Understanding Stop Orders in Trading
Stop orders are essential tools for managing risk in trading. They help traders minimize losses and, in some
cases, lock in profits automatically. Here are the three main types of stop orders and how they work.
1. Stop Loss Order
A stop loss order automatically converts to a market order when the security reaches your predetermined stop
price.
Example:
- You purchase a security at $72.75
- You set a stop loss at $70.00
- If the price falls to $70.00, your stop loss triggers
- Your position is sold immediately at the current market price
Key Benefit: Guaranteed execution, limiting your potential losses
Caution: During volatile markets, you might sell at a price significantly lower than your
stop price.
2. Stop Limit Order
A stop limit order combines a stop order with a limit order. It triggers at your stop price but only executes
if it can get your limit price or better.
Example:
- You purchase a security at $72.75
- You set a stop price at $70.00 and a limit price at $69.00
- If the price hits $70.00, a limit order activates
- If the price falls below $69.00, your order won't execute
- Your order will only execute if the market price is $69.00 or higher
Key Benefit: Price protection, but no guarantee of execution
Caution: If the price falls quickly and never rebounds above your limit price, your
position won't be sold, potentially leading to larger losses.
3. Trailing Stop Order
A trailing stop order automatically adjusts your stop price as the security price increases, helping to
protect gains while allowing for continued upside potential.
Example:
- You purchase a security at $72.75
- You set a trailing stop of $3.00 (or could be a percentage)
- Initially, your stop price is $69.75 ($72.75 - $3.00)
- If the price rises to $80.00, your stop price automatically adjusts to $77.00 ($80.00 - $3.00)
- If the price then falls to $77.00, your order executes
Key Benefit: Locks in profits while allowing for upside potential
Caution: During high volatility, a temporary price drop might trigger your order even if
the overall trend remains positive.
Comparison of Stop Order Types
| Order Type |
Execution Guarantee |
Price Protection |
Locks in Profits |
Best Used When |
| Stop Loss |
Yes |
No |
No |
You want guaranteed exit regardless of price |
| Stop Limit |
No |
Yes |
No |
You want price protection but can accept non-execution risk |
| Trailing Stop |
Yes |
No |
Yes |
You want to capture profit in an uptrend without constant manual adjustments |
Best Practices
When to Use Stop Loss
- When limiting potential losses is your primary concern
- In liquid markets with normal volatility
- When you want simplicity and certainty of execution
When to Use Stop Limit
- When you're concerned about price slippage
- When you believe a temporary drop might be followed by a rebound
- When you prefer not selling below a certain price point
When to Use Trailing Stop
- During upward trending markets
- When you want to "let your profits run" while protecting gains
- When you don't want to constantly monitor and adjust your stop levels