Understanding Order Types: Stop Orders

Stop orders help you manage risk by automating trades when stocks hit certain prices. They're essential tools for protecting profits and limiting losses. [DEFINITION] Stop Order (Stop-Loss): An order that becomes a market order when the stock reaches a specified "stop price." [DEFINITION] Stop-Limit Order: An order that becomes a limit order (not market order) when the stop price is triggered. ### How Stop-Loss Orders Work A stop-loss order protects against large losses: 1. You set a stop price below current market price 2. If stock falls to stop price, order activates 3. Stop-loss becomes a market order 4. Executes at best available price [EXAMPLE] You buy Tesla at $250. To limit losses, you set a stop-loss at $225 (10% below purchase). | Tesla Price | Stop Order Status | |-------------|-------------------| | $250 | Inactive (holding) | | $230 | Inactive (holding) | | $225 | TRIGGERS - becomes market order | | Fills at ~$224 | Sold, loss limited to ~10% | ### Stop-Limit Orders: More Control A stop-limit adds price control: 1. You set a stop price AND a limit price 2. When stop is triggered, becomes a limit order 3. Only executes at limit price or better [EXAMPLE] You set stop-limit: Stop at $225, Limit at $220. - Stock drops to $225 → triggers limit order - Limit order placed to sell at $220 or higher - If stock gaps to $215, order does NOT fill - You still own shares (which might be good or bad) [TIP] Stop-limit orders protect against execution at terrible prices during crashes, but they risk not executing at all in fast-moving markets. ### Trailing Stop Orders [DEFINITION] Trailing Stop: A stop order that "trails" behind a rising stock price by a set amount or percentage. **How trailing stops work:** - Set a trail amount ($ or %) - Stop price rises as stock rises - Stop price never decreases - Locks in gains while letting winners run [EXAMPLE] You buy stock at $100, set 10% trailing stop: | Stock Price | Stop Price | Action | |-------------|------------|--------| | $100 | $90 | Initial (10% below) | | $110 | $99 | Stop rises (10% below new high) | | $120 | $108 | Stop rises again | | $115 | $108 | Stock falls, stop stays at $108 | | $108 | TRIGGERS | Sells at ~$108 | Result: Bought at $100, sold at ~$108, locked in 8% gain even though stock peaked at $120. ### When to Use Each Stop Type **Stop-Loss (Market):** - Liquid stocks where execution matters most - Limiting downside on positions - When you MUST exit at any price **Stop-Limit:** - Less liquid stocks where gap risk is high - When you'd rather miss sale than sell too low - Earnings or volatile event periods **Trailing Stop:** - Letting winners run - Locking in gains without constant monitoring - Trend-following strategies [KEY] Stop orders are not guaranteed to execute at your stop price—they trigger a market order which executes at the next available price, which could be significantly worse in fast-moving markets. ### The Gap Risk Problem [WARNING] Stocks can "gap" past your stop price, especially: - Overnight on bad news - After earnings surprises - During market crashes - On trading halts [EXAMPLE] Your stop-loss is at $50. Overnight, company announces terrible earnings. Stock opens at $35. Your stop triggered at $50 but executes at $35—you lost 30% instead of the 10% you planned. ### Strategic Stop Placement **Too tight:** Stops triggered by normal volatility, selling you out prematurely **Too loose:** Losses larger than necessary before stop triggers **Common approaches:** - Below recent support levels - 7-10% below purchase price - Based on Average True Range (ATR) [EXERCISE] You own 100 shares at $80, currently trading at $100 (25% gain). You want to lock in at least a 15% gain while letting it run higher. What trailing stop percentage should you set? |ANSWER| Set a 10% trailing stop. If stock stays at $100, stop is $90 (10% gain locked in). If stock rises to $120, stop rises to $108 (35% peak, 35% gain locked if it reverses). The 10% trail protects gains while giving room to run. [SCENARIO] A biotech stock you own at $50 is at $75 before an FDA decision. You set a stop-limit at Stop: $60, Limit: $55. FDA rejects the drug, and the stock gaps to $30 at open. Your stop triggered but limit order at $55 never fills—you still own shares at $30. Sometimes a market stop-loss (accepting any price) is safer than a stop-limit during binary events.