How Stop Orders Work

Stop orders are special types of orders that stock exchanges make available to investors. A stop order is an order to buy or sell a stock as soon as the market price reaches a specified price, which is the stop price.

A stop loss order is a conditional market order whereby the investor directs the sale of a stock if it drops to a given price. For example, an investor owns 100 shares of company X, purchased at $50 and expect that the price will rise. In case the investor is wrong, he would want at least to limit the losses. Therefore, to protect the investment, he may set a stop loss order at $45. In case the stock price falls to $45, then the stop loss order will immediately become a market order and the stock will be sold at the prevailing market price.

A related stop loss tactic is a stop buy order, which is an order to buy a stock as soon as the market price reaches a specified price. Investors use a stop buy order when they want to minimize losses in case the market price increases. For example, an investor owns 100 shares of company X, purchased at $50 and expect that the price will fall. To protect the investment from an increase, the investor will place a stop buy order at $55 and the worst case scenario would be $5 per share. Stop orders provide the investors with the flexibility to cancel the first stop order and place a second one if the price of the stock increases. In this example, if the stock price increases to $46, the investor may cancel the stop order of $45, ensuring a loss of $4 per share instead of $5. As the market price rises, the stop order can be continuously adjusted until the price eventually falls and the stop order is executed.

Stop orders are typically placed by active investors, who favour a quick and automatic response to stock price movements. On the contrary, investors who favour buy and hold orders are highly unlikely to use this type of investment strategy. Investors, who use stop orders, do not have to worry if the market will decline sharply causing the profit to be lost. On the other hand, a stop order could be activated by a short-term market fluctuation. This is especially disadvantageous considering that once the stop price is reached, the stop order becomes a market order, which is an order to buy or sell a stock at the best current price. Therefore, in markets fluctuate at a swift pace the market price the investor will receive may be much different from the stop price.

Generally, stop orders are mostly used for stocks that trade on an exchange than in the over-counter (OTC) market. Market prices fluctuate at a swifter speed in stock exchanges and the intensity at which prices rise or fall intrigues investors. However, if a lot of stop orders are placed for a specific stop price, the share price may fall very quickly.