Every successful trader knows that protecting your capital is just as important as making profits. Stop orders are one of the most important risk management tools available to traders. In this guide, we will explain what stop orders are, how they work, and how to use them to protect your trading positions.
What is a Stop Order?
A stop order (also called a stop-loss order) is an instruction to buy or sell a stock once it reaches a specific price, known as the stop price. When the stop price is reached, the stop order becomes a market order and executes at the next available price.
The simple version: A stop order is like setting an alarm. When the stock hits your stop price, it triggers a market order to buy or sell. It helps you limit losses or protect profits automatically.
How Stop Orders Work
Here is what happens when you place a stop order:
- You set a stop price at which you want the order to trigger
- The order remains dormant until the stock reaches your stop price
- Once the stop price is reached or passed, the stop order becomes a market order
- The market order executes at the best available price
- The actual execution price may differ from your stop price
Sell Stop Orders (Stop Loss)
A sell stop order is placed below the current market price. It is used to limit losses on a long position or to protect profits after a stock has risen.
Example: Protecting Against Losses
You buy 100 shares of Tesla at $250 per share. You want to limit your potential loss to 10%.
- You place a sell stop order at $225 (10% below your purchase price)
- If Tesla drops to $225 or below, your stop order triggers
- A market sell order executes at the next available price
- Your maximum loss is approximately $2,500 (before slippage)
Result: If Tesla crashes to $200, you are already out of the position at around $225, limiting your loss.
Example: Protecting Profits
You bought Tesla at $250 and it has risen to $300. You want to protect some profits.
- You move your stop order up to $280
- If Tesla drops to $280, you sell and lock in a $30 per share profit
- If Tesla continues rising, your profits grow and you can move the stop higher
Result: You guarantee at least a $3,000 profit on your 100 shares while still participating in further upside.
Buy Stop Orders
A buy stop order is placed above the current market price. It is commonly used to enter a position when a stock breaks out above resistance or to cover a short position.
Example: Breakout Trading
Amazon is trading at $145 and has resistance at $150. You believe if it breaks above $150, it will continue higher.
- You place a buy stop order at $151
- If Amazon breaks above $150 and reaches $151, your order triggers
- You buy at the market price once the breakout occurs
Result: You automatically enter the position only if the breakout happens, avoiding a false entry.
When to Use Stop Orders
Stop orders are valuable in these situations:
- Risk management: Limit potential losses on every trade
- Protecting profits: Lock in gains as a stock rises
- Breakout trading: Enter positions when stocks break key levels
- When you cannot watch the market: Stops work even when you are away
- Enforcing discipline: Remove emotion from exit decisions
Advantages of Stop Orders
- Automatic protection: Works without you watching the market constantly
- Discipline: Helps you stick to your trading plan
- Risk definition: Know your maximum potential loss before entering a trade
- Emotional control: Removes the temptation to hold losing positions
- Free to place: No cost to set a stop order with most brokers
Disadvantages and Risks
Stop orders have limitations you should understand:
- No price guarantee: Once triggered, a stop order becomes a market order and may execute at a worse price than your stop
- Gap risk: If a stock gaps down overnight, your stop might execute far below your stop price
- Whipsaws: Volatile markets can trigger your stop and then reverse, causing you to sell at the bottom
- Stop hunting: Market makers may push prices briefly to trigger stops before reversing
Warning: During fast market moves or after-hours gaps, your stop order may execute at a significantly different price than your stop price. This is called slippage.
Where to Place Your Stop
Choosing the right stop placement is crucial:
- Below support levels: Place stops just below key technical support
- Percentage based: Use a fixed percentage like 5-10% below your entry
- ATR based: Use Average True Range to account for volatility
- Below recent lows: Place stops below the most recent swing low
Avoid placing stops at obvious round numbers where many other traders have stops.
Tips for Using Stop Orders
- Always use stops: Never enter a trade without knowing where you will exit if wrong
- Give room to breathe: Stops that are too tight will get triggered by normal price fluctuations
- Adjust as price moves: Move your stop up as the trade becomes profitable
- Consider stop-limit orders: For more price control, use stop-limit orders instead
- Account for volatility: More volatile stocks need wider stops
Stop Order vs Stop-Limit Order
A regular stop order becomes a market order when triggered. A stop-limit order becomes a limit order when triggered, giving you price protection but no execution guarantee.
- Stop order: Guarantees execution, but price may slip
- Stop-limit order: Guarantees price, but may not execute in fast markets
Track Your Risk Management
Pro Trader Dashboard helps you analyze your trades and see how effective your stop losses are. Track your win rate, average loss, and improve your risk management.
Summary
Stop orders are essential risk management tools that help protect your capital and enforce trading discipline. By automatically selling when a stock drops to a certain price, stop orders limit your losses and remove emotional decision-making. While they do not guarantee the exact price you will get, they ensure you will exit a losing position before it becomes catastrophic.
Want more control over your stop price? Learn about stop-limit orders or explore trailing stop orders for dynamic protection.