What's the difference between Stop Loss and Limit orders?
LONG ANSWER
Order types
Understanding the different order types and knowing which one to use and when, is vital. Getting it right may help you to snag a more advantageous entry or exit price, thereby adding an extra tick or so to profitable trades. This can make a big difference to your bottom line P&L figures. Needless to say, saving a tick or two on unprofitable trades can make an even bigger difference! Although the question posed is specific to stop and limit orders, it’s not possible to answer it fully without discussing the most common order type of all, namely market orders. The pros and cons of all three will be outlined, along with when, where and why to use them.
The spread
All tradable instruments are quoted in two prices, the difference between them is known as the ‘spread’. Before getting to grips with the various order types, it’s important to be clear about what the spread is and how it works. The tighter together the two prices are – i.e. the narrower the spread - the better. The lower price is known as the ‘bid’ price and the higher price is known as the ‘ask’ or ‘offer’. Usually (but not always), traders buy at the higher of the two and sell at the lower of the two. This is confusing to many novice traders, as they associate bid with buying and assume, incorrectly, that they will buy at the bid price (i.e. the lower one) and sell at the offer price (i.e. the higher one). If only trading was that easy! Actually, this is possible, and traders who do it capture the spread. But it’s not easy to do and is generally only achieved by traders with the right tools, experience and skills. For the purposes of this FAQ, it is assumed that you are a retail trader and, therefore, likely as not you’ll be buying at the ask (the higher price) and selling at the bid (the lower price).
Market Orders
This is the most common order type of all and the one most frequently used. If you want to get into or out of the market right now – then this is the order to use. This is the big advantage of market orders. Their disadvantage is that you may experience a poor ‘fill’ or ‘slippage’, both of which are explained later. Market orders do not guarantee that your order will be executed – or filled - at either the quoted ask price if you’re a buyer, or at the quoted bid price if you’re a seller. In other words, part of your order, or even all of it, could be filled at a less advantageous price. So, if you’re a buyer, you could pay more than you want and, if you’re a seller, you might not get as high a price as you want. Murphy’s Law dictates that poor fills and slippage nearly always work against retail traders and rarely in their favour, resulting in reduced profits on winning trades and larger losses on losing trades.
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Poor Fills
If you’re a buyer, you could experience a poor fill if there aren’t enough sellers willing to sell the quantity of shares / contracts etc. at the price you want to buy them. Essentially, the demand that you are helping to create is greater than the available supply. Buying pressure pushes up the price until sellers are tempted into the market. Your buy order will be filled as and when there are a sufficient number of sell orders to match it. The exact same process works in reverse if you’re a seller. If there aren’t enough available buyers willing to pay the price you want to sell at, then price will fall until there are. In very ‘liquid’ markets, this isn’t usually a problem, as there are lots of willing buyers and sellers on each rung of the price ladder. Poor fills are normally only an issue if you’re trading very large ‘size’, i.e. large numbers of shares or contracts, or if you are trading illiquid markets. ‘Penny shares’ - so called because the value of the shares is usually £0.10p or less, is an example of a market that tends to suffer from poor liquidity. Essentially, in all markets, price seeks parity between buyers and sellers, driven by supply and demand.
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Slippage
Slippage is a more common issue and a more serious one for retail traders. Those using market orders are at the thin end of the wedge in the order queue, as other types of orders such as limit orders (discussed next) will already be lodged at the exchange (in the case of futures and equities). These will be filled first, followed by market orders which themselves are filled on a first come, first served basis. So, in just the time it takes for your order to get from your computer to the exchange, a fast moving market could have ‘slipped’ a long way from the quote price you saw flashing on your screen. The net result is that your trade is filled at a less advantageous price than the one you would have liked.
Limit Orders
If slippage is a concern, fear not, limit orders are the solution. Quite literally, with this type of order, you are ‘limiting’ the price the order can be filled at, ensuring that it’s only ever executed at the price you stipulate - or better. You won’t ever experience slippage with limit orders. They can only be used to buy at or below the current market price or to sell at or above the current market price. So, if you place a sell limit order, you know that you’ll sell for the price you want - or at a higher one. Conversely, if you place a buy limit order, you’ll buy at the price you want - or at a lower one. All order types have a downside, and the catch with limit orders is that you may not get filled at all. So, if you know for certain that you want to be in or out of the market right now and you want your entire order filled, use a market order instead.
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Entries & Exits
The chart below provides an example of when a limit order might be used to enter and exit a trade. It’s of the ES, (the S&P 500 futures contract). Note how price dances around the zone between 1115.00 and 1116.00 (dashed blue lines), with the previous day’s low (PDL), indicated by the solid green line slap bang in the middle. This is referred to a zone of support and resistance (S&R) and many traders look to enter the market in these areas as they offer the potential for swift profits. Using limit orders helps to protect them from poor fills and slippage, the latter being of particular concern as price can accelerate away from S&R areas very quickly. This is caused by lots of closely bunched orders getting filled at the same time.
