A stop order is a contingent order that an investor utilizes to either enter or exit a market position. A stop order is activated, or triggered, into effect when a traded security – such as a particular stock – reaches a certain market price that is specified in the order. The market price that is referred to, in the context of a stop order, is the stop price.
When a stop order is triggered, it then effectively becomes a market order, to be executed immediately at the best available price. An exception to such a situation exists if the order is entered as a “stop-limit” order.
Stop-limit orders, in addition to specifying the stop price, also specify a limit price. Specifying a limit price means that the stop order will only be executed if it can be filled at the limit price or better – that is, at a price that is more advantageous for the investor.
A stop order is a contingent order that an investor utilizes to either enter or exit a market position if the traded security reaches a specified price level.
Stop orders are utilized to conserve profits, limit losses, or to enter a new trade under specified conditions.
Stop orders may be orders to buy or to sell and may be used to exit an existing trade or to initiate a new trade.
How are Stop Orders Used by Investors
Stop orders are used by investors in the stock, commodities, forex, and other financial trading markets for a variety of purposes. They can be used to conserve profits, to avoid or limit losses, or to enter a new market position when a trader believes that it may be profitable to do so.
A stop order is always either a “buy-stop” order or a “sell-stop” order. A buy-stop order is an order to execute a buy transaction if and when the specified stop price is reached. The order can only be placed with a specified stop price that is higher than the current market price when the order is entered.
Conversely, a sell-stop order is an order to execute a sell transaction if and when the specified stop price is reached. The order can only be placed with a specified stop price below the current market price. Both buy-stop and sell-stop orders may be used to either enter or exit a trade.
1. Using a Stop Order to Conserve Profits
After initiating a trade in the financial markets, which subsequently becomes profitable for an investor, the investor may enter a stop order for the purpose of protecting and preserving at least part of their profits.
For example, assume an investor buys some stock shares at $50 per share. The stock price subsequently rises to $70 a share. The investor does not want to liquidate his position then, as he is hopeful, the stock price will go higher. However, he also wants to guard against losing all of the profit he has from buying the stock.
Therefore, the investor may enter a sell stop order with a stop price of $60. If the stock’s price then falls to $60, the stop order will be triggered, and the investor’s position will be closed out, preserving roughly half of his profits and assuring that his winning trade doesn’t become a losing trade.
2. Using a Stop Order to Limit Losses
Stop orders are frequently placed by traders immediately after entering a new market position, to limit potential losses. Using the same example as before, when the investor buys stock shares at $50 a share, they may decide that they do not want to risk losing more than $5 per share on the trade.
They can then enter a sell-stop order with a stop price of $45. If the stock price falls as low as $45, the sell-stop will be triggered, and the investor’s position closed out with a contained loss. Such a type of stop order is commonly referred to as a “stop-loss order.”
3. Using a Stop Order to Enter a New Market Position
Stop orders are also commonly used by traders to initiate a new market position only in the event of certain circumstances that the investor believes will make a trade likely to be profitable. For example, a trader sees that a stock’s been trading back and forth in a range between $40 and $45 a share. They believe that if the stock breaks out of its trading range to the upside – trades higher than $45 – it is likely to continue rising to a substantially higher price.
Therefore, to take advantage of such a move if it occurs, the trader enters a buy-stop order to purchase 100 shares, with a specified stop price of $46. The order will only be executed if the stock trades as high as $46. By using the contingent stop order, the trader need not constantly monitor the stock to see where it is trading – they are assured of entering the market if the stock’s price movement meets their specified condition.