Stop-Loss Order Versus Stop-Limit Order

Both stop-loss and stop-limit orders are put in place by investors to limit losses and allow transactions to take place automatically.

Imagine you invested in a stock – say you purchased shares in a company at the price of N50/ share. However, as time passes, the price goes from N50, to N45, and then to N40.

What many investors tend to do at this point is panic and withdraw their funds officially. While this is not necessarily bad, there are other options to put in place to prevent losses, assuming the fundamentals of the company are not strong enough for it to be held for the long term.

As opposed to manually exit trades, these systems will allow you automatically do so even when you don’t have access to the market.

Stop-Loss Orders

There are two types of stop-loss orders: those to buy as well as those to sell.

The sell-stop order is one that protects long trading positions and triggers a market sell order where prices falls below a certain threshold.

The underlying strategy is that, if the price falls this far, it may continue to fall much further, so the loss is capped by selling at this price.

While the buy-stop order in the opposite is a type of stop-loss order which protects short trading positions usually set above the current market price and is triggered when prices rises above that set threshold.

Stop-Limit Orders

A stop-limit order is a type of stop-loss order set over a timeframe that combines the features of stop with those of a limit order in order to mitigate risk.

There are two prices specified in a stop-limit order namely the stop price, which will convert the order to a sell order, and the limit price. Instead of the order becoming a market order to sell, the sell order becomes a limit order that will only execute at the limit price or better.

Thus, stop-limit orders enable traders to have precise control over when the order should be filled, but it is not guaranteed to be executed especially if the stock price is rising or falling rapidly. Traders often use stop-limit orders to lock in profits or to limit downside losses.

Stop-limit orders are sometimes used because, if the price of the stock or other security falls below the limit, the investor does not want to sell and is willing to wait for the price to rise back to the limit price.

Stop-loss versus Stop-Limit

Stop-loss and stop-limit orders can provide different types of protection for investors. Stop-loss orders can guarantee execution, but not price and usually price slippage frequently occurs upon execution.

Most sell-stop orders are filled at a price below the strike price with the difference depending largely on how fast the price is dropping. An order may get filled for a considerably lower price if the price is dropping quickly.

Choosing which type of order to use essentially boils down to deciding which type of risk is better to take. The first step to using either type of order correctly is to carefully assess how the stock is trading. If the stock is volatile with substantial price movement, then a stop-limit order may be more effective because of its price guarantee.

Written by Lawretta Egba.