Part 3: The Stop Order
Giving you the chance to get out or avoid missing out
Note: Stop orders aren’t available on Canadian exchanges through Questrade. But that’s okay, because stop limit and trailing stop limit orders, which we cover next, are.
Stop orders are in some ways similar to limit orders, in that you have to set a price, and they only execute when that price is reached. But rather than setting a maximum limit to what you pay for a security, or a minimum limit to what you receive when you sell, they do the opposite – they set a minimum price you’ll pay to buy, or a maximum you’ll receive when you sell. Why on Earth would you want to do that? Let’s explain by starting with the case where you’re selling.
Imagine you bought $VT when it was trading at $45 (it’s been a few years since that was the case, but this is just an example). Now it’s trading at $55 or $56 and change. You want to lock in that profit of roughly $10. But you don’t want to sell yet, because you want to keep watching the stock, in case it goes to $60. So you set a stop order. A stop order on a sale will set a price where, if the stock falls to the stop price of $50 shown above, the order is converted to a market order, and assuming the market is liquid enough (on $VT it should be), it will be sold at the current price – hopefully around $49.99 or $50, and you’ll have secured your $5 gross profit (before trading costs) without paying attention to the stock. Note that we’re showing the duration of this order as “day,” meaning today. It’s unlikely the order will execute before the market closes at 4 pm Eastern time today. So this order will likely expire without being executed. In the scenario above, you’d probably want to change your duration to “GTC,” good until canceled – or “GTD,” good until a specific day.
Let’s talk briefly about the scenario where you use a stop order to buy. We think an especially obvious use of this type of order would be for when you’re trading based on support levels. If $VT is trading around $56, but you think, if it hits $60, it will rise all the way to $65, then you might want to place an order than only executes if it does, in fact, reach $60. A stop order to buy will accomplish this for you. At $60, it turns into a market order, most likely executes, and bam, if you’re right, you ride it to $65.
The other scenario you’d need a stop order is when you’re shorting a stock, or covering a short (getting yourself out of the order). You would use a stop order to set a purchase price or manage your risk. We’re not going to get into this here – more on this in other articles.
Overall, stop orders are a bit niche, and they do, in fact, present some pretty scary risks. In illiquid markets, a triggered stop to sell converts to a market order and is then in the market awaiting execution. As we noted in our discussion of market orders, this means you could get filled at a much lower price than the price you set the stop at. Because security prices move dramatically overnight (due mostly to how exchanges price securities first thing in the morning), a stop order at $50 could get executed but filled at $30! In extreme moves, you could lose a lot of cash. A great example is what happened to LinkedIn ($LNKD) between trading on February 4 and 5, 2016(View Here) . A huge miss on earnings meant the stock fell from almost $200 to just over $120 overnight. If you had a stop order in at $160, on the morning of February 5, that order was triggered, and you got filled at $120! You didn’t see that coming.
As we noted above, for perhaps these reasons, stop orders aren’t available from Questrade on Canadian markets. But fear not. These problems are all avoided with our next order type, the stop limit.