneficial for those who cannot continuously monitor their investments, they come with inherent risks:
- Uncertain Execution Price: Stop orders activate at a designated price (the “stop price”), but the actual price at which the trade is executed (the “execution price”) may differ, especially in volatile markets where prices fluctuate rapidly.
- False Triggers: Sudden, brief price movements can trigger a stop order, even if the price quickly rebounds. This may result in selling when it was not intended.
- Price Declines: Sell stop orders can exacerbate price drops during volatile periods. When a stop order triggers a sell in a declining market, it can further push the price down.
- Stop-Limit Orders and Missed Trades: Stop-limit orders provide more control by establishing a minimum acceptable price (the “limit price”). However, if the price continues to fall past your limit, your order may not be filled at all.
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