In the world of trading, an individual is bound to encounter three main types of orders: market, limit, and stop. A stop order, simply put, is an order that gets executed when a security's price reaches a predetermined trigger point. What makes a stop order unique is that it's always executed in the direction the price is moving. If the market is moving lower, for instance, a stop order is set to sell at a pre-set price lower than the current market price. If the price is ascending, the stop order is to buy once the security reaches a specific price higher than the current market price.
The Various Types of Stop Orders
Stop orders are not monolithic. They come in several forms, each varying based on your position and overall market strategy. Here are some of the most commonly used types:
Stop-Loss Orders: This type of order comes into play when you have an open position, with the objective of limiting potential losses. This provides a safety net against rapid market downturns.
Stop-Entry Orders: These are used to enter the market in the direction the market is moving. This strategy, often known as breakout trading, allows traders to ride the market momentum.
Trailing Stop-Loss Orders: This variant allows you to move your stop-loss order in the direction of the trade, thereby further protecting your investments against losses or safeguarding your gains.
In essence, a stop order is like a safety mechanism that protects an investor from undesirable market outcomes, akin to a fishing lure supervised by a robot, ready to cut the line if the fish is too small.
Trigger Points and Market Orders
The crucial feature of a stop order is its trigger point, which refers to a predetermined price level. When the security price crosses this trigger point, a market order is entered to buy or sell the security at the next available price. Depending on the intended action, it could be a buy-stop or sell-stop order.
Sometimes, though, the subsequent available price might not be ideal. Therefore, investors might further specify a limit at which the security can be bought or sold, once the actual stop order has been triggered. This results in what's called a Stop-Limit Order.
Straightforward Nature of Stop Orders
At its core, a stop order is pretty straightforward. If an investor puts a stop on their shares of a certain stock, and the price falls below the stipulated stop price, the shares are sold at the next available price. Such an order can also be referred to as a Stop-Loss Order, as it's primarily used to prevent potential losses from escalating.
Stop orders serve as a hedge and an automated mechanism that "fences in" an investor's exposure to market fluctuations. This means that an investor won't be caught off guard by unexpected market movements or be forced to manually enter a trade ticket whenever there's a change in price.
On the flip side, stop orders can also be used to lock in potential gains. If an investor believes that a security is unlikely to reach prices much higher than the current price, they could set a stop order at a higher price than what they paid for the shares, effectively agreeing to sell at what they consider a high-water mark.
In sum, these examples of conditional orders offer a way to manage potential risks and rewards in trading, and can be part of multiple orders within the same overarching order.
Summary
A stop order is like putting a lure out on a pond but having a robot there to cut the line or reel in the lure if the conditions are not met, such as a fish too small to bother with, to stick with the metaphor, so that the fisher-person (investor) can take a nap or attend to the many other lines he may have in the water.
A stop order names a price which serves as a trigger point, and once the security price has crossed this trigger point, a market order is entered to buy or sell at the next available price. It might be called a buy-stop or sell-stop depending on which action it pertains to.
The problem is that the next available price may not be ideal in some situations, and for this reason sometimes the investor may take it further and name a limit at which the security can be bought or sold, after the actual stop order has been triggered, which would be called a Stop-Limit Order.
So it can get a little confusing.
At the level of a Stop Order, though, it's pretty straightforward. For instance, if I put a Stop on my shares of ABC, if the price falls below the Stop price I've stipulated, the shares are up for grabs and I'll take the next available price for them.
That order can also be called a Stop-Loss Order because it's an attempt to stop the potential losses from getting any bigger.
It is a way to hedge and almost "fence-in" an investor's exposure to market fluctuations which might otherwise catch the investor by surprise and require the investor to manually enter a trade ticket whenever the news of the price change reached him.
It also might be an automated way to lock in potential gains. I could put a stop order at a higher price than I paid for my shares, if I don't believe the security is likely to attain prices much higher than that, to go ahead and agree to sell at what I believe would be a high-water mark in my estimation of things.
These are examples of Conditional Orders and can be entered as multiple orders in the same overarching order.