Investors have long relied on trading instructions, also known as orders, to establish what they want to happen in their portfolio. Stop orders trigger a purchase or sale if selected assets hit a certain price or worse. The two main types of stop orders are stop-loss, used to buy or sell stocks at a certain price, and stop-limit orders used to buy or sell at a price not less than your limit. These orders help automate actions in your portfolio to help maximize your return. Before deciding to take action with a stop-loss or stop-limit order you may want to speak with a financial advisor to help you determine the right course of action.
A stop-loss order is typically used to sell stocks. Under this instruction, your portfolio (either through its manager or an automated system) will sell the selected stock as soon as it dips below a certain price. With a stop-loss order, your stock will be sold at the best available price when it is triggered. This means that if the price dips dramatically when your loss amount is reached you may end up with more of a loss than your intended limit.
For example, say you own Stock A that sells for $10 but has been losing value. You set a stop-loss of $8. This means that if Stock A hits $8, your portfolio will immediately try to sell all of your Stock A shares at the best available price. So if the price drops below $7.50 while your portfolio is trying to sell, you’ll still sell at that lower price. The stop-loss order does not consider changing circumstances in either direction.
This is known as “converting to a market order.” That means that your stop-loss order (“look for this price and sell”) will become a market order (“sell the asset immediately”). The distinction is important because a stop-loss order cannot guarantee you a specific price. Your portfolio will immediately market the asset, but your actual return will depend on how the price moves during the transaction.
A stop-loss order can also be used to buy stocks. Short-sellers, for example, would set a stop-loss order to buy if the price of a stock they have shorted ever goes above a certain price. For example, you could set a stop-loss order for Stock B at $15. This means that if that stock ever climbs to $15, your portfolio will execute a market order to buy Stock B as soon as it hits that price. Whether it continues to climb or falls a bit during the process of buying, the order will still go through at the new price.
The stop-limit order exists to smooth out some of the unpredictability of a stop-loss order. As noted, the biggest problem with stop-loss is that it converts to a market order upon execution. This means that your portfolio will execute the trade at a potentially unpredictable price. Our sale of Stock A above will trigger at $8 per share, but we have no control over the price that stock will actually sell for.
A stop-limit order attempts to solve this. When the asset hits the stop price, triggering the order, this instruction becomes a “limit” order rather than a market order. A limit order is an instruction for your portfolio to buy or sell an asset at a specific price or better. This means that it will only sell an asset at or above the set price, and it will only buy the asset at or below the set price.
In other words, under a stop-limit order, you can specify that you would like to sell if it falls below a certain price, but you don’t want to sell it for any less than another price.
For example, say we set a stop-limit order for Stock A. Our stop price would be $8, while our limit price would be $7.75. If the price of Stock A hits $8 or below, the order would convert to a limit order set at $7.75. This would mean that our portfolio will immediately sell Stock A for any price at or above $8 when the $8 price is triggered. If the price of the stock falls too fast and the portfolio can’t sell it for at least the limit price, it will not sell.
As with stop-loss orders, investors can use stop-limit orders to purchase securities if they have taken a short position. In this case, you would issue an order to buy an asset if it goes above a stop price, but no higher than the established limit price.
Stop-Loss vs. Stop-Limit Orders
A stop-limit order is used to guard against a particularly volatile market. It allows you to sell your asset, but only within certain boundaries.
Returning to our example, if Stock A hit its $8 stop price but then immediately kept falling to $5 per share, you might consider that too much of a loss. At that price you might prefer, instead, to hang on to Stock A in hopes that it will regain its value.
A stop-limit order gives you that flexibility. It will sell the stock, but only within a range that you define. A stop-loss order would execute the sale at $5, losing more money than you had intended.
On the other hand, a stop-loss order can guarantee your transaction. The same protections that limit your losses in a stop-limit order can also prevent your portfolio from selling the asset at all.
Suppose that Stock A opens at $7 per share, below both your $8 stop price and your $7.75 limit. Your stop-limit order will convert into a limit order, but it will not execute the sale. Your portfolio will wait for Stock A to go back up to $8 before selling.
A limit order can become a liability in certain situations. If after a day of trading Stock A settles at $5 per share over a day of trading and never recovers, your order will never go through. You will have lost the chance to sell for $7 per share. In trying to mitigate your losses you will have actually magnified them.
Benefits And Risks of Stop-Loss and Stop-Limit Orders
As mentioned above, both stop-loss and stop-limit orders can be used to help improve the returns of your portfolio. Before jumping into using them, it’s important to explore the benefits and potential risks of each. Keep in mind that everyone’s situation is unique and the benefits for one might actually be a larger risk to someone else’s portfolio. It’s important to consider fully analyzing your options with a professional.
Benefits of Stop-Loss And Stop-Limit Orders:
- Both orders have the goal to limit losses during a stock sale.
- Orders can be used to protect profits on long and short positions.
- You can guarantee a minimum trade price when selling or a maximum trade price for a buy.
- You can use an order to establish a new position at a price level that is in line with your new expected trend for the stock or the industry.
Risks of Stop-Loss And Stop-Limit Orders
- Some stop orders could be executed at a price that is less favorable than the established stop price.
- When executing a stop-limit order, the sale may not go through if the price drops too harshly and you could end up losing more money if the price doesn’t rebound.
- Stop orders can take you out of a position you wanted to hold in order to hold more conservative positions if there are short-term fluctuations in the market.
A stop-loss order guarantees a transaction but not a price while a stop-limit order guarantees a price but not a transaction. What kind of order you use can make a big difference in the price you pay and the returns you earn, so it’s important to be familiar with the different types of stock orders. When executing one of these orders you’ll need to decide which strategy best suits your long-term investment approach.
- Consider talking to a financial advisor about whether your returns could be aided by stop-loss or stop-limit orders. Finding the right financial advisor who fits your needs doesn’t have to be hard. SmartAsset’s free tool matches you with up to three financial advisors who serve your area, and you can interview your advisor matches at no cost to decide which one is right for you. If you’re ready to find an advisor who can help you achieve your financial goals, get started now.
- Before you start buying stock, it’s important to understand the vocabulary of the investing world. Perhaps no lingo is more important than that which surrounds the different types of stock orders. You can read more about the variety of stock orders and become well-versed in how they might help your overall investing strategy.
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