When price approaches a known area of resistance, breakout traders will look to go long, often placing their stop loss orders (explained later) somewhere just below the resistance area. Reversal traders do the exact opposite. They believe that resistance will hold and look to enter short trades, usually placing their stop loss orders somewhere just above the resistance level. Obviously, both sets of traders can’t be right! Suppose the breakout above resistance is successful and price advances. Although the reversal traders were ‘wrong’, ironically, it’s their stop orders which then help to fuel the move up as they ‘buy to cover’ their short trades. Although they hold opposing market views, both sets of traders end up buying the same price zone at the same time. Breakout traders do so because they want to, while reversal traders do so because they have to in order to minimise their losses. The reverse is true if a breakout above resistance fails: both sets of traders end up selling the same price zone at the same time, causing price to fall very quickly. In both scenarios, using market orders is risky, as you can easily suffer from slippage. Limit orders are the safest option, but carry the risk of not being filled. Therein lies the rub, as there’s nothing more annoying than seeing price touch your limit order and not get filled, only to move swiftly in the intended direction, for what would have been a very profitable trade!
Stop Orders
Technically, stop orders aren’t orders at all, they’re a conditional order to your broker to initiate a market order as and when a particular price level that you specify is reached. The instant that price hits that level, a market order is automatically triggered. All the pros and cons already discussed about market orders apply to stop orders. Buy stop orders are always entered above the current market price and sell stop orders are always entered below the current market price. They have three primary functions: to restrict losses on losing trades, to lock in profits on winning ones and to enter long when the market is rising or short when it’s falling.
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Restricting Losses
The majority of traders use a stop loss order to exit a trade that’s not working. It’s a simple and effective tool which does what it says on the tin: it stops losses. If you enter a long trade, you can place a sell stop loss order somewhere below your entry so that if the market falls instead of rises, your long position is sold for (hopefully) just a small loss. If you are short the market, your stop loss order would be somewhere above your entry and, if hit, would be executed to buy to cover your position, again for a small loss.
Just about every book, website and trading guru out there advises new traders to place actual stop loss orders on their trading platform with every trade. The golden rule of thumb is to never move your stops further away from your entry price. They should only ever be moved closer to it. Many, many novice traders (and some not so novice ones) have blown up their accounts by moving their stop orders ever further away from their entry price or, worse still, failed to use them at all. A tiny minority of hardcore traders claim that they never use stop loss orders and are pretty dismissive about traders that do. Perhaps it’s just coincidence, but these braggarts tend not to be on T2W for very long! Some experienced traders just use ‘mental’ stops - because their trading style, skill and personal discipline permits them to do so. However, until you consider yourself to be an experienced trader, using ‘hard’ stop loss orders is highly recommended!
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Locking in Profits
Being stopped out of losing trades can be very annoying, none more so than when price reverses and goes in the intended direction. The flip side of this is that price does what you expect it to do right from the get go. At some point, as it moves on up if you’re long or on down if you’re short, you’ll be able to move your stop loss order to your breakeven point. You’re now sitting in the position that every trader wants to be in: a trade that no longer carries any risk. Now it’s a case of managing the trade in order to extract the maximum profit from it. Many traders choose to trail their stop order a certain distance behind the current price, simply referred to as a ‘trailing stop’. A stop loss order and trailing stop order are both the same, the only difference being that the former will close your trade for a loss, while the latter will usually close it for a profit or, at worst, break even.
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Entering Trades
Stop orders aren’t restricted to closing out trades; they can also be used to enter trades. They are especially useful for swing traders who don’t want to be glued to their screens all day and for whom a small amount of slippage is a price worth paying. If certainty of execution is more important than entering at a specific price, then you can set your stop order and walk away from your computer. If price reaches the level you set, a market order will be triggered and filled. The other advantage of this type of order is that price will already be moving in the intended direction when it’s triggered. By contrast, traders who use limit orders will only be able to enter short at the current price or higher, or enter long at the current price or lower. In other words, price could actually be moving against them at the time their order is filled. Subject to the restrictions of your broker, broadly speaking, a stop buy order can be placed anywhere you like above the current market price. Visa versa for stop sell orders. An example of when this order type might be used is when price is trading in a tight range. Some traders will place a stop buy order at the top of the range and a stop sell order at the bottom of the range. Sooner or later, price will either breakout above the range, or break down beneath it, and one or other of the orders will be filled.
Summary
Market orders, limit orders and stop orders are the three most common order types, available on almost any trading platform. However, there are numerous others and some of the combinations are quite bewildering. In the links in the next post, there is one to a very well known broker, used by many T2W members, which lists no fewer than fifty two order varieties! Trade entry, trade management and trade exit can be as simple or as complex as you want it to be. However, without doubt, there are many successful traders who never stray beyond the three basic order types described here.
