There are many different order types in the world of investing and trading. It’s pivotal to have the knowledge in your repertoire no matter the market style you enjoy. In this article we are going to dive into the details of the stop-loss and the stop-limit order. What are they? When do you use them most effectively? All will be covered in this blog.
First we have to dissect the meaning of the two individually before comparing them and identifying when you use one or the other.
What is a stop loss order?
Stop loss orders are exactly what they sound like, they’re protection orders in the market to minimize the loss a trader takes. The order type indicates that if a security should pass a certain price the position will be closed. There are two different types of stop loss orders. Sell-stop orders and buy-stop orders.
What are sell-stop orders?
The sell-stop order is used to protect long positions. This is put into place to sell the position at market if price falls under a certain level. The sell-stop is used to protect investors from the downside in a security. The assumption is that if the price drops under the level it will continue to fall. This way the max loss is protected. This is also based on the risk willing to take.
For example, if you own 100 shares of Apple stock, bought at $295, and it’s now trading at $320. You want to lock in $7 of the profit, which equates to $700 of gain on the position. You will place a sell-stop order at $302. That means if the stock drops below $302 the order becomes a market order and will be filled and closed out at market price. Which usually is more or less $302, if not exactly that level. With the sell-stop you do not guarantee the price you get out. The fill depends on the liquidity of the stock, highly liquid stocks will have better stop fills.
What are buy-stop orders?
The buy-stop order is used on the other end of the trade. It is the same as a sell-stop however they are used to protect a short-position. So that means if you are shorting a market, stock or otherwise you use the buy-stop order to limit the upside exposure. This is because an asset can theoretically rise infinitely. So there is a lot of exposure above. The buy-stop is activated as a market order when price goes above that level, buying back the short position.
For example, if you short 100 shares or Apple at $320, you want to protect yourself. You can place a buy-stop at $325 to cap the risk at the $5 per share. If this same position resulted in Apple dropping down to $280, you can place a buy-stop at $300 to secure $20 of gains.
What is a stop-limit order?
The stop limit order is very similar to the stop order, with one slight difference that might make a world of difference depending on the liquidity of the market you trade. First we need to identify and explain the limit order first.
What is a limit order?
The limit order is an order either on the buy or sell side that is placed to get into the market. This order is placed at a specific price. The limit order doesn’t necessarily guarantee a price, but we’ll see in the stop-limit how it may affect the order.
What is a stop-limit?
This order is very similar to the stop order, however as the name suggests, the limit order portion of the order means that there is a limit of the price where the position will be executed and filled. The stop-limit order has two components. The stop price, which converts the order to a sell or buy order and the limit price. This order doesn’t become a market sell or buy order, the order becomes a limit order that will only execute at the limit price or a better price.
For example, assuming that you have Apple shares, yet again and it doesn’t drop down to the stop-loss price. It continues to rise, hitting $350 at one point. You would probably cancel the stop-loss order at $302. Then you may put in a stop-limit order at $320 with a limit at $315. Meaning if Apple falls below $320, the order becomes an active sell-limit order. So if Apple drops under $315 before the order is filled, then that order will remain active until the $315 level is revisited.
In most cases, you would see the investor or trader cancel their limit order, if not filled. It was in place for a purpose. On the other end, you can have a buy stop limit order that works the same way. The main risk with the stop-limit order is there is no guarantee you will get a fill at your limit level.
The two orders are very similar but there is one key difference for investors and traders. The stop-loss order is a guarantee of execution while the stop-limit order guarantees the price at which you will get filled. However not that you will get filled.
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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 for your own financial situation. TRADEPRO Academy is not responsible for any liabilities arising as a result of your market involvement or individual trade activities.