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What Is a Stop Order & How Does It Work?

July 25, 2022
6
min

Stop orders allow investors to place limits on when securities will be bought and sold on their behalf. They can be set up by brokers or on trading apps.

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A stop order is an instruction to buy or sell an asset when the price meets, exceeds, or falls below a certain level. When a stock reaches a desired price, the stop order becomes a market order, which is an order to buy or sell at the current price.

What Is a Stop Order? 

A stop order is an instruction to buy or sell an asset when the price meets or rises above or falls below a certain level. Investors can use them on many types of investments, including stocks, exchange-traded funds (ETFs), currencies, and commodities.

Stop orders can be thought of as sort of if-then statement: If an investor bought X Corp. stock at $125 and it appreciates to $150, the investor, concerned that the price might fall, could then  place a sell-stop order at $145 to lock in a $20 gain. On the other hand, if the stock keeps rising, no transaction takes place.

Or imagine an investor who has been watching Y Corp. shares trade between $23 and $25 for several months. The investor thinks if Y Corp. breaks out of that range the shares probably will continue rising. The investor then places a buy-stop order at $27, thinking that will be the start of an upward trend. But in this case, if the stock doesn’t rise to $27, no transaction occurs.

Stop orders can be used to preserve gains, or dodge or mitigate a loss. Investors holding a security may use a sell-stop order to cushion a loss, while short-sellers who profit from a falling share price could use a buy stop order to protect their position from a rising price that could inflict losses. One type of investor who may find stop orders useful are those who can’t or don’t want to watch markets all the time; when the price reaches the desired level, a sale occurs automatically. 

How and when might investors use stop orders? 

Stop orders can be used to set a minimum price to sell an investment or a maximum price to buy. In either case, the investor must accept a chance that their order isn’t executed because the target price is never reached.  An investor might use a stop order instead of a market order to:

  • Lock in profits. A stop order can be used when an investment has increased in value and the investor wants to be sure to sell if it falls a certain amount, thus locking in a profit. If the investment keeps appreciating, no sale will take place. In that case, the investor can keep watching that investment and perhaps set up a new stop order at a different higher price, ensuring an even bigger gain. 
  • Limit losses. Likewise, if an investment has gone bad, an investor can set a level to sell at a certain price, to cut their losses. This setup can allow an investor to hold their investment for now with the confidence that it will be sold if it hits the predetermined floor.
  • Anticipate gains. Investors can use a stop order to try and get in at the low end of an anticipated rally in an investment. If, say, pork belly prices have been steady, but an investor thinks they’re about to head higher, they can set a buy stop order a little bit above current prices, hoping to jump in at the start of a rising trend. This requires the investor to correctly guess that pork bellies will in fact go higher, something no investor can know in advance. If the prices don’t rise as the investor expects, no purchase takes place.

Yet extreme market turmoil can lead to bad outcomes when using stop orders.

During so-called flash crashes—almost instantaneous plunges in prices and equally fast recoveries that may be caused by automated or computerized trading—traders using stop orders may wind up selling at an excessively low price that bounced back quickly.

For example, on Aug. 24, 2015,  the Dow Jones Industrial Average fell more than 1,000 points in less than five minutes, only to snap back almost as fast. Something similar occurred on Oct. 7, 2016, when the U.K. pound weakened 6%—a huge move for a major currency—before paring losses and ending trading down just 1.5%. 

Types of Orders

A stop order is one of several types of stock orders that also include: 

  • Market. Market orders are used by investors who are willing to buy something now at the current price instead of waiting for a better price.
  • Limit. These are instructions to only buy shares at or for less than the requested price.
  • Sell limit. This order type means to only sell shares at or above a certain price.
  • Buy stop. A buy stop order to a broker to buy shares when the price moves above current levels. It’s often used by investors who expect prices to rise even more. The name is a bit misleading—it’s not an order to stop buying, but an order to buy once prices hit the stop or trigger price. 
  • Sell stop. This is an instruction to sell a security or to sell a stock when it falls below a certain price. This can be used to finalize profits or to limit losses. 
  • Stop-limit order. A stop order merged with a limit order sets a floor and ceiling on when to buy or sell. It is designed to control risk. A stop order triggers buying or selling when the stock price hits a certain point, and the limit order prohibits buying or selling beyond another predetermined price. These orders often are used by short-sellers—investors who profit when a security declines in price—as a way to protect profits or avert losses when using this costly, high-risk investing strategy.

The bottom line 

Stop orders allow investors to place limits on when securities will be bought and sold on their behalf. They can be set up by brokers or on trading apps. Buy stop orders can be used when investors think prices will rise and they want to get in early. Sell stop orders can be set up to lock in gains in a security that has gained value. They also can be used to take gains or cut losses during price changes.But investors can miss out on bigger gains or if they don't choose the wrong buy and sell stop parameters well. And if the investment never reaches the target level, the order to sell or buy won't be executed.

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