Traders and investors who seek to limit potential losses can use several types of orders to get them into and out of the market at times when they may not be able to place an order manually. Stop-loss orders and stop-limit orders are two tools that can accomplish this, but it is critical to understand the difference between the two similar sounding orders.
There are two types of stop-loss orders.
1) Sell-stop orders protect long positions by triggering a market sell order if the price falls below a certain level. The underlying assumption behind this strategy is that if the price falls this far, it may continue to fall much further, so the loss is capped by selling at this price.
For example, let's say a trader owns 1,000 shares of ABC stock. He purchased the stock at $30 a share and it has risen to $45 on rumors of a potential buyout. He wants to lock in a gain of at least $10 per share, so he places a sell-stop order at $41. If the stock drops back below this price, then the order will become a market order and get filled at the current market price, which may be more (or more likely less) than the stop-loss price of $41. In this case, he might get $41 for 500 shares and $40.50 for the rest. But he will get to keep most of his gain.
2) Buy-stop orders are conceptually the same as sell stops except that they are used to protect short positions. A buy-stop order price will be above the current market price and will trigger if the price rises above that level.
Stop-limit orders are similar to stop-loss orders, but as their name states, there is a limit on the price at which they will execute. There are two prices specified in a stop-limit order; the stop price, which will convert the order to a sell order, and the limit price. Instead of the order becoming a market order to sell, the sell order becomes a limit order that will only execute at the limit price or better.
Of course, there is no guarantee that this order will be filled, especially if the stock price is rising or falling rapidly. Stop-limit orders are sometimes used because, if the price of the stock or other security falls below the limit, then the investor does not want to sell and is willing to wait for the price to rise back to the limit price.
For example, let's assume ABC stock never drops to the stop-loss price, but it continues to rise and eventually reaches $50 a share. The trader cancels his stop-loss order at $41 and puts in a stop-limit order at $47 with a limit of $45. If the stock price falls below $47, then the order becomes a live sell-limit order. If the stock price falls below $45 before Frank’s order is filled, then the order will remain unfilled until the price climbs back to $45.
Many investors will cancel their limit orders if the stock price falls below the limit price because they placed them solely to limit their loss when the price was dropping. Since they missed their chance to get out, they will then simply wait for the price to go back up and may not wish to sell at that limit price at that point in case the stock continues to rise.
As with buy-stop orders, buy-stop-limit orders are used for short sales where the investor is willing to risk waiting for the price to come back down if the purchase is not made at the limit price or better.
Benefits and Risks
Stop-loss and stop-limit orders can provide different types of protection for investors. Stop-loss orders can guarantee execution, but not price. And price slippage frequently occurs upon execution. Most sell-stop orders are filled at a price below the strike price; the amount of difference depends on how fast the price is dropping. An order may get filled for a considerably lower price if the price is plummeting quickly.
Stop-limit orders can guarantee a price limit, but the trade may not be executed. This can saddle the investor with a substantial loss in a fast market if the limit price does not get filled before the market price drops below that amount. If bad news comes out about a company and the limit price is only $1 or $2 below the stop-loss price, then the investor must hold onto the stock for an indeterminate period before the share price rises again. Both types of orders can be entered as either day or good-until-cancelled (GTC) orders.
Choosing which type of order to use essentially boils down to deciding which type of risk is better to take. The first step to using either type of order correctly is to carefully assess how the stock is trading. If the stock is volatile with substantial price movement, then a stop-limit order may be more effective because of its price guarantee. If the trade doesn't execute, then the investor may only have to wait a short time for the price to rise again. A stop-loss order would be appropriate if, for example, bad news comes out about a company that casts doubt upon its long-term future. In this case, the stock price may not return to its current level for months or years, if it ever does, and investors would therefore be wise to cut their losses and take the market price on the sale. A stop-limit order may yield a considerably larger loss if it does not execute.
Another important factor to consider when placing either type of order is where to set the stop and limit prices. Technical analysis can be a useful tool here, and stop-loss prices are often placed at levels of technical support or resistance. Investors who place stop-loss orders on stocks that are steadily climbing should take care to give the stock a little room to fall back. If they set their stop price too close to the current market price, they may get stopped out due to a relatively small retracement in price and miss out when the price starts to rise again.
Stop-loss and stop-limit orders can provide different types of protection for both long and short investors. Stop-loss orders guarantee execution, while stop-limit orders guarantee price.
Mark Cussen can be contacted via this link: Mark P. Cussen