Structuring Trades: Know the Difference Between Stop Losses and Stop Limits

[RichardCox 10]

Structuring Trades: Know the Difference Between Stop Losses and Stop Limits

 

 

Technical analysts are fully aware that protective stop losses are an absolute requirement before any real-money positions are taken. But many traders are unaware of the fact that there are different methods for setting these protective stop orders. Here, we will look at the differences between a stop loss order and a stop limit order. It is important for traders to understand these differences because they are widely unknown even though they are regular features in almost every trading platform. These protective orders can get traders in and out of the market without the placement of manual orders but there are some key differences that should be understood before looking for areas to enact both strategies.

 

Traditional Stop Losses

 

Stop loss orders can be broken up into two different types: the Sell-Stop order and the Buy-Stop order. Sell-Stop orders are used in long positions, set below the market price, and trigger a market sell order if prices reach a level that was previously unexpected or in some ways invalidates the strategy that inspired the trade in the first place. So, if prices fall below a certain level after you have opened a long position, a Sell-Stop order can be used to prevent further losses if prices continue to drop. Buy-Stop orders work in the same way (only in reverse) and are used when initiating short positions. Buy-Stop orders are set above the trade entry price and are triggered when prices hit that unexpected bullish level (invalidating prior expectations and the reasonin behind your trading strategy).

 

Market Protection with Stop-Limit Orders

 

Stop limit orders have much in common with traditional stop losses, but there is literally a “limit” that is placed on the execution price. When placing a stop limit order, two price levels must be identified: the limit price, and the price at which the trade is converted to a sell order. Here, it should be remembered that a limit order is an order to buy or sell an asset at a set price (or better). So, rather than seeing the order trigger as a sell market order, it instead becomes a limit order that executes once the limit price is reached. Time limits can also be placed on limit orders so that they are not triggered after a set expiration point.

 

Because of these specific requirements, there is no guarantee the order is going to be filled and this is even more true when market volatility hits extreme levels. Stop-limit orders can be used when asset prices fall outside the limit, if the investor unwilling to buy or sell and instead wants to wait for prices to move back toward the limit price. For example, let’s assume we have a long position in the EUR/USD and prices never fall to hit the stop loss level. Since prices are steadily rising, the trader might choose to cancel the stop loss order, instead placing a stop limit order at higher levels. As a point of illustration, let’s assume the limit order is placed at 1.3050, with the limit placed at 1.30. If the EUR/USD drops under 1.3050, the sell-limit order will be live. If EUR/USD prices fall below 1.30 before the order is filled, that order will not be filled unless prices move back to the limit of 1.3050.

 

In most cases, traders cancel limit orders when the stock price drops below the established limit price, as these orders were placed with the intention of reducing loss exposure when prices gaining in downside momentum. If a trader misses the opportunity to exit the market before volatility reaches extreme levels, that trader can wait for prices to rise again (not selling at the set limit) because there might still be scope for gains. If the trader is unable to exit the market at 1.3050 and prices drop to 1.30, the order can be canceled because if there is enough momentum later to bring prices back to 1.3050, then there could be scope for additional runs higher. Similar to buy-stops, buy-stop-limits can be used in short positions in cases where traders have enough patience and risk tolerance to wait for prices to drop if the buy entry is not made at a level at (or better) than the limit price.

 

Pros/Cons of Stop Losses and Stop Limits

 

Stop losses and stop limits offer trade protection for different types of market environments. Stop losses ensure that an order is filled. But since broker execution is ultimately what determines price levels for entries and exits, stop loss prices cannot be guaranteed. Highly volatile markets can create slippage and larger than expected losses but for traders that are not actively monitoring their positions, this approach does offer protection from margin calls.

 

Stop-limit orders, on the other hand, provide guarantees for price limits, but not for the actual execution of the order. If market volatility reaches extreme levels, this can generate significant losses if markets move in the wrong direction without hitting the limit price. For example, a significant news story or data release, traders could be forced to absorb any losses contained in the area between the entry price and the limit order. Both stop losses and stop limits can be structured in terms of time limit, with either a set execution time as as a Good Til Canceled order (which offers more manual flexibility).

 

Conclusion: Which Order Should You Choose?

 

Making the decision on which order to choose means assessing possible risks relative to the current market environment. If the market is particularly volatile, stop limit orders have an advantage because of their guaranteed price levels (protecting against the enhanced possibility for slippage). If market prices fail to reach the limit (and the order is not triggered), the traders might then have to wait for prices to move back toward the entry level. Conversely, stop loss orders work best if sentiment changes and traders need a guaranteed exit for their positions. In these situations, the original motivation for taking the trade has been removed and there is relative certainty that the position should no longer be held. Stop losses are preferable here because a stop limit order could lead to larger losses if the order is not triggered.

 

In all cases, stop placement is highly critical and there are various ways of determining where stop loss levels should be placed in your trades. Stop losses that are placed too close to the current market prices are vulnerable to being hit quickly before reversing back toward a favorable direction. So simple strategies (like placing stops slightly above resistance or below support) will generally require a more thought-out approach in order to avoid being stopped-out unnecessarily. Stop losses and stop limits offer trade protection in different reforms and can be used in both long and short positions. Stop losses offer guaranteed execution, whereas stop limits offer guarantee price levels. The decision to choose which type of order will depend on market conditions and your methods for managing risk.