A stop order, also known as a “stop-loss order,” is a conditional order to buy or sell a security once the price exceeds the trader’s target “stop” price. Unlike market orders, which execute almost instantaneously upon entry, stop orders sit dormant until the target stop price is exceeded. At this point, the stop order automatically converts to a market order which is promptly executed.
Stop orders are excellent risk mitigation tools that allow traders to limit their losses or lock-in profits. They are typically used by advanced investors on trades where large price swings are a common occurrence, such as options contracts, cryptocurrencies or even highly volatile equities. They’re also useful for risk mitigation when active traders are unable to adequately monitor their investments for an extended period of time.
This guide covers stop orders and is part of a larger collection of guides which cover common order and execution types. Take a look at our table below to see the key features of stop orders and how they stack up against other order types.
|Order Type:||Stop Order||Stop-limit order||Market Order||Limit Order|
How does a stop order work?
Stop orders are used when you want a trade to execute only when the price exceeds a specific level, or “stop price”. A stop order behaves like a “line in the sand” drawn by traders based on their views of what an acceptable maximum loss is, or at what point they should lock in their profits.
Stop, or stop-loss orders can be placed as buy-stop orders or sell-stop orders. In either case, they remain conditional market orders, but differ based on whether the investor wants to acquire or divest themselves of a position.
When to use a stop order
You can use a stop order regardless of whether you’re the buyer or seller of a security. The most common uses of a stop-order are to protect against downside risk or lock in profits. We define and cover the most common scenarios for stop orders below:
- Stop-Loss Order for Protection (Trader short a security)
- Buy-Stop Order for Profit (Trader buying a security)
- Sell-Stop Order for Protection (Trader selling a security)
What is a Buy Stop Order?
From a buyer’s perspective, a buy stop order is a directive to purchase a security once the price of that security exceeds a trader’s established “stop price.” Once the stop price threshold is exceeded, the “stop order” automatically converts to a market order to purchase the investment.
For buy stop orders, the stop price must be set at a level above the current market price. They are typically used as either a form of protection, in the case of “stop-loss” orders, or to take advantage of a bullish trend.
Buy Stop Order for Protection (Stop-Loss)
Buy-stop orders are most commonly used as a form of protection against the unlimited losses of a short position, which is why they’re often referred to as “stop loss orders.” Traders who are short a position because they are bearish on its future prospects often hedge their bets by setting a buy-stop price to cover their short position.
Buy Stop Order for Profit
Buy stop orders can serve as a good way to time entry points for buyers, seeking to enter a position. Operating under the assumption that a stock’s price that is showing a bullish pattern will continue to rise, placing a buy stop order at a key entry point can be a profitable decision for technical traders following a momentum strategy.
Technical traders often rely on resistance and support levels to dictate their entry and exit points for a trade. A stock price that rises past its resistance level undergoes what’s known as a “break-out” and this signals that the stock price is likely to continue to rise.
What is a Sell-Stop Order?
From a seller’s perspective, a sell stop order is a conditional market order to sell a security in your portfolio if the price drops below your established “stop price.” Once the stop price threshold is exceeded, the “stop order” automatically converts to a market order to sell the security.
The stop price must be set below the current market price of the security for sell-stop orders to work. For owners of a security, sell-stop orders are typically used as either a form of protection, to protect against the security-owners downside risk in the event of a precipitous price drop.
How to Place a Stop Order?
The majority of trading platforms will allow you to place a stop order through their standard trade routing system.
- First, select whether your trade action is either a buy/sell order, depending on whether:
- (sell) you own the security and wish to protect your gains
- (buy) you’re seeking to purchase the security if it moves upwards
- Second, make sure you select “stop” or “stop-loss” as your order type (the language may differ slightly depending on your trading platform)
- Third, enter your target “stop price.” This must either be above the security’s current market price for a buy-stop order, or below the current market price if you’re entering a sell-stop or stop-loss order.
- Finally, enter how long you want your stop order to remain outstanding, your typical options will usually be:
- Day – In effect for the duration of the trading day. If the stop price is not triggered, the order will automatically expire at market close.
- GTC – “Good til cancelled” – the trade will last through future trading sessions until the stop price is triggered, the order is cancelled by the trader, or it will time out once the maximum allowed order period expires.
Strategies for Implementation: Where should you set your stop order?
The appropriate stop price will depend on a number of factors, including your appetite for risk, how volatile a particular investment is, and what direction the market is trending. All of these concerns will apply regardless of whether you’re seeking to lock in profits, limit losses, or cover your downside risk using a stop order.
In any case, the ultimate goal of a stop order will be to cap your potential losses or ensure that you come away with a minimum viable level of profit if the market goes awry. When gauging an acceptable stop price, consider the following:
- The current range in price between your assessed stop price and the current market price of the security
- The current direction prices are trending in (this may require you to view price charts over the course of several days, if not months)
- How volatile the security is on any given day.
|Pro Tip: Stop orders and momentum|
Stop orders can be a powerful tool for technical traders when used in tandem with support and resistance levels to execute on a momentum-oriented trading strategy.
Risks of a stop order
There are some obvious risks raised with the concerns above. Namely, a stop price set too close to the current market price of your security can result in a trade getting executed earlier than expected. This may not be ideal as stop orders placed on particularly volatile securities can execute prematurely.
However, a stop-price set too far away from the current market price of your security may cause you to lose out on earlier support/resistance levels and sap your total return. The range of pricing may also be too great for you to maximize any benefits gained from a protective stop-order; this is particularly risky if you’ve set a stop-loss sell order as “good-til-cancelled” when it’s already been gapping upwards (or downwards) for several days. It’s a good idea to periodically reset your outstanding sell-stop orders if they’re intended for protection, especially if the price of the security continues to rise and you wish to lock in your profits.