What is a stop order?
Searching for a stop order definition? A stop order – also referred to as a stop-loss order - is an instruction that you give to your broker to buy or sell a security when it reaches a certain price. It's a way of limiting the potential losses or protecting gains of a trade, especially if you're not going to be able to monitor your opened positions for a while.
Where have you heard about stop orders?
You may have placed a stop order with your broker when going on holiday, knowing that you wouldn't be able to keep a close eye on your portfolio while you were away. If you're an individual investor, you can also place stop order instructions on a trade you're conducting through an online platform.
What you need to know about stop orders…
No investor likes to see a loss in a portfolio. There are various hedging techniques you can employ to help avoid this, from complex options strategies to simple diversification, but perhaps the easiest strategy to implement is a stop loss order. This type of order can be entered for any equity position, option or futures contract and for forex positions. Because of its simplicity, a stop loss order is a good technique to use for any investor who’s looking to mitigate downside risk. Essentially, a stop loss order should be seen as a key component of risk management. If a stop loss order isn’t implemented to your open trades, you’ll be forced into psychological battles with yourself that could cost you a substantial amount of capital.
Traders place stop loss orders either to limit risk or to protect a slice of existing profits in a trading position. Placing a stop loss order is generally offered as an option through a trading platform whenever a trade is placed, and it can be changed at any time. With a stop order, your trade will only be executed when the security you want to buy or sell reaches a certain price (the stop price). Once the stock has reached that price, a stop order becomes a market order and is executed at the next available price (not obligatorily at the stop price).
You might want to place your stop price 5-15% below your purchase price, depending on your level of comfort. This will stop you riding the stock all the way down and help to keep losses manageable. Knowing what your downside is enables you to prepare for a potential worst-case scenario – an important part of a sensible trading strategy.
Buy stop orders and sell stop orders
There are buy stop orders and sell stop orders:
- A sell stop means to sell after the price goes below the stop price. A sell–stop price is always below the current market price.
- A buy stop is typically used on a short sale. A buy-stop price is always above the current market price.
For example, if you own shares of Omnicorp, currently trading at £15.60, and you place a stop order to sell at £14.00, your order will only be filled if Omnicorp stock drops below £14.00. This strategy enables you to limit your losses, but can also be used to lock in profits. So, if you bought Omnicorp at £14.50 per share and the stock is now trading at £15.60 per share, placing a stop order at £15.00 will guarantee profits of around £0.50 per share, depending on how quickly the market order can be executed. But note that the trade won’t necessarily go ahead at the exact stop price because of price slippage. It’s also possible that a stop order could be triggered by a short-term fluctuation in the market price of the security that isn’t representative of a broader trend.
Traders sometimes use trailing stops to automatically advance their stop loss order to a higher level as the market price rises. Trailing stops can be easily set up on most trading platforms, with the trader specifying the percentage change or price change or pips amount that they want the stop order to trail behind the market high. A EUR/USD forex trader, for example, might specify a 50-pip trailing stop. This would mean that when the market reaches 1.1500, the stop will automatically shift to 1.1450. If the market then rises to 1.1520, the stop advances to 1.1470.
Limit orders and stop-limit orders
A limit order sets the maximum or minimum at which you’re willing to buy or sell a certain stock. For example, if you want to buy Omnicorp stock, trading at £15.60, you can set a limit order for £15.50, which will guarantee that you’ll pay no more than £15.50 to buy the stock. Once the stock reaches £15.50 or less, you’ll automatically buy a predetermined amount of shares. On the other hand, if you already own Omnicorp stock, you could place a limit order to sell it at £16.00.
The main advantage of a limit order is it guarantees that the trade will be made at a particular price, or better. But, you should note that your brokerage will probably charge a higher commission for the limit order, and it's possible that your order won’t be executed at all if the limit price isn’t reached.
A stop-limit order combines elements of a stop order and limit order, and is executed at a particular price – or better – once a specified stop price is reached. At that point the stop-limit order becomes a limit order. Two price points have to be set for a stop-limit order - the first triggering the start of the required action (the stop); and the second being the outside of the investor’s target price (the limit). A stop-limit order also requires a timeframe for execution.
Stop-limit orders give traders exact control over when their order is filled – but remember that the trade isn’t guaranteed to be executed if the security doesn’t reach the stop price within the stipulated timeframe.
Investors should be careful about where they set a stop order, as it could be unfavourable if it’s activated by a short-term fluctuation in the stock's price. For instance, Omnicorp stock might be relatively volatile and fluctuate by 20% a week, so a stop loss set at 15% below the current price could lead to the order being executed at a disadvantageous moment.
Volatility is essentially the amount of movement to expect from a security over a particular period. The most popular volatility indicator used for stop order placement is the average true range (ATR). A volatility stop takes ATR value for specified time period (common length is 14), multiplies by 2 (or 0.5 or 1 or 3), adds or subtracts it from the open price, and places the stop at this price.
The idea behind the stop is that the trader accepts that there’ll be noise price fluctuations – but by multiplying this noise as measured by the ATR by a factor of two or three, for example, and adding or subtracting it from the open price, the stop will be kept out of the noise. This can enable the trader to maintain their position for longer, giving the trade a higher chance of success.
Other type of stops based on volatility are stops that are calculated with reference to the highest high or lowest low over a period and best suited for swing traders.
Pros and cons
There are several big advantages to stop loss orders. Firstly, a stop loss order costs nothing to implement. Your regular commission is only charged once the stop loss price has been reached and the stock must be sold. You can see it as a free insurance policy. A stop loss also allows decision making to be liberated from emotional influences. Many people fall in love with stocks, thinking that if they give a stock another chance, it’ll come around. This can cause procrastination and delay, during which time the losses mount.
The disadvantage is that a stop price can potentially be activated by a short-term fluctuation in a stock's price. It’s crucial to try and pick a stop-loss percentage that allows a stock to fluctuate, while avoiding as much downside risk as possible. Setting a 5% stop loss on a stock with a history of fluctuating 10% or more per week isn’t a good strategy. You could end up losing money on the commissions generated from the execution of your stop loss orders. So, do some technical analysis!
Find out more about stop orders…
If you’re looking for more context around buy stop and sell stop orders, our extensive glossary features lots more related definitions and explanations, such as those for market order, broker and risk management.