Order Types 101
Knowing various order types is key to smart financial management and risk avoidance. Let’s take a look at two important types of orders that traders commonly use, stop orders and stop limit orders. While they both seek to accomplish the same thing, they work in very different ways. This article provides a closer look at the major differences between these two types of orders. It takes a deep look into their mechanics, purposes, and how they are most often used in the current trading landscape.
A stop order, or stop-loss order, is a critical instrument for investors. It allows them to hedge against future losses and guarantee a certain profit. As such, it only executes as a market order once the stock price touches a specified stop price. Only when the price falls to the pre-established level does the stop order become active. It then moves to be executed instantly at the prevailing best market price. The straight-through nature of execution itself is one of the main reasons this is enticing to traders who want to reduce risk as fast as possible.
A stop limit order allows you more precise control over your trades. It allows you to specify a maximum limit price at which you want the order to be executed. This kind of order only becomes a limit order when the stock hits the set stop limit price. A market order fills at the current best market price. With a stop limit order, an order is only executed at the specified limit price or better. This feature is an especially valuable option for traders who want to minimize risk associated with unpredictable market movements.
The use of stop limit orders is very strategic, commonly used in conjunction with stop orders to better tune trading strategies. Both types of orders cut financial exposure by capping losses or locking in profits. Which one you should choose largely comes down to your individual goals and willingness to take on risk. A stop limit order offers more precision and control to traders. They can indicate a maximum price or minimum price they’re willing to agree to. This can be especially crucial in fast-moving markets, where prices can change within a matter of minutes.
When a trader places a stop order, they identify a trigger point. Once that limit is hit, their order simply becomes a market order. Our example investor owns shares of a company whose stock is today trading at $50. In order to limit their losses and defend their investment, they choose to place a stop order at $45 for when the price falls that low. If the stock ever hits that price, the stop order becomes a market order. It then gets filled at the current market price, which could be higher or lower than $45 depending on how the order book looks at that minute.
If the same investor decides to use a stop limit order instead, they have more control. In addition to specifying the stop price, they can set the limit price. For example, if they decided to set their stop price to $45 and limit price at $44. If the price falls to $45, your order will automatically become a limit order. In practice, it only makes sense to run it if you can monetize it for at least $44. This prevents the sale from happening under their reservation price.
Stop limit orders are especially helpful during times of increased market volatility when prices are more likely to experience sudden fluctuations. With the ability to set both a stop and limit price, traders can protect themselves from selling at unacceptable prices. This approach offers them the opportunity to get out of positions themselves if their financial predictions turn south.
As is the case with any order type, stop limit orders pose risks, even with their benefits. The first and only risk is that the market is a fast moving one. If it goes through the limit price, your order may not be executed at all! Traders need to weigh their inclination for control with the risk of losing out on the opportunity.