Whether you are a trader or an investor, you must clearly understand stop loss and stop limit concepts from getting a safer, more profitable trading experience.
Orders are trading instructions to brokers provided by traders and investors. Market orders are the most typical and widely used type of orders that buy and sell securities immediately. These orders provide a guarantee of the execution of the order, irrespective of any changes in price.
Stop orders, on the other hand, ensure the purchase or sale of stock once the price is at a specified level. Stop orders can be classified into two types:
- Stop-loss orders
- Stop-limit orders.
The following discussion is thoroughly constructed to help you get a proper understanding of all there is to know about stop-loss and stop-limit orders.
Defining the Types of Orders
Before going into the details and dynamics of how these orders work and the risks & benefits associated with them, let’s define the very concepts of these orders.
The purpose of stop-loss orders is to limit losses or protect profit. These types of orders are used to ensure trade or transactions are executed at the current market price or up to a specified price level.
The likelihood of the order being executed is fairly high due to its conditions. However, if the price fluctuates too fast, that would create the possibility of the order being executed at a price much higher or lower than specified.
Since stop-loss orders ensure execution of trade at current market prices, it automatically refers to the possibility of slippage occurring.
Stop-loss orders can be classified into the following types:
Sell Stop-loss Orders
The point of a sell stop order is to trigger a sale if the price drops down to a certain specified level. This execution is based on the assumption that implies that it’s more likely for the price to fall further since it’s already fallen to this level. Selling the stock at this price protects you from incurring any further loss.
Sell stop orders protect purchases that are expected to rise in value with time. This is termed as a long position for investors.
Buy Stop-loss Orders
Traders often sell a security to repurchase it at a lower price when available. This is termed as a short position, and buy stop orders are used to protect such. Buy stop orders function just like sell stop orders. The only difference is they trigger the purchase order when the prices rise over the specified level.
The specified price is set based on the assumption that it might rise further up. The buy stop order executes the purchase order to close the short position.
Stop Limit Orders
A stop-limit order, unlike stop-loss orders, take advantage of a specified price level. This type of order executes trades after stock prices are at a prespecified level. The prices might not be available due to low liquidity.
Trade is not executed in such cases, and slippage from the specified price does not occur. This enables preventing stop-loss orders from triggering in unprofitable circumstances.
A stop-limit order holds a limit on the price, which will trigger trade execution. That means there are two specified prices:
- A stop price that executes sell order
- A limit price
This makes stop-limit orders even better. Rather than becoming a simple sell order, the sell order turns into a limit order executing only at and above the limit price.
Stop limit orders can be classified into the two following types:
Sell Stop Limit Order
This is the type of limit order that executes sale if the price of a stock or security falls to and below the specified stop price. The limit price refers to the least acceptable price per share in this case.
Thus, executing a sell stop order implies that the share would be sold if the price fall to or below the specified limit. It’s important to note that this would be done only if there’s a possibility of earning a certain amount or more from each share.
Buy Stop Limit Orders
If the price rises to or above the specified stop price, the buy order would be executed according to the concept of a buy stop limit order. The maximum acceptable price per share to be paid is set as the limit for buy stop-limit orders.
This executes purchase orders when the price of shares rises to and above the specified limit. But this is only applicable if each share can be purchased for a specified amount or less.
Which Stop Orders to Use and Why
There’s no fixed strategy in terms of stop-loss and stop-limit orders that would be applicable for all circumstances. However, they can be adapted into various strategies and situations to reduce the probability of potential loss.
Following is a discussion on how each of them affects short-term and long-term traders and investors:
What’s common in all short-term traders is the tendency to cut losses as fast as possible and run the winners. Short-term traders mainly focus on arbitrary and volatile contracts.
This makes them perfect candidates for selling stop-loss orders since pricing is so tight. This helps traders at a loss to neutralize faster and redirect efforts to move in the right direction.
Moreover, short-term traders are not generally inclined towards even recoveries with medium-term contracts. This cuts them some slack, and they can afford sales below the stop-loss limit.
Long-term investors tend to naturally consider the implications of their investment over a longer period. Hence, stop-limit strategies are more suitable for them.
Long-term investors mostly consider a specific target index level and generally don’t mind waiting to get there. However, they continue to reassess the potential and prospects of their investments.
Moreover, long-term investors are naturally less susceptible to price changes or fluctuations that are shorter and more arbitrary. They function on the principle that fair value always prevails sooner or later.
Risks and Benefits
Using stop loss and stop-limit orders can be beneficial and disadvantageous depending on the circumstances. Following are some of the major and evident risks and benefits of executing these concepts:
- A greater extent of protection from unpredictable price fluctuations using stop-limit orders
- In fast-moving markets, any further losses can be limited or minimized using stop-loss orders
- Stop-loss orders can ensure trade but not the certainty of price levels
- Stop limit orders can’t ensure trade execution but provide the certainty of a minimum price level.
- The likelihood of executing a trade rises as the difference between the minimum price and stop-limit price increases.
- There is no scope to make contentious decisions in stop-loss orders. They are definitive and final.
- Specifying the stop-loss prices at lower levels provides better protection from short-term price fluctuations
- Investors and traders can reconsider and reinstate their position even if they miss the limit price under a stop-limit order.
The discussion above should provide a better understanding of the concepts of stop loss and stop-limit orders. Their applications, risks, and benefits all suggest that there’s no absolute rule of thumb to implement these strategies.
Rather, adopting the appropriate concept depending on the circumstances, conditions, and intentions would provide better yield, risk minimization, a guarantee of execution, and much more.