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Stop Limit vs. Stop Loss: Orders Explained

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  • Stop Limit vs. Stop Loss: Orders Explained

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    Question From TraderX: I am new to trading and do not understand the difference between a stop limit and a stop loss. What is the difference between the two order types and when should each be used? Thanks,

    OK I spent a good 40 minutes on our online chat yesterday explaining this to a newbie trader. With some time an patience and the image above he was finally able to grasp the differences between a stop and a stop limit. Its not the first time we have been asked and it wont be lthe last. So here is a quick explanation of why one is better than the other.


    There's a subtle, yet important, difference between stop-loss and stop-limit orders. And it matters most when things, as they occasionally do on Wall Street, get a little out of control. We are using stocks for the sake of example but you can insert any futures or commodites..the theory is the same.

    A stop-loss order becomes a market order when a security sells at or below the specified stop price. It is most often used as protection against a serious drop in the price of your stock.



    So let's say you own stock XYZ and it is trading at $20. It's a volatile stock, so you put a stop-loss order on at $15. That means that if the stock falls to $15 or below, your order becomes a market order and will be sold immediately at the best available price.



    In theory, XYZ could be sold above your stop-loss price of $15 if the stock touches $15 and then rebounds. Or it could sell well below your stop-loss price at, say, $14, if the stock keeps cratering in a fast-moving market.



    Now, you might not have wanted to sell the stock unless it went below $15, but you are out of luck, because you put in a stop-loss order, not a stop-limit order. A stop-limit order becomes a limit order -- not a market order -- when a specified price level has been reached.



    That means if XYZ touches $15 in a fast-moving market, triggering the stop, then it will have to hit $15 again (the limit) for the order to be executed.



    It's worth noting that XYZ could also open below $15 if some really horrific news is announced before the market opens. Let's say the stock opens at $12.50. In that case, a stop-loss order immediately turns into a market order and will be sold around the $12.50 price.



    A stop-limit order at $15 in such a scenario would not be exercised, since the stock falls from $20 to $12.50 without touching $15. That's why a stop loss offers greater protection for fast-moving stocks.



  • #2
    Traders Keep in mind that when you use a stop limit to offset that if the market blows thru your limit part of the stop you have no fill....thereby leaving yourself open to greater losses than using a stop market order.

    Comment

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