Stop order or stop-loss order is an order to buy or sell a financial instrument as soon as the price reaches the stop price. A stop price is a set limit price in a stop order. A stop order becomes a market order once the stop price is reached. Traders use multiple order strategies when trading in order to limit their chances of losing money.

Differences between stop order, market order, and limit order

For example, Share XYZ was trading on the market for $180. Unlike limit order, a market order does not offer guarantees that a trader’s buy or sell price will be filled at $180. It is possible that the trader will get a price lower than $180 or higher.

Limit order, on the other hand, offers some form of guarantee because limit order fills a buy or sell order at a price pre-determined by the trader. Unless the price action reaches the predetermined price set by the trader, a limit order will not execute.

A Stop order, on the other hand, is set to execute after the price of a certain financial instrument reaches a specific price termed the stop price. This type of order is usually set on long-term trades, for instance when the trader is going on a trip and cannot monitor the trade.

How to use stop orders

A buy stop order is placed at a price which is above the current price in the market. A sell stop order, on the other hand, is placed at a price which is below the current price in the market. For instance, a trader bought XYZ for $145.  The current price for XYZ on the market is $175. In order to limit any form of loss in the foreseeable future, the trader places a sell order for XYZ at a stop price of $160. In case XYZ falls in price, the trader’s stop order will be triggered when the price action reaches $160.

As mentioned earlier on, a stop order quickly becomes a market order once the stop price is reached. What this means is that the order will not be filled once the price action reaches the stop price. Since the stop order becomes a market order, the initial executed price maybe worse or better than the stop price. The trader above can sell his shares for $160, %159.75, or 160.03. Stops do not offer a hundred percent guarantee that the trader will attain his desired entry/ exit point. This can be a huge disadvantage since if a stock gaps down, the stop order put in place by the trader may be triggered at a price lower than he expected.

Using the above example, you can see how you can apply stop order to limit losses and gain profit. The trader above sill still makes a profit when he places the stop order at $160. That is 160 – 145 = $15 per share which is better than nothing. In a situation where the price moves down past his initial cost price of $145, the stop order will still protect him.

By Ricardo Martinez

Ricardo Martinez has been active in the financial markets for around 10 years. In the early days in his career he was a trader and worked as market analyst in different online brokers advising clients on key decisions of trading instruments in foreign exchange and commodity markets. Ricardo is currently working as independent trader with diversified portfolio over different markets. His writing for LearnMarketonline is part of his commitment to share knowledge with traders.