Table of Contents:
Stop Order Explained
A stop order is a market order to buy or sell that gets executed once an asset reaches a specific stop price defined by the trader. Market orders get executed instantly upon availability, so if the stop price is reached then based on the availability of the asset, your order will become filled if possible.
There are different stop order types such as:
- Buy Stop Order
- Sell Stop Order
- Stop-Loss Order
- Stop-Limit Order
- Trailing-Stop Order
There’s a lot of confusion with this order type, just because we read the word “stop” we tend to imagine that the order is exclusively designed to “hold off” or to “pause” something and that’s not the case as a stop order can be used to buy or sell for example.
If you read our limit order guide, then you know that if you wanted to buy a stock that right now trades at $20 and you’re only willing to enter your buy trade when the stock reaches $25, you know that using a limit order would be impossible.
Limit orders get you the specified price or a better price, so if you trigger a limit order to buy at $25 when the asset is trading at $20 you’ll be instantly executed at $20 as the condition of buying at the specified price or better is being met.
$20 is clearly better than $25 when it comes to buying.
Market orders would get you the best available price at the time of execution.
So, how do we get in a buy trade under these conditions? We use a Buy Stop Order.
Let’s do a brief description of each order type with a visual example.
Buy Stop Order
Buy Stop Orders are used to enter a trade when you want to buy the asset at a more expensive price than its current price. Once your stop price is reached, a Buy Market order will be executed.
For example, a stock is trading right now at $10 and you believe that if the price moves past $15 then it broke the resistance level and it will continue to climb.
If you want to automate this entry and instruct your trading platform to open a buy market order once the price reaches $15, then you can use a Buy Stop Order.
If you read some of our other guides on trading orders, you’ll probably notice that we complain a bit about the different naming conventions being used by brokers in order to oversimplify trading. Here goes a clear example of one of this cases:
A Buy Stop Order is the same as a Stop-Loss order in a Short Trade.
In case you don’t know, a short trade means that you’re betting against the asset expecting prices to go down so you can profit from that movement by buying cheaper, returning the borrowed asset and pocketing the difference for yourself.
When you open a short trade you’re exposed to the risk that if an asset’s price goes up then that means you’re losing money as if you had to buy it back you would be doing so at a more expensive price.
What type of order do you need to protect yourself by buying something at a more expensive price than it’s current price?
A BUY STOP ORDER.
But your broker usually doesn’t tell you this, they want to oversimplify things and just go and call everything that limits losses a stop-loss order.
At least now you know it, to cover a potential loss in a short trade, a buy stop order is being used.
Sell Stop Order
Sell Stop Orders are used to enter a trade when you want to sell an asset at a cheaper price than its current price. Once your stop price is reached a Sell Market order will be executed.
Comparing them to a limit order is good to understand the differences.
If right now a stock is trading at $25 and you want to short sell it (bet against it expecting the price to go down) once it reaches $10 because you believe it broke the support level and it’s just going to keep falling.
Using a market order would be impossible, it would get you the current best available price upon execution.
Using a limit order would also be impossible, it would get you your specified price or better, so the moment you execute your order it will activate your short sell trade at $25 which is better than $10 when it comes to selling. Remember, in limit order logic, the more expensive the better.
So, how do we get in this trade in this particular condition? Using a Sell Stop Order.
The most common use cases for a sell stop order are:
- Opening a Short Trade (at a cheaper price than the current price).
- Limiting Losses in a Buy position which means selling what you bought at a cheaper price (In the end we’re talking about a stop-loss order again. The real name for a stop-loss in a buy trade is Sell Stop, but brokers oversimplify it).
Stop-Loss orders are a type of trading order designed to limit a trader's losses by activating a market order once a specific price is reached.
As you read during our guide, stop-loss is just the generic simplified name that brokers give to any order that will limit your losses but in reality you could be using Buy Stop Order, Sell Stop Order, Stop Limit Order, etc.
Here lies the importance of truly understanding order types, it will give you a good understanding on what to expect from your broker’s execution.
A Stop-Limit Order shares the same behaviour of the stop order but instead of triggering a market order when the price is reached, a limit order is sent, meaning that you’ll only get the exact desired price that you’ve previously set or a better one.
In the example above the current price is $10 and you set a Buy Stop-Limit order at $15 to buy 100 shares. Maybe by the time the price jumped to $15 and passed the level quickly there were only 40 shares available and that’s all you’re gonna get. The rest of your order will remain unexecuted.
