Saturday, March 13, 2010

Stop Loss and Stop Limit Orders

In recent weeks, I have written about risk and included concepts like protective puts and stop loss orders as ways a trader might endeavor to cut losses in the event a position moves against her. The articles sparked a question from a subscriber who wanted to know about the difference between stop loss and stop limit orders and how the two might be used by a trader.

The stop loss order is an order to a broker that says if a stock hits a specific price the position is to be closed at the market. Suppose, for example, that we own shares of XYZ trading at $25 a share and we see a support around $24.25. If the stock goes below $24.25, it has broken support and is no longer showing the bullishness for which we initially bought the stock. In such a circumstance we might place a stop loss order at $24.20 thereby instructing our broker to sell our shares in the event XYZ hits $24.20 OR BELOW. Once the stock price hits $24.20 or below, our order goes to the market as a market order. I emphasize the "or below" part because there are times when a stock may gap down and never touch our stop. In the XYZ example, suppose, for example, that the stock closes at $25 a share today and that this evening it announces unexpectedly poor earnings. Tomorrow, the stock opens at $23 a share. Well, it didn't hit our stop price at $24.20, but passed right over it. In that event, our stop is activated, the sell at the market order goes to the floor, and we are sold out of the position at the market which is now around $23. While we did not get the $24.20 we might have expected, but, quite importantly, we are out of the position and that might not be a bad thing since the stock is falling sharply and we want to cut losses.

Instead of utilizing a stop loss order, we might have chosen a stop limit order. Actually a stop limit order is two separate orders combined into one. The first part, the stop is the same as I described in the preceding paragraph. The second part is the limit which places a limit on what we are willing to take. Using the XYZ example, above, we might place a stop limit with a stop at $24.20, limit, $24. Now, we have instructed our broker to sell our shares if the price hits $24.20 or below, but only if we can get $24 or better. In the situation where the stock gaps down the following morning, our stop would be hit because the price is now at $23, well below our stop, but we would not be sold out of the position because our order was to sell at a limit of $24.20 and since the stock is selling well below our limit, we would not be filled and would still own the falling stock. In general, then, if we are placing a stop so we can get out of a position that is moving adversely, we would probably want to use a stop loss rather than a stop limit order.

When might we want to use a stop limit order? Perhaps, if we saw a stock that was dealing with a resistance and we wanted to buy shares, but only if it broke above that resistance. Let's say ABC has been trading in a range between $14 and $16 a share and we saw a triple top resistance at $16. If the stock breaks through that resistance, we might want to own shares, but we would like to get in fast on that break above $16. In such circumstances, we might choose to place a buy stop limit order. The order might be buy stop at $16.10, limit $16.50. By that order, we have instructed the broker to place a limit order to buy the stock at $16.75 or better, but only if the stock hit $16.10 or higher. In that event, if the stock broke resistance and hit our stop number, our limit order would go to the floor, and we would buy the stock provided it was at or below our limit of $16.75. Such an order would prevent the situation where the stock broke above resistance, but rocketed past a price at which we were willing to buy.

As you can see, these orders, used properly, can be very valuable additions to a trader's arsenal. In "Trade Your Way to Wealth," I discuss in detail a number of important orders available to the trader that can be used to help control losses and to protect gains. Knowledge of available orders can be extremely helpful to the trader and I often use them in my own trading.

by Bill Kraft, Editor
Copyright 2010, Makin' Hay, Inc.
All Rights Reserved


P.S. Save $50 PER MONTH on my subscription trading newsletters!
SAVE on my Under $10 Stock Trader Service!
SAVE on my Option Trader Service!
SAVE on my Trend Trader Service!

Technorati tags:

To comment on Bill's article click on the "comments" link below.

8 comments:

Norman Smith, San Jose CA said...

The term stop "loss" is a misnomer. As mentioned in the article, a stop can be used to get into a position, as well as out. And is also ideal for exiting a position with a profit, as well as limiting a loss, so calling it a stop-loss order is only one of it's uses. Further, there are two types of stop orders, market and limit. Either can be used to stop loss, or for the other purposes listed above. Stop loss and stop limit are not opposites. There are 4 types of orders: Market, Limit, Stop Market and Stop Limit. All the stop means is that the order is not placed until the price moves adverse to the stop value. That is, on a buy order the price has to move UP to the stop value, and on a sell order it moves DOWN to the stop value. On the contrary, a limit order means that the price moves beneficially to the limit value. On a buy limit order, the price has to move DOWN to the limit value, and on a sell order the price moves UP to the limit value. When using a stop order, when the stop price is surpassed, then the order is placed, whether that be a market order or a limit order. So a stop limit and a regular limit both operate the same way, except that a stop limit does not even get entered until the stop price is triggered. You need to be careful, also, because some brokers/software use the best bid or asked price as the trigger, rather than the last sale. And some software can be configured to require 2 or more sales at the stop price before it gets triggered. This is beneficial so that you do not get stopped out due to one extremely high or low priced transaction.

Anonymous said...

" In such circumstances, we might choose to place a buy stop limit order. The order might be buy stop at $16.10, limit $16.50. By that order, we have instructed the broker to place a limit order to buy the stock at $16.75 or better, but only if the stock hit $16.10 or higher. In that event, if the stock broke resistance and hit our stop number, our limit order would go to the floor, and we would buy the stock provided it was at or below our limit of $16.75."

Where did the $16.75 come from?

Anonymous said...

It's a Diddo on the $16.75 from Atlanta.

Anonymous said...

I wonder was it a typo error? Limit order mentioned initially was $16.50, if stock continues to move up after hitting $16.10, we are suppose to get filled at or below our limit of $16.50?

Bill Kraft, MarketFN.com said...

My mistake, Anonymous. The last sentence should say "at or below $16.50." In other words, no fill beyond my limit. Thank you very much for catching me on that one.
Bill Kraft

Anonymous said...

Bill:

Thanks for the thorough explanation...and also, on the buy side.

You are the best teacher in the business.

Doug said...

While we're nit-picking, paragraph 3 talks about a limit of $24, then says "our order was to sell at a limit of $24.20." This sort of thing is confusing, Bill.

Bill Kraft, MarketFN.com said...

Thanks, Doug. I guess my typing failed to keep up with my brain. That's what happens when I'm in a rush and I apologize to all. I am glad, however, to see that some folks are catching me. That part is great.
Bill Kraft