What is Stop Order?
A stop order is a type of order that is placed to buy or sell a security at a specific price or better once the market price reaches that level.
For example, if you buy a stock at ₹100 per share, you may place a stop-loss order at ₹95 per share to limit your loss to 5%. If the market price of the stock falls to ₹95 per share, your stop-loss order will be triggered and your shares will be sold at the next available market price.
Stop Order Types
Stop-Loss Order: This is one of the most widely used stop orders in India. Traders use stop-loss orders to limit their potential losses by automatically selling a security if its price falls below a certain threshold. For example, if a trader owns shares of a stock and sets a stop-loss order at 10% below the current market price, the shares will be sold if the stock's price drops by that percentage.
Stop-Entry Order: Unlike a stop-loss order, a stop-entry order is designed to initiate a trade when the market reaches a specific price level. For instance, if a trader believes that a stock's price will increase when it breaks a resistance level, they can place a stop-entry order to buy the stock once it reaches that predefined price.
Trailing Stop-Loss Order: This type of stop order is particularly useful for locking in profits while allowing potential gains to run. A trailing stop-loss order adjusts the stop price as the security's price moves in a favorable direction. If the price moves in the opposite direction by a certain percentage or amount, the stop price remains unchanged. This mechanism helps traders capture more significant gains while protecting against sudden reversals.
Stop Order vs. Limit Order
Stop orders differ from limit orders in their execution. While stop orders become market orders when the specified price is reached, limit orders are executed at a specific price or better. In the Indian context, limit orders are commonly used to set target prices for buying or selling securities. Stop orders, on the other hand, are used to trigger trades automatically when a certain price level is hit, regardless of the actual execution price.
Advantages of Stop Orders
Risk Management: Stop-loss orders help traders limit potential losses, providing a safety net in volatile markets.
Automation: Stop orders automate trading decisions, reducing the need for constant monitoring of market movements.
Entry and Exit Strategies: Stop-entry orders allow traders to enter the market at opportune moments, while trailing stop-loss orders help secure profits.
Disadvantages of Stop Orders
Slippage: In fast-moving markets, stop orders may be executed at a less favorable price than the specified trigger price due to slippage.
False Signals: Market volatility can lead to false trigger points, resulting in premature executions or missed opportunities.
Overreliance: Relying solely on stop orders without a comprehensive trading strategy can be risky and lead to losses.