Stop order is an order to buy or sell a security when its price moves past a particular point, ensuring a higher probability of achieving a predetermined entry or exit price, limiting the investor’s loss or locking in a profit. Once the price crosses the predefined entry/exit point, the stop order becomes a market order. Also referred to as a stop or stop-loss order.
A stop order is placed when an investor or trader wants an order to be executed after a security reaches a specific price. This price is known as the stop price and is usually initiated by investors leaving for holidays, entering situations where they are unable to monitor their portfolios for extended periods of time, or trading in volatile assets, such as cryptocurrencies, which could take an adverse turn overnight.
Investors and traders can execute their buy and sell orders using multiple order strategies to limit the chance of loss. The basic market order fills an order at the ongoing market price of the security. For example, if on January 5, 2018, AAPL was trading for $175 per share at 1:00 p.m., a market order does not guarantee that an investor’s buy or sell price will be filled at $175. The investor may get a price lower or higher than $175, depending on the time of fill. In the case of illiquid or extremely volatile securities, placing a market order may result in a fill price that significantly differs from $175.
On the other hand, a limit order fills a buy or sell order at a price (or better) specified by the investor. Using the example of AAPL above, if an investor places a $177.50 limit on a sell order, and if the price rises to $177.50 or above, his order will be filled. The limit order, in effect, sets the maximum or minimum at which one is willing to buy or sell a particular stock.
A buy stop order is entered at a stop price above the current market price. A sell stop order is entered at a stop price below the current market price. Let’s consider an investor who purchased AAPL for $145. The stock is now trading at $175, however, to limit any losses from a plunge in the stock price in the future, the investor places a sell order at a stop price of $160. If an adverse event occurs causing AAPL to fall, the investor’s order will be triggered when prices drop to the $160 mark.
A stop order becomes a market order when it reaches the stop price. This means that the order will not necessarily be filled at the stop price. Since it becomes a market order, the executed price may be worse or better than the stop price. The investor above may have his shares sold for $160, $159.75 or $160.03. Stops are not a 100% guarantee of getting the desired entry/exit points. This could be a disadvantage since, if a stock gaps down, the trader’s stop order may be triggered (or filled) at a price significantly lower than expected, depending on the rate at which the price is falling, the volatility of the security or how quickly the order can be executed.
Using this example, one can see how a stop can be used to limit losses and capture profits. The AAPL investor, if his order is filled at stop price of $160, still makes a profit from his investment: $160 – $145 = $15 per share. If the price spiraled down past his initial cost price, he will be thankful for the stop. On the other hand, a stop-loss order could increase the risk of getting out of a position early. For example, let’s assume AAPL drops to $160, but goes on an upward trajectory to $185. Because the investor’s order is triggered at the $160 mark, he misses out on additional gains that could have been made without the stop order.
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