Stop-Limit orders are an amazing tool but quite dangerous. If you use a Stop-Limit Order as your exit strategy for a buy trade (a stop-loss in oversimplified broker language) then you’re risking your ability to even be able to exit the trade at all.
The Limit Order will once be filled if there is availability at the particular price you requested or better, so if this is your stop-loss order and you’re sleeping, what happens if the market jumps that price and there is nothing available to fill the order?
It will remain as a pending order and never get executed leaving you exposed in that trade you could never exit.
Same works for using a Buy Stop-Limit or Sell-Stop Limit regardless of the purpose. You’re eliminating the market order element and replacing it for the limit order behaviour.
It can make execution difficult, especially in highly volatile or illiquid assets.
Trailing Stop Order
Trailing Stop orders are also called a dynamic stop and the main advantage is the ability to adjust the stop price dynamically according to a specified distance that a trader can set initially.
We’re not gonna go into too much details in this guide about the trailing stop order as it requires an individual guide for it, but what you need to know is:
- Trailing Stops work using a distance measure, for example, if the price is $50 and you’re trailing stop is set at a distance of 0.30 then your initial trailing stop price is $49.7
- In the example above we’re setting a trailing stop-loss with a distance of 0.30, what this does is dynamically move the stop price maintaining ALWAYS a MAXIMUM distance of 0.30 from the current price.
- Notice we used the word MAXIMUM, as the trailing stop limits the maximum (furthest away) distance in price that the stop can be, this doesn’t affect how close it can be.
- If the price in our example changes to $51, the trailing stop will move automatically to $50.7
- If the price goes a little down to $50.9, the trailing stop will remain at $50.7
The most common use for a trailing stop is to lock in profits and let a trade run trying to catch more profits when it’s going in a favourable direction.
How to Place a Stop Order
Some trading platforms will automatically determine the type of order you need to set based on the current price and the specified price you want to set when creating your order.
If you want to create a pending order (with a price different than the current price) the trading platform will automatically detect if it’s a limit order or a stop order, here are the two most common scenarios:
If you try to place a pending buy order with a price more expensive than the current price, the trading platform will automatically create a Buy Stop order.
If you try to place a pending sell order with a price cheaper than the current price, the trading platform will automatically create a Sell Stop order.
These 2 cases are for trading platforms that oversimplify things. Professional trading platforms will ask you to choose from a drop-down menu the type of order and manually enter each parameter.
In this case you have to manually choose STOP order, enter a price and then click buy or sell.
Remember, professional trading platforms have no mercy, if you enter the wrong order you can get executed instantly so read our order guides several times and practise a lot before doing anything real.
Advantages and Disadvantages of the Stop Order
The main advantage of a Stop Order is the ability to enter or exit a trade at a future stop price which a trader can set.
The main disadvantage is that it functions like a Market order and it doesn’t guarantee the price. It all depends on the asset’s availability at each price level at the moment of execution.
When should you use a Stop Order?
Here are the most common use cases for a Stop Order:
- If you want to open a BUY trade at a more expensive price than the current price. Perhaps you believe that once an asset climbs past a certain price level it will continue climbing. (Buy-Stop Order)
- If you want to automatically limit your losses in a BUY position once if falls below a certain level (Sell-Stop Order).
- If you want to limit your losses in a short position which basically means creating a stop-loss for a short trade as you’re required to buy to cover. (Buy-Stop Order).
- If you want to open a short trade at a cheaper price than the current price (Sell-Stop Order).
As you can see you can get really creative with trading orders.
And the funniest part in all of this is that most brokers don’t even tell you what type of order you’re sending.
You just see stop-loss on their system but you’ve got no clue if it’s a Sell Stop or a Sell Stop-Limit.
I know, funny right?
Common Stop Order Mistakes
Stop orders are very simple and are not so prone to many mistakes as other order types, yet there is something you need to be careful with:
- Stop Orders reach the Stop price and a Market order gets sent.
If you remember, market orders don’t guarantee a price, you’re buying or selling at market price.
The main mistake when using stop orders is when traders expect to get a specific price for all the quantity of the assets they bought or sold and they realise they didn’t get it.
That’s because it’s completely random and unpredictable, especially in highly volatile assets or illiquid ones.
Just be careful to know where you are using your order and why.
Understanding the type of order that you use and how to use it, can save you a lot of trouble as depending on the trading platform that you use, some might save you from your own mistakes and others might execute them.