Trader Mentality: Stop vs. Stop Limit

Some find confusion when it comes to understanding the difference between a stop limit and a stop order. Some online brokers offer two options to click on their order screens that say “STOP LIMIT” or simply “STOP.” When the average trader looks at this screen, the word “stop” tends to jump out at them. They don't stop and think about what the difference between the two is.

Most traders will set a price where they want their "safety net" to be, which is their stop limit, so they check the box that says “stop limit” and enter their absolute bottom price before they get out.

I need to clarify this issue, as it is very important. A stop limit order and a stop loss (or stop) order are two very different orders. It is important that you are aware of the difference so you don’t place the wrong order and essentially lose money as a result.

Stop or Stop Loss Orders

I'll make an overall statement, then go back and explain it. The simple rule is: DON'T USE A STOP LIMIT ORDER. Instead, use a stop loss or a stop order. (A safety net order.)

So what exactly is the difference? Only a single word completely changes the method of how your order is handled. Let’s take a look at the differences.

Say we enter a position at $20 a share, and at a maximum, we are willing to risk 20% of that. This means that the stock could drop down to $16 before we would want to sell. As a result, $16 is where we place our stop loss (safety net) order to get us out. If you are using an online broker like EToro or SureTrader that will allow you, you can place the order for good-‘til-cancelled (or GTC) to keep the order in place until you cancel it, without having to put the same stop loss order in every day on a daily basis.

What would trigger our stop order and automatically close our position (or sell) is a decrease in the price of the stock to $16 or less. If the $16 price is reached during normal market hours, the order is triggered. The broker then sends a market order to the exchange, which is then filled (or sold) at the current market price.

It is important for you to understand, that doesn’t necessarily mean you will get out at $16. It simply means that when the stock price hits $16, the brokerage house will send in a market order to get you out at the current market price. This could be a little below or above $16, but it is the $16 price that triggered the market order being sent.

Stop Limit Orders

So how is a stop loss order different from a stop limit order? First and foremost, it’s important for you to understand what a limit order is. A limit order can be an order to buy or sell a position where we set the minimum price we’re willing to sell for, and the maximum price we're willing to buy a stock for. In both a buy and a sell order, this price is our limit. A limit order will not be filled until you are able to get your limit price or better. Now, let’s apply this to a stop order.

Let’s use the previous example of a $20 stock with a stop at $16. Keep in mind, our plan is to sell if the price drops to $16 or lower. If we set a stop limit order at $16, and the stock price drops and hits $16, instead of sending an order through that will sell our stock as soon as possible at the current price (or a market order), a limit order is placed at $16 or better to sell. The order won’t get filled until you are able to sell at $16 or better. As a result, if this stock keeps dropping passed the $16, and goes all the way down to single digits, you will have never sold as originally planned, simply based on the type of order you submitted.

Damn. Take a minute to soak that in. If you didn't know it before you read it, read it again. It may have just saved you thousands.

Stop Orders and Gap Down Plays

Let’s just assume the position we own has now traded down to $16.50 from the original $20 price where we bought it. Then overnight, while the market is closed, the company announces a short-fall in their earnings. The next morning when the market opens, the stock opens up at $14. This is called a “gap down.” The opening price for the day is lower than the close of the previous day, which leaves a gap in the daily price chart.

Notice the gap lower in price that occurred in late January in MSFT (highlighted in red). You can obviously see a “gap” in the price chart from one day to the next. This is a gap down. For reference, there is also a gap up in the chart in late April (highlighted in green) where the price gapped higher from one day to the next.

If a similar occurrence took place with our $20 stock, our stop limit order would be triggered once the price of the stock dropped below $16, and our limit order to sell would be sent to the exchange. However, since the stock is no longer trading at or above $16, it wouldn't get filled until the price came back above $16. If the stock continues to drop, you would continue to lose more money.

Do you see where the problem is now? You've submitted an order, you put up the safety net, except that by selecting a stop limit order rather than a traditional stop order, you told the broker that you are only willing to accept a sell price of $16 or better. With a stop loss order, once the price hit $16, it would have sold as a market order, at the current stock price, therefore side-stepping any further price declines.

"Thinking of them as stop market and stop limit orders will help you understand the difference."

If you plan to use a stop as a safety net to sell out of a position at a certain price, you should always use a traditional stop order rather than a stop limit order. Thinking of them as stop market and stop limit orders will help you understand the difference.