What is a Stop Order? Types & Advantages

A stop order is a type of order used in financial markets to buy or sell a security once it reaches a specified price, known as the stop price. It is one of the three main order types commonly encountered in the market, along with market orders and limit orders.

The primary characteristic of a stop order is that it is always executed in the direction that the price is moving. This means that if the market price of a security is moving downward, a stop order will be set to sell the security at a predetermined price below the current market price. On the other hand, if the price is moving upward, a stop order will be set to buy the security once it reaches a predefined price above the current market price.

Types of Stop Orders

The three types of stop orders commonly used in trading are: stop-loss orders, stop-entry orders, and trailing stop-loss orders.

• Stop-Loss Order:

A stop-loss order is designed to limit potential losses by automatically exiting a position if the market moves against the trader’s position. It is primarily used to protect existing positions from substantial losses when the market price reaches a predetermined level. By placing a stop-loss order, traders ensure that their position will be automatically sold or brought once the stop price is reached or breached. Stop-loss orders are especially useful when traders cannot actively monitor the market or need protection from sudden market events or adverse price movements.

• Stop-Entry Order:

A stop-entry order is used to enter the market in the direction that it is currently moving.  A stop-entry order is a type of order that combines the features of a stop order and a limit order. When the stop price is reached, the order becomes a limit order and is only executed at the limit price or better.

For example, if you place a stop-entry order to buy a stock at Rs. 100, the order will not be executed until the price of the stock reaches Rs. 100. Once the price of the stock reaches Rs. 100, the order will become a limit order, and a buy stop order will only be executed at Rs. 100 or better.

• Trailing Stop-Loss Order:

A trailing stop-loss order is a type of stop order that automatically adjusts its stop price as the market price of the security moves. This means that the stop price will always be a certain distance (percentage or amount) behind the market price.

For example, if you place a trailing stop-loss order to sell a stock at 5% below the market price, the stop price will automatically adjust as the market price moves. If the market price of the stock rises to $100, the stop price will adjust to $95. If the market price of the stock falls to $95, the sell-stop order will be triggered, and the stock will be sold.

These three types of stop orders provide traders with various tools to manage risk, protect profits, and enter trades based on specific market conditions and strategies. It’s important for traders to understand and effectively utilise these stop orders in their trading plan to enhance their risk management and improve their overall trading performance.

Advantages of Stop Orders

1. Guaranteed execution: When a stop order is triggered, it becomes a market order, ensuring that the trade will be executed. This provides traders with certainty that their order will be filled, even if it means at a slightly different price than the stop price.
2. Additional control over trades: Stop orders give traders additional control over their trades. They allow traders to set predefined exit or entry points based on their analysis or trading strategy. This helps remove emotional decision-making from the trading process and ensures that trades are executed according to predetermined rules.
3. Loss limitation: Stop orders are commonly used to limit potential losses. By setting a stop-loss order, traders can specify the maximum amount they are willing to lose on a trade. If the market moves against its position, the stop-loss order will automatically trigger, helping to prevent further losses.

Disadvantages of Stop Orders

1. Fluctuation risk: Stop orders are susceptible to short-term price fluctuations and market volatility. In fast-moving or turbulent market conditions, the price may briefly dip or spike, triggering the stop order and potentially resulting in an unfavourable execution price. Traders need to be aware of this risk and consider placing their stop orders with some margin of error.
2. Slippage: Slippage refers to the difference between the expected execution price of a stop order and the actual price at which it is executed. Slippage can occur when the market moves rapidly or when there is insufficient liquidity, causing the executed price to deviate from the stop price. This can impact the overall profitability of a trade, especially in volatile markets or during significant news events.

Example of a Stop Order

Suppose you own 100 shares of ABC stock that are currently trading at Rs. 100 per share. But you are concerned that the price of the stock is going to fall, so you place a sell stop order at Rs. 95 per share.

Now, if the price of the stock falls to Rs. 95 or below, your stop order will be triggered and your 100 shares of ABC stock will be sold at the best available price at the time. This will ensure that you do not lose more than Rs. 5 per share on your investment in ABC stock.

Stop Order vs Limit Order

Various order types let you specify more precisely how you want your broker to execute your trades. When you place a limit order or stop order, you are informing your broker that you do not want your order to be completed at the market price (the current price of share) but rather at a predetermined price.

However, there are a few factors which differentiate the Stop Order and Limit Order:

• While a stop order utilises a price to initiate an actual order when the specified price has been transacted, a limit order uses a price to specify the lowest acceptable amount for the transaction to occur.
• The market can see a limit order but only a stop order once the stop order is activated.

Let’s use an example to explain this further: If you want to purchase a stock for ₹100 at ₹99, the market can recognise your limit order and fill it when vendors are prepared to accept that price. A stop order won’t be visible to the market and will only take effect once the stop price is reached or surpassed.

Should I Ever Move My Stop-Loss Order? 

The investors should move stop-loss order only if it is in the direction of your position. Consider the situation when you are long on ABC Ltd with a stop-loss order placed ₹5 below your entry price. You can increase your stop loss to reduce your risk of losing money or to lock in earnings if the market cooperates and climbs higher.

What Should I Do if My Stop-Entry Order Is Filled?

Suppose you have a position in the market; you must, at the very least, set up a stop-loss (S/L) order for it. Adding a take-profit (T/P) order is another option. You now have commands surrounding your position that have been combined. These orders are frequently linked together and are referred to as one-cancels-the-other (OCO) orders, which means that if the T/P order is filled, the S/L order will be immediately cancelled, and vice versa.

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