You know you should take a rest day when you exercise. But you don't and you end up with an injury that sidelines you for weeks or months. You know you shouldn't eat that dessert. But you do and now the progress you made in your diet is blown.
We usually only understand the importance of self-discipline when we don’t take care to exercise it. The same is true in investing. There’s no way you can protect yourself from all risk, and every investor’s risk tolerance is different. However, there are ways we can manage risk.
A common way to manage investment risk is through the use of stop orders. That's the topic of this article. In this article, we'll define what a stop order is and when they’re used. We’ll explain the limitation of a traditional stop order and go over the subtle difference between types of stop orders and how they can help work around this limitation to provide a greater level of risk management.
What is a stop order?
A stop order (also known as a stop loss order) is a trading mechanism that automatically issues a market order to buy or sell a stock once its price reaches a predetermined target. This is known as the stop price. A buy stop order is issued to buy the stock at a price above its current market price. Buy stop orders can be used as a way to wait until a stock gets some upward momentum before jumping in, or as a way for short sellers to protect themselves from losses or to protect their profit. A sell stop order is issued to sell the stock at a price below its current market price. Sell stop-loss orders are used to protect against a bigger loss or to protect profit.
Stop loss orders are very useful when active traders are on vacation or will have limited access to the markets or their brokerage account. But even during a routine workweek, most experienced traders use stop orders on a regular basis. Placing stop orders is an ideal way to manage the risk of having open positions by ensuring that trades are made at the price you set.
To illustrate how this works, it’s important to understand the difference between a market order and a stop order. A market order is an order to buy or sell a stock immediately and at current market prices. A market order is only executed during market hours, and only when there are willing buyers and sellers. A market order places a priority on execution, not price. A stop order, by comparison, places a priority on price, and only once a certain price is reached is it executed. A stop order essentially becomes a market order at that point.
As an example, if I have a stock that I bought at $32, but is now trading at $40, I can put in a sell stop order at $38 to protect some of the profit potential I’ve gained so far, just in case the price drops back down. If the stock hits $38.00, a market order would be issued and my stock would be sold. If done via electronic/online trading, this trade is done in milliseconds. I get the profit at that moment, which is great if the stock stops climbing or goes back down. However, if the stock continues to go higher, I will miss out on that gain.
Conversely, let’s say that I purchase a stock that is selling at $25 per share. I know it’s a volatile stock so I put a stop loss order at $22.50 because I don’t want to absorb a loss of more than 10 percent. If the stock drops to $22.50, a market order is issued and the stock is sold. While I take a loss, if the stock goes lower, I am protected against that larger loss. However, if that dip to $22.50 was only a minor hiccup or head fake from an upward trend, I may lock in a loss that I could have avoided.
Stop orders protect profits and losses
Stop orders are used to protect against a loss, whether by avoiding a larger loss or protecting a trader’s profits so far. One of the keys to remember is that the stop loss only triggers a market order when the stop price is reached, and some stop orders will never be executed.
Let’s imagine you bought a stock at $20 a share and set a sell stop at $18. That sell stop would be in place to prevent you from losing more than 10%. Imagine now that the stock rises to $23, and you adjust your sell stop to $22 a share. This time you are locking in a 10% profit – nice!.
You can also set multiple stop-loss orders for portions of your shares in a company, which may be particularly useful for more volatile stocks. Because volatile stocks can tend to blow through stop price triggers, this would allow you to have a fallback position to guard against a major downturn.
Stop orders can be used for short selling
Stop-loss orders can trigger a buy order as well as a sell order which can make it a tool for short sellers. As an example, if a trader has short sold 100 shares of a company at a price of $60, they can set a buy-stop order at $65 to guard against prices moving above that level. If the stock climbs to $65, instead of dropping like the short seller predicted, the stop order is triggered and the trader will automatically buy 100 shares at or near that current price. However, because of the nature of the market, there is no guarantee that they will actually buy at that price. It could be higher or lower.
As another example, let’s say that you short stock in a company that is currently trading at $20 a share. You set a buy stop order for $22, in case the price goes up instead of down, and leave on vacation. When you come back the stock price has fallen to $16.50. All of your indicators are saying the stock is heading to $15, so you adjust your stop order lower so that you can maximize your gain.
