Stop Loss Order / Stop Order

What is a stop loss order, also known as a stop order?

This is an order that becomes a market order when a particular price level is reached. A sell stop is placed below the market, a buy stop is placed above the market. (Source: CFTC)

A stop order is an order to buy or sell a stock once the price of the stock reaches a specified price, known as the stop price. When the specified price is reached, your stop order becomes a market order.

Buy Stop Order — Investors typically use a stop order when buying stock to limit a loss or protect a profit on short sales. The order is entered at a stop price that is always above the current market price.

Sell Stop Order — A sell stop order helps investors to avoid further losses or to protect a profit that exists if a stock price continues to drop. A stop order to sell is always placed below the current market price.

The advantage of a stop order is you don't have to monitor how a stock is performing on a daily basis. The disadvantage is that the stop price could be activated by a short-term fluctuation in a stock's price. Also, once your stop price is reached, your stop order becomes a market order and the price you receive may be much different from the stop price, especially in a fast-moving market where stock prices can change rapidly. An investor can avoid the risk of a stop order not guaranteeing a specific price by placing a stop-limit order.

The use of stop orders is much more frequent for stocks that trade on an exchange than in the over-counter (OTC) market. In addition, your broker-dealer may not allow you to place a stop order on some securities or accept a stop order for OTC stocks. Before you enter into these types of orders, you should speak to your broker or financial advisor about how these orders work. (Source: SEC)

A stop order (sometimes known as a stop loss order) is the complement of a limit order. It is an order to buy (or sell) a security once the price of the security climbed above (or dropped below) a specified price, known as the stop price. When the specified price is reached, the stop order is entered as a market order. The difference between stop order and limit is that in the former, a desired selling price (ask) will always be below the current price. Similarly, in stop order a desired buying price (bid) will always be above the current price. However, in limit orders, the ask will be above current price and the bid will be below current price. Hence, stop order is the complement of limit.

A sell stop order is an instruction to sell at the best available price after the price goes below the stop price. A sell stop price is always below the current market price. For example, if an investor holds a stock currently valued at $50 and is worried that the value may drop, he/she can place a sell stop order with the broker at $40. If the share price drops to $40 for whatever reason, the broker will sell the stock at the next available price. This can limit the investor's losses (if the stop price is at or below the purchase price) or lock in at least some of the investor's profits (if the value of the security has risen between when the security was purchased and the stop order placed).

A buy stop order is typically used to limit a loss (or to protect an existing profit) on a short sale. A buy stop price is always above the current market price. For example, if an investor sells a stock short (borrows stock and sells it immediately at current market price (Shorting), and the investor hopes the stock price goes down in order to give the borrowed shares back at a lower price (Covering) while pocketing the difference), the investor may try to protect himself against losses if the price goes too high using a buy stop order.

With a stop order, the customer does not have to actively monitor how a stock is performing. However because the order is triggered automatically when the stop price is reached, the stop price could be activated by a short-term fluctuation in a security's price. Once the stop price is reached, the stop order becomes a market order. In a fast-moving market, the price at which the trade is executed may be much different from the stop price. The use of stop orders is much more frequent for stocks, and futures, that trade on an exchange than in the over-the-counter (OTC) market. (Source: Wikipedia)

See also:
Stop-Losses Blog Posts