Stop Orders That Can Save Your Account

11/24/2011 9:00 am EST

Focus: STRATEGIES

Briefing.com gives us a quick lesson on the types of stop orders available on most trading platforms and when you’d want to use each type.

Stop loss orders are some of the best techniques available to investors. But make sure you know the difference between a stop and stop limit order. 

When you already have a position, you can place a "stop loss" order. These are standing instructions, with a time line, which direct your broker to sell your stock under certain conditions. Generally, stop loss orders are used to either protect a profit, or to prevent a loss. 

There are two kinds of stop loss orders: stop and a stop limit order. Both are designed to sell your stock "automatically" when certain events occur. However, it is important to understand the difference between the two, because the circumstances under which the order is executed is different. To get the results that you want, make sure you place the right type of order. 

Note: Most brokerages use the terms "stop" and "stop limit," as described below. However, you may wish to confirm the meaning of a stop loss order if your brokerage uses terms other than those described here. 

Stop Orders

A sell stop order is used to protect a long position. 

A sell stop order is an order to sell below the current market price, but only when the market trades below your specified stop price. The market must actually trade below your specified price for your order to become effective. 

When the stock trades below your stop price, your sell stop order immediately becomes a sell at market order. It will most likely be executed quickly after the market trades below your stop price. 

It is important to note that because a stop sell order becomes a market order, your executed price may not be close to your stop price.

For example, a sell stop order for 100 shares of XYZ for $22 does not guarantee that your stock will be sold around or even close to $22. If bad news comes out overnight, and XYZ opens at $15, below your stop of $22, your sell may occur at $15 or even $14. However, your order was executed. If the stock continues to fall to $10, you may be gratified that you got out when you could.

By contrast, however, in situations where a stock price drifts lower, rather than collapses, the sell stop order generally trades close to the specified stop price.

A buy stop order is effectively the same, but for an initial short position.

NEXT: Stop Limit Orders

|pagebreak|

Stop Limit Orders

A stop limit sell order is similar to a sell stop order, however, the specified limit price is the only price that you will accept for the trade. As soon as the ask price hits your specified stop price, your trade becomes a sell at limit order. This does not guarantee that your order will be filled. There must be another party who fills your order.

In a rapidly falling market, your order may never be filled with a stop limit sell order. If other sell orders at lower prices start to appear, your order will be left behind, unexecuted at the higher price.

For example, in the scenario above, if XYZ opens at $15 from a close of $30 the day before, your stop limit sell order at $22 will never get executed. This may be what you want, but if the stock continues to drop to $10, you may wish you had a stop sell order at $22 and been "stopped out" at $15.

A stop limit buy is the same type of order for an initial short position.

Which to Choose?

The sell stop order makes it more likely that your order will be filled. The risk you take is that a rapidly falling market will sell your shares lower than you expected. However, you can always re-enter a stock position at lower prices after your sell stop order. Choose the sell stop when you truly want to make sure your order is filled and you are fairly certain that any decline will be orderly.

The stop limit sell order specifies the minimum price you will receive if your order is filled. Your order will not be filled unless the market begins to trade right at the price you specify. Since all stocks fluctuate to some degree, you probably should not set a stop limit sell order too close to the current price if you are trying to protect profits.

The risk you take with a stop limit sell is that the market moves right past your limit price and you are left holding stocks when the price is well below where you wanted out. Choose the stop limit sell if you want to avoid feeling cheated in a rapid decline and would rather guarantee the price when, and if, your order is filled.

With most brokerages, both sell stop orders and stop limit sell orders can be placed as either day orders, or good until cancelled orders.

A Final Word

Stop loss orders are useful, but they don’t eliminate all risk. You can either make sure your stop order is filled (stop loss) or you can make sure you get the price you want (stop limit), but you can’t get both.

By the Staff at Briefing.com

Related Articles on STRATEGIES