A stop order is a trading order placed with a broker to buy or sell a security once that security’s price reaches a specific level, known as the stop price. Once the stop price is reached, the stop order becomes a market order and is executed at the current market price. This is primarily used to protect a profit or limit the potential loss on a transaction.
Types of Stop Orders
Sell Stop Order
A sell stop order is placed below the current market price. It is used to limit a loss or protect a profit on a security that an investor already owns. For example, if an investor owns shares currently trading at $50, they might set a sell stop order at $45. If the price drops to $45, the sell stop order is activated, and a market order is placed to sell the shares immediately at the current market price.
Buy Stop Order
A buy stop order is placed above the current market price. It is used to limit a loss or protect a profit on a security that an investor has sold short. For instance, if an investor has short-sold shares at $50, they might set a buy stop order at $55 to cap potential losses. If the share price rises to $55, the buy stop order is triggered, and a market order is placed to buy the shares at the current market price.
Special Considerations
Gap Risk
One of the risks associated with stop orders is gap risk, which occurs when the price of a security opens significantly higher or lower than the previous day’s close. In such a scenario, a stop order can be executed at an unintended price, potentially leading to a larger loss or smaller profit than expected.
Market Conditions
Market conditions such as high volatility, low liquidity, or market closures can impact the execution of stop orders. Investors should be aware of these conditions when placing stop orders to avoid unexpected outcomes.
Examples
Protecting Profits: An investor buys a stock at $40 and it rises to $60. To protect the $20 profit, the investor sets a sell stop order at $55. If the price falls to $55, the stop order activates, converting into a market order, and the shares are sold at the current market price.
Limiting Losses: An investor holds shares bought at $30. Fearing a potential decline, they place a sell stop order at $25. If the stock drops to $25, the sell stop order triggers, and the shares are sold to limit further losses.
Historical Context
Stop orders have been a fundamental tool in stock trading since the early 20th century, providing a mechanism for traders to manage risks associated with price movements. They gained popularity with the advent of electronic trading platforms, making it easier to automate stop orders.
Applicability Across Markets
Stop orders are not limited to stock markets. They can also be used in futures, options, and forex markets. However, the specific mechanics and regulations may vary across different financial markets.
Related Terms
- Limit Order: An order to buy or sell a security at a specific price or better.
- Market Order: An order to buy or sell a security immediately at the best available current price.
- Trailing Stop Order: A stop order that moves with the market price by a set percentage or dollar amount, helping to lock in profits while capping losses.
FAQs
Can a stop order be canceled?
What happens if the stop price is never reached?
Are stop orders guaranteed to execute at the stop price?
References
- Investopedia. “Stop Order.” Investopedia
- Securities and Exchange Commission (SEC). “Types of Orders.” SEC
Summary
A stop order is a crucial tool for traders and investors, enabling them to automatically trigger a buy or sell order once a security reaches a specified price. By understanding and utilizing stop orders effectively, investors can better manage their trading positions, protect profits, and limit potential losses, making them an integral part of any trading strategy.
