A stop loss order and a stop limit order are two tools that can be used by an investor to get into and out of the market at times when an investor may not be able to place an order manually.
By using these orders, an investor is telling his broker that he does not want to buy or sell the stock at the current market price but that he wants to buy or sell the stock when the stock price moves in a certain direction. From this article, investors will gain a basic understanding of a stop loss and stop limit order.
Stop Loss
There are two types of stop loss orders: sell-stop orders and buy-stop orders.
A sell-stop order protects against long positions in a stock by triggering a market sell order if the stock price decreases below a certain level. The idea behind this order is that, if the price decreases to a certain level, then it may continue to decrease much farther. So by implementing a sell-stop order, the loss is capped by selling at that initial certain level.
For example, assume an investor owns 500 shares of stock XYZ. He purchased the stock at $50 per share. Assume the stock is now trading at $60. The investor executes a sell-stop order at $55. If the stock drops below $55, then the sell-stop order will be triggered. This means that the shares of XYZ will be sold automatically at a price very close to $55. It may be $54.50, $54.70, or wherever the market price is.
A buy-stop order is essentially the same thing as a sell-stop order. The difference is that a buy-stop order triggers a market buy order if the stock price rises above a certain level.
For example, assume an investor owns 500 shares of XYZ. He purchased the stock at $50 per share. The investor executes a buy-stop order at $55. If the stock rises to $55, then the buy-stop order will be triggered. This means that the shares of XYZ will be automatically bought at a price very close to $55. It may be $55.40, $55.90, or wherever the market price is.
Stop Limit
A stop limit order is set over a timeframe and requires two price points. The first price point is the stop price, which is used to convert the order to a sell order. The second price point is the limit price.
Instead of the order being executed at the stop price, the sell order becomes a limit order. A limit order can only be executed when the stock’s price is at the limit price or at a price more favorable than the limit price.
For example, assume that stock XYZ is trading at $50 per share. The investor executes a stop limit order to buy with a stop price at $55 and a limit price at $57. If XYZ moves to $55, then the order is activated and is turned to a limit order. If the order can be filled between $55 and $57, which is the limit price, then the order will be executed and shares of XYZ will be bought. If the stock rises above $57, then the order will not be executed.
Closing
Stop loss and stop limit orders provide ways for investors to enter and exit the market without being fully present.
Stop loss orders guarantee that a trade will be executed but cannot guarantee the exact price of that trade. Stop limit orders guarantee an exact price for a trade but cannot guarantee that the trade will be executed.
Both orders are important to understand as they provide protection to investors in long and short positions.
