A stop order is an order placed to either buy above the market or sell below the market at a certain price.
It is an instruction to your broker to execute a trade at a particular level that is less favorable than the current market price.
In the image above, the blue dot is the current price.
Notice how the green line is above the current price. If you place a BUY stop order here, in order for it to be triggered, the current price would have to continue to rise.
Notice how the red line is below the current price. If you place a SELL stop order here, in order for it to be triggered, the current price would have to continue to fall.
The meaning of a stop order is the opposite of a limit order, which instructs your broker to buy or sell an asset at a particular price that is more favorable than the current market price.
Stop orders are normally used to take the trader out of a trade in the event the market goes against his/her position.
Types of Stop Orders
There are two types of stop orders: stop-loss orders and stop-entry orders.
A stop-loss order can be used to limit risk, by automatically closing a position once it reaches a certain level of loss.
There are a variety of types of stop-loss orders, including a basic stop-loss, a trailing stop-loss, and a guaranteed stop.
A stop-entry order is used to take advantage of market movements by opening a position when a market drops to a certain level.
Traders used them to make sure they don’t miss any opportunities to enter and exit trades when they can’t monitor the market.
An order sent to a broker which becomes a market order when the market reaches the specific price stated. In volatile (or fast) markets, slippage may occur.
When should you use a limit order?
Using a stop order is a great way to manage your positions without having to constantly monitor the markets and be there at the exact moment of execution.
The key is to choose a stop order level that allows your asset to fluctuate in price while still protecting you from downside risk.
When selecting your stop order level, it is important to realize that this no guarantee of execution.
Basic stop orders can incur slippage when opening and closing positions if there are large movements or gaps in the market.
If your level is reached, your stop order will be filled at the best available market price, which could be totally different from your desired price.
If you choose to use a stop order, and the market movement is only temporary, you may lose out on potential profit.
For example, if your stop-loss order closes out your position, and right after, price rises again.