Trading Up-Close: Stop and Stop-Limit Orders

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Narrator: Stop and stop-limit orders are both tools traders use to manage risk, but they're not the same.

Let's look at how they work and explore why you would use each of them.

A sell stop order is set at a specific price, below the last trade price. If the stock falls to or below this price, it triggers a market sell order.

Widely recognized as the quickest way to exit a trade, market orders are filled at the next available price. But, stop orders will not protect you from a gap in prices during market hours, or from one regular market session to the next.

Now, a stop-limit order is like a stop order, but with an extra layer – a limit price. Again, you set the stop price, where you want the sell order triggered. But here's where they differ. You exercise a measure of control over the trade by also setting a limit price. Instead of the trade being executed at the next available price, you specify the lowest price you are willing to accept.

Here's an example of what can happen if you set a stop order without a limit price. Let's say you hold shares of XYZ at $100. Your analysis suggests that if the price falls to $98, it could continue to move lower. With the intention of limiting your downside risk to $2 per share, you set your stop at $98. The stock closes at $100, but due to a disappointing after-market earnings announcement, the stock opens the next day at $90. Because the stock has traded below your stop-price of $98, it triggered a market sell order. 

The good news is that your trade went through. The bad news is the price at which it executed was near $90, not near the $98 you anticipated. And, if the price bounces back during the day, to say $96, you might be sorry that trade went through.

The stop-limit order can help address this scenario. Let's use this same premise, with you holding shares of XYZ at $100, and setting a stop order at $98. But this time, you're also going to place a limit at the minimum price you're willing to sell these shares – let's say $95. In our first example, you were sold out at $90 because once the stop was triggered, it became a market order and executed at the next available price. Using the stop-limit order, your order is still triggered, but doesn't execute unless the price rallies and hits your limit of $95.

In this case, it works well! The price rebounded and the limit price protected you from taking a greater loss. You might think this is a better approach – but what if that price didn't rebound, and instead continued to fall, hitting $85, $80, $75 or even lower? Now you are left holding those shares while their market value evaporates.

So when does it make sense to use a stop versus a stop-limit order? A stop order typically ensures that your trade is executed, but it does not guarantee the price. It can provide protection during regular market hours, but in a volatile market, you have no control over the price you'll get and you may face a larger than anticipated loss. Use a stop order when you are more concerned with getting out of the trade and are not as concerned about the price. A stop-limit order typically ensures that you get the price you set, but it doesn't guarantee that your trade will go through. As a result, you could be left holding shares worth far less than you anticipated. Employ a stop-limit order when you are willing to hold the shares if you can't get your desired price.

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