Understanding the limitations of stop orders
One of the limitations of a stop order is that once it has been converted to a market order, there is no guarantee that the sale will be made at the price that an investor was hoping for. That may seem counterintuitive. After all, isn't that why you place a stop order? This is where you have to remember, a market order puts a priority on execution over price. A market order can only be executed when the markets are open, but stock prices can still go up or down after the U.S. markets close. So in our earlier example, if you have a stop order set at $38 and the stock hits that level in after-hours trading, a market order will be issued. However, by the time the markets open the next day (which allows the market order to be executed), the price of that stock may have gone higher. But it also may have gone lower. And if it’s a particularly volatile stock it may have even dipped below your buying price.
Also, some stocks, particularly volatile ones such as penny stocks and some aggressive growth stocks can have rapid price fluctuations in a matter of minutes that don’t accurately reflect the trend of a stock. This can cause the price to move above or below a stop price very quickly and then change direction just as quickly. However, if you’ve set a stop price, the market order will be triggered as soon as that price is reached. It may not bother you to miss out on a larger gain (pigs get fat; hogs get slaughtered) but if your stop sell order kicks in and the stock moves back up to your purchase price, you could be taking an unnecessary loss. Understanding the normal volatility and the potential movement of a stock is crucial to setting stop orders.
Another potential limitation of a stop order is how the stop price is determined. Depending on the type of stock, a brokerage firm may use the last-sale price as the determining factor that triggers a stop order or they may use a quotation price. As with many things in life, knowing the rules you’re playing by can help avoid confusion and mistakes.
Stop-Loss Orders vs. Stop-Limit Orders
These two order types are similar but differ in subtle and important ways that we’ll explain below:
Stop-Loss Order: As we described above, a stop-loss order is used to protect an investor from the downside risk of owning a stock. They allow investors to set the order for the amount of money they are willing to accept. So if they are only willing to accept a 10% loss they would set a stop-loss order for $22.50 on a stock they purchased for $25.00.
However, a stop-loss order will automatically trigger a market order once the stop price is reached, but it does not guarantee that you will get the price you want for the sale of your stock. If a stock is particularly volatile, that could mean that the stock price could move far past the stop price in milliseconds meaning you could lose more than 10%.
Stop-Limit Order: An alternative to a stop-loss order that can help you manage that risk is the stop-limit order. With the stop-limit order, you set a stop price just as you do with a stop-loss order. The difference is that the stop-limit also sets a price range that the trade must be completed in. So if the price of a stock drops below your stop-limit price of $22.50, but you have also set a limit of $21, your broker or software will execute the stop-limit order only if they can find someone willing to buy between $21 and $22.50.
Unlike a stop-loss order, a stop-limit order is not a set it and forget it option. In many cases, a stock can break below your stop price and your limit price and continue going down. If you have a stop-limit, you will still be holding the stock as the price falls because the order will only be executed if the stock price recovers back to that level.
The bottom line on stop orders
One of the most important things investors can do is to understand their risk tolerance. Yet, most investors will have one or more “war stories” of a time when they zigged when they should have zagged. A momentary, or prolonged, failure to apply discipline to their trades may have caused losses they are still recovering from.
Stop-loss or stop-limit options are a way to prevent those huge mistakes. One the one hand they act as a kind of life preserver. You may hope you never have to use it, but if you do, you’ll sure be glad it’s there. Yes, you may have to sell some stocks at a loss. But you may have established that you are not willing to accept a drop in your portfolio of more than 10 percent. Look at your entire trading history and ask yourself: if you had limited your downside risk to 10% on any one stock, would your portfolio look better or worse than it does?
And remember, stop options do not have to be a complete killjoy. When appropriate, you can always keep adjusting your stop-loss higher and higher to ensure you don’t lose profits you’ve already made.
In summary, stop options can do the following:
- Limit your downside risk as closely as possible to a level you determine.
- Prevent the catastrophic loss.
- Take the pressure and stress out of investing decisions.
- Allow you to trade faster and more efficiently.
Of course, some investors like the thrill and may have more risk tolerance than you. Electronic, even mobile, trading gives investors unprecedented options and the speed to carry them out. Although stop options can provide very tangible benefits in terms of allowing you to cut your losses and fight another day, they have limitations.