Free excerpt from Build Wealth in Any Market: How to create consistent, reliable income from the stock market by Ross Jardine.
Stop Order vs. Stop Limit
Many investors are confused when it comes to the difference between a stop order and a stop limit order. Many of the online brokers actually have two buttons you can click on their order screens that say “STOP” or “STOP LIMIT.” When most investors look at this screen, the word “stop” jumps out at them. They do not pause to think what the difference is between the two.
In fact, some people reason that since they are going to put a price where they want the safety net to be, that is their stop limit, and they click the box that says “stop limit” and enter the price where they want to get out.
Now let me clarify this issue, because it is very important. A stop loss order and a stop limit order are two very different things. And it is very important that you understand the difference so you don’t use the wrong one.
I am going to make a blanket statement and then explain it. Here is the simple rule: DO NOT USE A STOP LIMIT, just don’t do it. What you want to use is a stop order or a stop loss order. (A safety net order.)
So what’s the difference? In this case, one single word can totally change the meaning of what you’re doing. Let’s look at the difference.
Let’s say we buy a stock for $20 and that we are willing to risk 20 percent of that. This means that the stock could drop down to $16 before we would get out. So this is where we place our stop loss order to get us out. If our broker will allow us, we would place our order good-‘til-cancelled (GTC) to keep it in place without having to re-enter it on a daily basis.
The thing that would trigger our stop order is a drop in the price of the stock to $16 or less. When the $16 price is reached, at anytime the market is open, our order is triggered. The brokerage firm then sends a market order to the exchange that is filled at the current market price.
That doesn’t necessarily mean you are going to get out at $16; it just means that when the stock hits $16, the brokerage house will send a market order in to get you out at whatever the market price is when your order arrives. This may be a little above or a little below $16, but it is the $16 price that triggered the market order being sent.
Now, how is this different than the stop limit order? First, it’s important that you understand what a limit order is. This can be an order to buy or sell an investment where we set the minimum price we’re willing to accept. This price is our limit. A limit order is not filled unless you are able to get your limit price or a better price. So let’s apply this to a stop order, as we understand it thus far.
Let’s use the same example of the $20 stock with a stop at $16. Remember, our intent is to get out if the price drops to $16 or lower. If we set a stop limit at $16, and the stock goes down and hits $16, instead of a market order being sent to the exchange to sell our stock, a limit order to sell our stock at $16 or better is sent. The order to sell won’t be filled unless you are able to get $16 or better, which, in this case, would be a higher price. If the market for the investment doesn’t trade at, or above, your limit price, the order is not filled. So why is this important?
Let’s assume the stock we own has traded down to $16.50 from the $20 price where we bought. Then, overnight, while the market is closed, the company announces a shortfall in their earnings. The next morning the stock opens up at $14. This is what is called a “gap down.” The opening price is lower than the previous day’s close, leaving a gap in the price chart.
Notice the gap lower in price that occurred the first week in January in MSFT stock (Figure 4.3). You can see the “gap” in the price chart from one day to the next. This is a gap down. For reference, there is also a gap up in the chart the last week in October where the price gapped higher from one day to the next.
In this case, our stop limit order would be triggered once the stock traded below $16, and our limit order to sell would be sent to the exchange. But since the stock is no longer trading at, or above, $16, it would not be filled. If the stock continues to drop, we would continue to lose more money.
Can you see how you are stuck? You have an order in—you put up the safety net—but by selecting a stop limit order rather than a traditional stop order, you specified that you are only willing to accept a sell price of $16 or better. With a stop loss order you would be filled at the opening price and, therefore, sidestep any further price declines.
If you are going to use a stop as a safety net to sell out of an investment at a certain price, you should always use a traditional stop order and not a stop limit order. Think of them as a stop market and stop limit and it will help you to understand what the difference is. This will make your order go in as a market order and not a limit order.
A stop limit order is typically used as a buying order, not a selling order. An investor may want to buy into a stock after it reaches a certain price they’ve determined to constitute a new breakout, but they don’t want to buy if it doesn’t reach that price. They use a buy stop limit order to trigger their order at a certain price, which assures them of that price or better. This is not an order to be used by the novice investor. Experienced investors, who clearly understand what they are trying to accomplish and recognize the stop limit order as the vehicle to help them, are typically the only ones who use this type of order.
So let’s review the simple rules relating to stops:
• Always set a stop when you enter a new position.
• Use traditional stop loss orders and not stop limit orders.
• Place hard stops with your broker as good til cancelled (GTC), if possible.
• If your broker does not allow GTC stop orders, use either day orders or mental stops.
• If you use mental stops, write down the stop price to help you become more disciplined.
• Set your stops on stocks somewhere in the neighborhood of 10 to 20 percent of the purchase price.
• Set your stops on option positions at 30 to 50 percent of the premium paid.
• Never lower a stop loss trigger price from your original stop price.