What is a Stop Order? Overview, Definition and Strategy

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 OrderStop-limit orderMarket OrderLimit Order
Price CertaintyUncertainCertainUncertainCertain
Execution CertaintyCertainUncertainCertainUncertain

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.

Example

Stop-loss order

You recently shorted Tesla stock (TSLA) because you thought it was overvalued at $800; on top of that, the technical indicators that you’ve been following show that the stock price may be entering a bearish trend at current levels. 

However, the stock has historically been volatile, and its stock price has continued to rise in spite of selling pressure on multiple past occasions. Wary that history may repeat itself, you enter a stop-buy order of $900 to set a cap on your potential losses should your bet be wrong. 

The next day, the government declares a generous new environmental tax credit for all Electric Vehicle buyers. Simultaneously, Elon Musk decides to unveil plans for an exciting new Model Z Tesla vehicle that will enter production as early as next quarter. In response, retail investors bid the price up by twenty percent to $960 within the hour. Unfortunately, you happened to be napping when the news release dropped, so you were unable to react to the headlines.

Luckily however, the stop-loss order you entered automatically deployed a market order buy-to-cover your short position once Tesla breached the $900 stop price level. As a result, your losses were minimized at -12.5%, or -$100, rather than the -$160 loss (and climbing) that you could have faced, had you maintained a naked short position against Tesla.

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.

Example

Buy-Stop for Profit

You’ve been eyeing Facebook Stock (FB), currently trading at $270 as of this morning, and has been trading within a range of $260 – $280 for the past 2 weeks. Based on your stellar technical research, you believe the next resistance level on this stock to be approximately $285. If the stock price rises above that level, you believe it may be posed to break out even higher.

To plan for this possible event, you place a buy-stop order to purchase Facebook with a target stop price of $285. At this point, you step out for a drink with your friends.

Immediately, that same afternoon, Mark Zuckerburg announces that they’ve introduced an exciting new machine-learning technology that increases the likelihood of users clicking on their ads by 35%. Simultaneously, the Department of Justice announced that they will be dropping all litigation suits against Facebook from this point on. Excited by the news, retail investors bid up the price by 20% to $324 by noon. Unfortunately when the news hit, you were 3 cocktails into lunch.

Luckily for you, the buy-stop order you entered that morning automatically deployed a market order to buy Facebook stock once its price exceeded your stop price of $285. As a result, you were still able to benefit from the majority of the price spike, pocketing a tidy $49 per share (unrealized) profit.

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.

Example

Sell-stop order

You acquired a small stake in Starbucks stock (SBUX) at $100 in anticipation of a potential recovery in the market. However, times are tough and you’re nervous that a broad market sell-off may occur. If so, you wish to lose no more than 10% on this trade. As a result, you place a sell-stop order at $90, or exactly 10% below the price you initially acquired it.

The next day, your nightmares come true, and the National Bureau of Economic Research (NBER) officially announces that we’re in a recession. Coffee consumption across American is likely to fall by as much as 35%. In response, the market contracts, with Starbucks stock dropping by 15%. Unfortunately and ironically, you were too busy out grabbing a cup of coffee when the market began its descent. 

Luckily for you, the sell-stop order you placed automatically triggered a market order to sell SBUX once it fell past the $90 stop price. As a result, you were able to avoid more serious losses, capping your losses at approximately $10 per share.

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.

  1. 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
  2. Second, make sure you select “stop” or “stop-loss” as your order type (the language may differ slightly depending on your trading platform) 
  3. 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.
  4. 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:

  1. The current range in price between your assessed stop price and the current market price of the security
  2. The current direction prices are trending in (this may require you to view price charts over the course of several days, if not months)
  3. 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.