Traders and investors who want to limit potential losses can use several types of orders to get into and out of the market at times when they may not be able to place an order manually. Stop-loss orders and stop-limit orders are two tools for accomplishing this. However, it is critical to understand the difference between these two tools.
- A sell-stop order is a type of stop-loss order that protects long positions by triggering a market sell order if the price falls below a certain level.
- A buy-stop order is a type of stop-loss order that protects short positions; it is set above the current market price and is triggered if the price rises above that level.
- Stop-limit orders are a type of stop-loss, but at the stop price, the order becomes a limit order—only executing at the limit price or better.
There are two types of stop-loss orders – one used to protect long positions (sell-stop order) and one to limit losses on short positions (buy-stop order):
Sell-stop orders protect long positions by triggering a market sell order if the price falls below a certain level. The underlying assumption behind this strategy is that, if the price falls this far, it may continue to fall much further. The loss is capped by selling at this price.
For example, let’s say a trader owns 1,000 shares of ABC stock. They purchased the stock at $30 per share, and it has risen to $45 on rumors of a potential buyout. The trader wants to lock in a gain of at least $10 per share, so they place a sell-stop order at $41. If the stock drops back below this price, then the order will become a market order and get filled at the current market price, which may be higher (or quite likely lower) than the stop-loss price of $41. In this case, the trader might get $41 for 500 shares and $40.50 for the rest. But they will get to keep most of the gain.
Buy-stop orders are conceptually the same as sell-stop orders. However, they are used to protect short positions. A buy-stop order price will be above the current market price and will trigger if the price rises above that level.
Stop-limit orders are similar to stop-loss orders. But as their name states, there is a limit on the price at which they will execute. There are two prices specified in a stop-limit order: the stop price, which will convert the order to a sell order, and the limit price. Instead of the order becoming a market order to sell, the sell order becomes a limit order that will only execute at the limit price or better.
Of course, there is no guarantee that this order will be filled, especially if the stock price is rising or falling rapidly. Stop-limit orders are used in situations where although the price of the stock or other security has fallen below the limit price, the investor does not want to sell at the current low price and is willing to wait for the price to rise back to the limit price.
For example, continuing with the above example, let’s assume ABC stock never drops to the stop-loss price, it continues to rise and eventually reaches $50 per share. The trader cancels his stop-loss order at $41 and puts in a stop-limit order at $47, with a limit of $45. If the stock price falls below $47, then the order becomes a live sell-limit order. If the stock price falls below $45 before the order is filled, then the order will remain unfilled until the price climbs back to $45.
Many investors will cancel their limit orders if the stock price falls below the limit price because they placed them solely to limit their loss when the price was dropping. Because they missed their chance to get out, they will simply wait for the price to go back up. They may not wish to sell at that limit price at that point in case the stock continues to rise.
As with buy-stop orders, buy-stop-limit orders are used for short sales, when the investor is willing to risk waiting for the price to come back down if the purchase is not made at the limit price or better.
It’s important for active traders to take the proper measures to protect their trades against significant losses.
Benefits and Risks of Stop-Loss and Stop-Limit Orders
Stop-loss and stop-limit orders can provide different types of protection for investors. Stop-loss orders can guarantee execution, but price and price slippage frequently occurs upon execution. Most sell-stop orders are filled at a price below the limit price; the difference depends largely on how fast the price is dropping. An order may get filled for a considerably lower price if the price is plummeting quickly.
Stop-limit orders can guarantee a price limit, but the trade may not be executed. This can saddle the investor with a substantial loss in a fast market if the order does not get filled before the market price drops through the limit price. If bad news comes out about a company and the limit price is only $1 or $2 below the stop-loss price, then the investor must hold onto the stock for an indeterminate period before the share price rises again. Both types of orders can be entered as either day or good-until-canceled (GTC) orders.
Choosing which type of order to use essentially boils down to deciding which type of risk is better to take. The first step to doing so is to carefully assess how the stock is trading.
If the stock is volatile with substantial price movement, then a stop-limit order may be more effective because of its price guarantee. If the trade doesn’t execute, then the investor may only have to wait a short time for the price to rise again. A stop-loss order would be appropriate if, for example, bad news comes out about a company that casts doubt upon its long-term future. In this case, the stock price may not return to its current level for months or years (if it ever does). Investors would, therefore, be wise to cut their losses and take the market price on the sale. A stop-limit order may eventually yield a considerably larger loss if it does not execute.
Another important factor to consider when placing either type of order is where to set the stop and limit prices. Technical analysis can be a useful tool here; stop-loss prices are often placed at levels of technical support or resistance. Investors who place stop-loss orders on stocks that are steadily climbing should take care to give the stock a little room to fall back. If they set their stop price too close to the current market price, they may get stopped out due to a relatively small retracement in price. They may also miss out when the price starts to rise again.
Can stop-loss orders be used to protect profits on long and short positions?
Yes, they can. The term “stop-loss order” is a bit of a misnomer in this context. While the basic application for stop-loss orders is to prevent steep losses on long or short positions, they can also be used to protect gains on existing positions, since they get activated when the security price trades past a certain level. However, because they get converted to market orders once the specified price level has been breached, the actual price at which the trade gets executed may be well below the stop-loss price (for a sell-stop order) or above the stop-loss price (for a buy-stop order).
Can an investor get “whipsawed” by using a stop-loss order?
Yes, an investor can get whipsawed by using a stop-loss order. For example, their long position may get closed out when the stop-loss order gets executed, but if the stock subsequently reverses course and trades higher, the loss-making position could actually have been a profitable one if they had held on and not sold earlier.
How can I determine at what levels I should set my stop-loss levels?
Technical analysis can be very useful to determine the levels at which stop-losses should be set. For example, for a long position, figuring out key support levels for the stock can be useful for gauging downside risk. The premise here is that once a key support level crumbles, it may signal additional losses for the stock. Beware of false breakouts, however. Ensure you research stop-loss levels diligently using technical analysis and other tools before you enter them into your trading platform.
Are stop-loss and stop-limit orders foolproof?
Unfortunately, neither stop-loss nor stop-limits orders are foolproof or guaranteed to cap your losses at the desired level. Since a stop-loss order becomes a market order once the stop-loss level has been breached, it may get executed at a price that is significantly away from the stop-loss price. With a stop-limit order, the risk is that the trade may not get executed at the specified limit price. There are pros and cons to both types of orders, so ensure you do your homework and understand the differences before placing such orders.
The Bottom Line
Stop-loss and stop-limit orders can provide different types of protection for both long and short investors. Stop-loss orders guarantee execution, while stop-limit orders guarantee the price.