- January 11, 2022
- Posted by: CoachShane
- Category: Trading Article
Protecting your capital is job number one for a trader or an investor. To do so, traders will often use two main types of protection order to automatically limit their losses:
- Stop loss order
- Stop limit order
Stop-loss and stop-limit orders both protect investors from losing too much when prices move against them. They’re similar in some ways but different enough to be worth knowing about individually.
What Is A Stop Loss Order?
Stop loss orders come in two varieties: One protects your long positions (a sell-stop) and another limits losses for any short positions (a buy-stop).
The common variable with both of these stop loss orders is they sit in the market until price reaches it. Once the market price reaches the stop order, it is converted into a market order and gets filled at the best possible price. You will get filled however you may get filled at a much worse price than you intended with your original risk profile on the trade.
This stop would be used if you are long an instrument. This stop would be set at a price lower than current price and be triggered if price declines.
On this chart, assume a trader entered long on a breakout of the descending trendline at $325.00.
A sell-stop order is originally set at $318.84 to limit any downside loss.
The sell-stop order is then trailed up and adjusted to $339.40 to lock in profit and to exit if the stock price breaks down below the stop.
If you were short an instrument, you would place a buy-stop order above price to exit if market price put in a rally.
Assume you entered this trade just before the close of the day upon the break of the triangle chart pattern at $275.75.
You’d place an initial buy-stop order to exit for a loss if price rallied against you and hit your trigger price of $284.95.
As the market continues to move down, a trailing stop methodology would have your final adjusted exit when the current market price became $262.98.
Biggest Risk For Stop Loss Orders
Since stop-loss orders are treated as market order when hit, orders may sometimes execute at prices lower/higher than their stop prices.
This may have you losing more than one times your initial risk as your order experiences price slippage. The biggest risk is having a large gap in price beyond your protective stop. This could lead to a massive loss of capital.
Traders may find a buy stop-limit and a sell stop-limit order safer than a standard stop loss as there is a price constraint on your fill price.
- Buy stop limit is for short positions
- Sell stop limit is for long positions
A stop-limit uses combines two different price levels when being set:
- Stop price (minimum price) which when hit, is converted to a limit order as opposed to a market order
- A limit price (maximum price) which is the set price, or better, that your stop will execute at
Essentially, if price makes a large move and hits the stop price and you can’t be filled at your set limit price or better, you don’t get filled.
If you can’t get filled, usually due to a gap, traders will then look for price to move back in their direction for a better exit price.
These types of traders are using a stop-limit order to, barring any large moves against the position, to better manage their risk against potential losses. They know that for the majority of the time, they won’t face losses beyond what they intended. It’s a double edged sword as price may continue going against them and will have to eventually use a market order to exit.
Let’s look at a buy stop limit for this example.
Imagine you are short this stock, you’ve been able to lower your stop order and price begins to rally against you.
What this chart shows is you would have a stop price of $262.98 and with a buy limit of $267.73.
- Once the stop price is hit, the limit price comes into effect
- You are looking to be filled anywhere from 262.98 to 267.73
- If price quickly rises from the stop price in a fast moving market, you may not get filled if price beats your limit price
The other issue is that once your stop price is hit, there may not be enough liquidity in the market to close your entire position.
If you were trading 100 shares and only 50 were filled, you would still have 50 shares open that are not protected with any protective stop.
This is an example of a sell limit order.
A trader going long in this stock on the breakout would set the sell stop at $31.67 with a sell limit of $31.19.
Once price hits 31.67, the limit order would be triggered and you will, in a perfect world, get filled somewhere between $31.67 and $31.19.
What Are The Risks?
Both stop loss order and stop limit orders are not guaranteed to work all the time and traders should be aware of that.
Stop loss orders act as market orders and slippage is a very real risk to your capital. It is quite possible to get filled at a price point this is multiples of your original risk amount.
Stop limit orders may not get executed at all if there are big price moves. You may also only get filled on partial positions if there is not enough liquidity to handle your entire order.
Use A Stop Order Or Stop Limit Order?
The decision to use one type of order over another can be determined by your risk tolerance.
The main difference between the orders is the stop loss order is guaranteed to be filled. The downside is the execution price could be worse than you could have imagined.
The stop limit order, depending on price movement and liquidity, your order may not get filled or only partially filled. Stop limits do give you greater control over execution prices and the truth is in the vast majority of the time, you will be filled somewhere between the stop and limit price.
Regardless of which one you choose, it is vital that traders protect their capital through the use of an order to exit the market. Pick one that is right for your and one that you will use consistently.