Many traders use stop orders to help protect an unrealized gain or limit potential losses on an existing position. Such orders can be useful tools. They help you play defense by setting parameters for transactions, and may provide comfort when markets are volatile.
However, stop orders aren’t without risks. I have heard from traders who have placed stop orders only to suffer losses when executions were triggered far below their stop price. Others have found themselves shut out of opportunities for appreciation.
Let’s examine three different types of stop orders and when it might make sense to use them.
With a regular stop order, you set a stop (or trigger) price below which you would no longer be interested in holding a stock. If that price isn’t reached, then nothing happens. However, if your stock declines to your stop price, a market order is placed to sell the stock at the next best available price.
Stop orders offer execution protection, but not price protection. That means that while execution is generally guaranteed when the price trigger is reached, the final sales price isn’t. If your stock price declines slowly, that might not be a problem—your trade would likely be executed at a price level that is close to your stop price. However, if a stock “gaps down,” or suffers a sudden sharp drop, your trade could execute at a price level far below your stop price.
Keep in mind that if your stock price rises, you may want to help protect your unrealized gains by canceling any existing stop orders and then resubmitting them at a higher price.
A stop-limit order can address the price risk associated with regular stop orders by letting you set a floor under your stop order. In other words, you set two prices—a stop price and a limit price. If the stop price is triggered, a limit order is placed to sell at your specified limit price or better. However, if the next available price after the stop price is reached is below the limit price, then the order will not be executed.
Stop-limit orders offer price protection, but not execution protection. That means that while you can avoid having a trade execute far below your stop price, you can’t guarantee an execution will occur if your stock drops below your limit price.
As with regular stop orders, you will have to cancel and resubmit existing stop-limit orders if you want to help protect unrealized gains as your stock price increases.
Trailing stop orders
A trailing stop order is essentially a stop order that adjusts upward with a rising stock, eliminating the need to cancel and resubmit orders as you would with a stop or stop-limit order. Once a stock stops rising and begins to move lower, the stop price freezes at the highest level it reaches. If the stock declines enough to trigger the order, it becomes a market order just like a regular stop order.
And like a regular stop order, a trailing stop order offers execution protection, but not price protection.
Stop order strategies
Once you’ve picked what type of order you’d like to employ, you have to decide where to set your price levels. Where you position your stop and limit prices is important—the right price can help protect you from the downside while giving your positions room to run.
Where to set the stop price ultimately depends on how much of a loss you are comfortable taking. Many traders have a standard policy of setting a trailing stop price 5–10% below the current price. You can also identify a level using the stock’s point value. Traders who determine the size of each trade based on the dollar amount invested may find the latter approach more effective than using a percentage.
It’s important for traders to approach every stop order differently, accounting not just for overall market conditions but also for the specific security’s volatility and trading history.
All three types of stop orders discussed above typically work well in slowly declining markets. They are less helpful in halted or gapping down markets due to the possibility of losses or an inability to execute.
Volatility could present other problems. If stocks are experiencing major price swings, you may face a higher chance your stop order will be executed. The trick in volatile markets is to give your positions enough room to move around without triggering a premature sale. Short-term traders may also want to give themselves some breathing room to prevent locking in a loss too soon.
And then there’s the question of how volatile your particular stock is. If the stock you’re trading has a history of fluctuating as much as 5% in price daily, placing a stop order 5% below your entry price is likely to result in an unfavorable outcome. In contrast, a 5% stop order may be appropriate for a stock that has a history of fluctuating 5% in a month.
You can calculate the average daily price change for a stock with a few days of pricing data. The table below lists the hypothetical daily closing prices for stock XYZ over six consecutive trading days. As you can see, the average day-to-day closing price change for the week was $0.45, or about 0.82%. For the full week, the net change was $0.28, or about 0.51%. Entering a 5%, or a three-point, stop order on XYZ would likely provide adequate protection and reduce the risk of being stopped out too soon.
In addition, you should look ahead to events like earnings releases that might cause an increase in volatility. I rarely leave a stop order in place if a company is going to report earnings after the market closes. Overnight stop orders create a false sense of security for many traders, who think they have more protection than they really do. The risk is just too great that the stock will open sharply lower if the company’s earnings disappoint.
Stop orders are mainstay tools for traders to manage downside risk and lock in potential profits, but make sure you understand their limitations. While each order type can help you protect your positions, you need to be strategic in using them. Carefully selecting the right tool and establishing the right pricing parameters can vastly help increase your success rate.
Gauging stock volatility
Schwab’s StreetSmart Edge® trading platform has a historical volatility chart that lets you gauge the recent volatility of any stock.
The charts below compare the volatility of two hypothetical stocks, XYZ and ZYX. In the first chart, we can see that the 30-day historical volatility (the blue line) of XYZ is 21.82%. In the second chart, we see ZYX has a historical volatility of 68.83%. Clearly, ZYX is the more volatile of the two. If you wanted to use a stop order with ZYX, you would want to allow more room for price changes, whether you are setting it based on points or percentage.
Source: StreetSmart Edge. For illustrative purposes only.
Source: StreetSmart Edge. For illustrative purposes only.