Stop Order: What is a Stop Order?
In our last lesson we continued our course on the logistics of stock trading, with a look at how to execute a limit order. In today's lesson we are going to continue our discussion of how to place stock trades, with a look at a stop order.
Thus far, we have learned how to place an order to be executed at the best price available in the market (the market order), and how to place an order that will only be executed if the market trades at the price you specify in the order or better. What about if you would like to place an order to buy a stock at a price that is higher than the current market price or to sell a stock at a price that is lower than the current market price? If you tried to do this with a limit order the order would immediately execute at the current market price, because in both these situations the current market price would be better than the price where you placed the order.
In this situation, you would place what is known as a stop order. A stop order is an order placed to sell a stock below the current market price or to buy a stock above the current market price. Once the market hits your stop price, your platform will activate the stop order which will be sent to the exchange as a market order to be executed at the best price available in the market at that time.
Like using a market order, the advantage of placing a stop order is that you are pretty much guaranteed to be filled on your trade. The disadvantage is that you do not know the price that you will be filled at until after the order is filled by your broker. For traders who prefer price certainty as most do, most platforms also offer what is referred to as a stop/limit order. The stop/limit order works in a similar manner to the stop order in that it is an order you place to buy a stock at a price that is above the current market price, or an order to sell stock at a price that is below the current market price. The difference between the two orders is that a stop/limit order turns into a limit order once the stop price is hit, meaning that the trade will only be executed at the price you specified in the order or better. This is in contrast to the straight stop order, which will be executed at the best available price in the market, which can be a worse price than the price at which the stop order was placed.
Now that we understand this, lets login to our ThinkorSwim paper trading accounts and place a stop and a stop/limit order. If you have not done so already I encourage you to push the pause button, and click the link above this video where you can register for a free ThinkorSwim demo account
, so you can follow along with us as well.
Once you have logged into the platform, lets go ahead and pull up a quote for the ETF which tracks the price of the S&P 500 Index, the SPY. For this example lets say that I want to buy if the market trades up 5 points from the current price. Since I am buying, I would click the ask price to populate the order window and then I would change the order column which currently reads limit, to stop. Once I have done this a new row of options will appear, which allow me to adjust the price in the price column to 5 points above the current market price. I want this order to sit on the platform until my price is hit, so I am going to click the blue arrow beside where it says "day" under the rules column, and then select good till cancelled (GTC) in the window that appears.
Once I have done this I am going to push the confirm and send button, and then after confirming that everything is correct with the trade, I am going to send the order to be executed. After pushing the send button you should see the order appear in the order book, with the word "working" in the status window where it will sit until your stop price is hit.
The process for placing a stop/limit order is exactly the same, with the exception of the order column, where you would choose stop/limit from the dropdown instead of stop.
Thats our lesson for today. In our next lesson we will look at how to close trades using market, stop, and limit orders so I hope to see you in that lesson. As always if you have any questions or comments please leave them in the comments section below, and good luck with your trading!
Stop and Stop/Limit Order Resources:
stop order: Definition from Answers.com
What is a Stop Order?