Stop loss vs Stop limit: The Ultimate Orders Guide.
You would surprised how many investors and traders in the world trade without a loss limiting order, either a stop loss or a stop limit. It isn’t uncommon to see positions without these attached orders. In the following article, TRADEPRO Academy will differentiate between stop loss orders and stop limits orders. Outlining their pros and cons and how they should be used by traders.
First, both of these orders are risk management tools that all traders and investors should implement when dealing with financial risk. The loss in a position can be substantial and praying and hoping your asset climbs back up can be detrimental. This is why we at TRADEPRO recommend you use of the following orders: A stop loss or a stop limit.
Stop loss vs Stop limit- The Stop loss
The stop loss order is a very useful but basic tool in trading any asset. Whether you trade futures, Forex or options or invest in stocks, every trader should be well equipped with the stop loss. There are two main stop loss order types.
The first is a protection tool for your long position. This sell stop loss order is placed on a long position that you hold to sell the asset at market if the price of the asset falls below a predetermined level. This protects your position against a substantial loss. Traders place sell stop losses at the max risk they’re willing to take on a position and anything more is unwanted. The assumption in using this order type is that one the assets price falls under your stop loss level, there is a good possibility that it will continue to fall.
Lets look at an example, below is a chart of Apple. Let’s assume that the green line is our entry price ($218.52/share) and the red line will represent the stop loss order. That means if price on the Apple stock drops under $211.55/share the stop loss order will be triggered as a market order to sell us out of our position. We have marked this level as the most risk we are will to take on this trade.
But wait, there’s more. There is another type of stop loss order. The buy-stop order. This type of order essentially does the same thing as the sell-stop loss order, but triggers a buy back of a short position. What we mean by this is, assuming you have entered into a short position. I.e you think that Facebook stock will continue to drop and you have shorted the stock. Shorting stocks is dangerous because the potential risk is essentially infinite, if the stock sky rockets.
Implementing a buy-stop order will limit a short positions risk. This involves setting a price to buy back your short stock if the price rises about that level. The assumption here is that if the stock climbs above your buy-stop price, there is possibility and probability of the price continuing to the upside.
Below you will see a chart of Facebook. This time, the red line represents the price ($160.25/share) at which a trader short sold the Facebook. While the green line represent the buy-stop loss price ($165.50/share). This means if Facebook’s stock rises above $165.50/share, the buy-stop will be activated and your short position will be bought back at market. This is the maximum risk we are willing to take on this position.
Stop loss vs Stop limit- The Stop limit
The stop-limit order is not to be confused with the stop-loss order. Although very similar and easily mixed up. The key difference is in the name; limit. The stop-limit order has two prices associated with it. The stop price and the limit price. This is where it might get a little convoluted for you, but were here to explain! The stop price portion of this order converted the order into a sell order. So instead of selling you out of your position at market like in the stop loss. The stop price triggers a limit in which your order will be executed at that limit price or a better one. Like the stop loss, there are two types of stop limit orders.
Let’s show you an example before we go any further. Assume you that buy PayPal stock at the green price mark ($78.80). You’ve set up a stop-limit order at $77.08 (red line) with a limit of $75.46 (yellow line). This means that if the stock price get back under the red line ($77.08). The order will get activated as a sell limit order. But price continues to drop, passed $75.46 (yellow line) and you order doesn’t get a chance to get filled. You will still be in the position until price gets back to the yellow line or above, because that’s where you set the limit to fill.
That means, as the above example illustrated, this order type is not a guarantee. There is no 100% certainty that your position will get liquidated if a stop-limit order is set. Scenarios where the order will not get filled are periods of volatility where price rapidly rises or falls. A common occurrence among traders and investors when using stop-limits is their cancellation of the order. Often times when the limit is not filled, a trader will just cancel the order and wait for the price to climb back up. Tying into this if the price climbs back, common thought is that there is not point in liquidating the position for a loss when there is more upside potential.
The buy stop doesn’t begin and end at the stop-loss. There is such thing as a buy-stop limit order. Which is similar to the sell-stop order. In fact it does the exact same thing for traders or investors that have short sold a stock. The same principles apply, assuming you sold Caterpillar stock below at the red line ($140.55/share). You’re a smart investor and want to manage your risk so you set a buy-stop limit at the $144.30/share (green line) level with a limit at $146.70/share (yellow line). This buy-stop limit will get activated if price rises above the green line. The order will get filled if it touches the yellow and remains under. Although there is possibility that the stock price rises drastically past the yellow line and you will not get filled. That is the maximum risk that you are willing to take but it is not a guarantee that it will get filled at that level.
Stop loss vs Stop limit-Benefits and Risks
There are benefits and risks to both stop order types, stop loss orders and stop limit orders offer investors a risk management tool that protects their position. The only catch is that the price at which the position is liquidated is not a guarantee in either situation.
Starting with the stop loss order; this order type does guarantee execution. But the price can be unexpected because once the order is activated the price at which the position is liquidated is at market. If you are in a stop loss situation and the price is quickly dropping, hits your stop and continues. The likelihood of a lower market fill is high, effectively losing more than expected.
There may be some confusion as to what order type to use and when. Traders and investors should take into consideration the nature of the asset in question. If a trader is trading a stock, volatility should be a larger factor in this decision.
If a stock is volatile traders and investors would be better off using a stop-limit order. This is because even if the price drops well past the limit, the chance of it climbing back is high as well.
Alternatively, the stop loss would be wise when trading an asset that has been on a huge trend for example. If a company recently came out with some very bad news, and the stock turns bearish, with no signs of rallying for months if not years. If a trader was long this stock, the better risk management decision would be to liquidate the stock, as there is no real sign of a rebound. In this case, a stop-limit would result in a substantial loss.
Retrospectively, these two similar order types are actually very different. These different orders are protective stops for trader and investor position. The stop-loss guarantees market liquidation after a certain price is hit, but the price at which the position is closed is not guaranteed. The stop-limit guarantees the price at which the order will be executed but the fill is not guaranteed. Both have their place in trading, but it would be wise to consider the asset in question when deciding which to use. For more information on order types and technical analysis, check out the TRADEPRO Academy Foundations Course!
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The information contained in this post is solely for educational purposes, and does not constitute investment advice. The risk of trading in securities markets can be substantial. You should carefully consider if engaging in such activity is suitable to your own financial situation. TRADEPRO Academy is not responsible for any liabilities arising as a result of your market involvement or individual trade activities.