By Aniket Bose. Edited by Arjun Chandrasekar.
What are Stop-loss Orders?
A stop-loss order is an order that is placed with a broker with the intent to either buy or sell a certain stock once that stock reaches a specific price point. It is designed to limit the loss of an investor on a security position. For example, if an investor sets a stop-loss order for 15% below the price that they bought for a stock it will limit the loss of the investor to 15%. Suppose that the investor purchases Microsoft’s stock at $50 per share and after purchasing they enter a stop-loss order of $19, then if Microsoft’s stock price falls below $19, the investor’s shares will be sold at the current market price.
The most beneficial thing about stop-loss orders for investors is that it does not cost anything to implement. Investors are charged with a regular commission only once when the stop-loss price has been reached and the stock must be sold. Another way to think about a stop-loss order is like a free insurance policy. This investment strategy is only useful to the investors that are stick to the strategy and make intelligent decisions; stop-loss trade orders are useless for hardcore buy-hold investors. The advantage for investors that use stop-loss orders is that it helps them to stay on track and can prevent any second thoughts from the emotion of investing. Another advantage of stop-loss orders is that investors do not have to monitor how their stock is performing daily.
The main disadvantage of stop-loss orders is that even a short-term fluctuation in a stock’s price point could end up activating the stop price. In order to avoid this, investors should pick a stop-loss percentage that can allow a stock to fluctuate day-to-day while preventing as much risk as possible for the risk. Another thing for investors to keep in mind when they are using stop-loss orders is that once their stock reaches its stop price, that stock automatically becomes a market order. This means that the price that the investor will sell their stock may be different than the original stop price. Another restriction on stop-loss orders is that many bankers do not allow investors to place a stop-loss order on securities like OTC Bulletin Board stocks and penny stocks.
What are Stop-limit Orders?
A stop-limit order is a conditional trade over a certain timeframe that combines the features of a limit order and is used to mitigate risks for investors. It is very closely related to other order types, including limit orders (an order to either buy or sell a certain number of shares at a set price) and stop-on-quote orders (an order to either buy or sell specific security after its price has surpassed a specific price point). They enable traders to have precise control over when the stop-limit order should be filled, but there is no guarantee that it will be executed. Traders often use the strategy of stop-limit orders so that they can lock in on profits or so that they can limit their downside losses. The stop-loss order will be executed at a specific price that is set by the trader or investor after the stop price has been reached by that stock. After the stop price has been reached, the stop-limit order becomes a limit order to either buy or sell at the limit price or even better than the limit price that was originally set.
Stop-limit orders are available with almost every online broker, which is highly beneficial for investors and traders. As an example, assume that Apple Inc. is trading at $170 and there is an investor that wants to buy Apple’s stock when it begins to show some significant upward growth. The investor then decides to put in a stop-limit order to buy with the stop price being $180 and the limit price being $185. If the price of Apple’s shares becomes more than the stop price of $180, then the order is activated and automatically turns into a limit order. As long as the order can stay filled under $185, which is the limit price set by the investor, the trade will then be filled. However, if the shares of Apple continue to grow and go over the limit price of $185, the order will not be filled.
In short — we covered some of the major differences between stop-loss and stop-limit orders, and we gave some insight into the benefits and drawbacks of each one.
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