One of the most important ideas Day Traders need to sear into their brain is that trading is just as much about preserving wealth as it is about creating it. In order to preserve your wealth, it’s important to understand how to limit your potential losses. One of the most common ways to limit losses is to use a type of sell order called a Stop loss or a Stop limit Order. They sound very similar, but the difference is important to understand.
Stop Loss Orders
What is a Stop Loss Order? A stop loss order is an order to sell your stock once the stock price hits a price point that you specify. When the price of the stock hits your price point, your brokerage will automatically and instantly turn that order into a market sell order and sell the stock.
Here’s an example: Let’s say you own 500 shares of Ford stock that you purchased for $5 per share. A rumor has hit the web about a potential buyout from Tesla and the stock has run all the way up to $10 per share. If this happened, you’d probably be thinking it’s time to cash in and sell! While locking in profit is never a bad idea, on a rumor like this you must imagine that the stock might continue to climb so if you sell now you will miss out on even more profit. That’s when a Stop loss Order is your best friend!
In this example, you tell yourself that no matter what happens, you want to make $4 of profit per share but you want to ride it out to see if it keeps climbing. In order to do this, you would place a stop loss sell order at $9. If the stock drops at or below $9, then your brokerage firm will sell it at a market order, and it will get filled at whatever the market price is at the time of the order. Something to keep in mind is that from time to time, depending on the size of the order and how quickly the stock is dropping, the market order may fill for less than your stop loss price of $9. 250 shares may sell at $9 and the other 250 may sell at $8.95.
Stop Limit Orders
A stop limit order is an order to sell your stock at a price you choose once the price hits a point that you specify. When the price of the stock hits your price point, the order automatically turns into a limit sell order. This order will only execute if it can sell for the limit price that you specified when placing the order.
That means that when you place a stop limit order you will be entering two prices into the order. The first price will be your stop-price that triggers to convert into a limit sell order. The second price is the limit price, which is the price that the converted limit order will execute at, or better.
Keep in mind that if a stock falls below the stop price but does not hit the limit price, the sell order will not execute.
Let’s use the Ford example again: You bought 500 shares of Ford stock at $5 per share and it’s climbed up to $10 on a rumor of a buyout. But another tweet just came out that drove the price up even further to $15 a share and the market is acting pretty irregular with wild price swings.
In this instance, you’d cancel the stop loss order you previously placed at $9 and enter a stop limit order. This stop limit order would have a stop-price of $11 with a limit-price of $11. If the stock falls at or below $11 then the order converts into a live limit-sell order but will only execute at $11 or better. If the stock falls rapidly down to $10.50 – then the order will only execute if the price climbs back up to $11.
Benefits and Risk of Stop Loss and Stop Limit Orders
Stop loss and Stop limit orders can offer traders an enormous amount of protection against large losses and unexpected market downturns. Knowing the difference between the two types of orders can help you be better equipped to preserve your wealth and not get stuck holding a stock that drops exponentially.
Stop loss orders guarantee that a stock sale will happen. They do not guarantee the price of the stock when the sale occurs. Remember, it all depends on how fast the stock price is falling and what the best strike price is at that moment in time.
Stop limit orders can guarantee a price-limit, but they do not guarantee that the sale of the stock will execute. The risk with stop limit orders is that if the stock doesn’t hit the limit price then you can be stuck with huge losses or holding the stock for extended lengths until the price recovers.
The Final Word
Both Stop loss and Stop limit Orders can help provide you with layers of protection against potential losses or unexpected market downturns. But as always, it’s important that you understand what types of orders you’re placing and practicing via paper trading first.
Before you get started make sure you read our Quick Guide To Day Trading!