Stop-loss vs stop-limit orders: What are they and how do you use them?

Keeping an eye on the price of stocks or other securities can be nerve-wracking and time-consuming. Instead, investors could place a stop-loss or stop-limit order with their chosen broker. When a price reaches a specific level, the orders serve as directions to execute trades. The goal is to help investors bag profits and mitigate potential losses.

The article below answers your most pressing questions about these two trading order types, which can be used when trading stocks, forex, derivatives and other instruments.

What is a stop-loss order?

A stop-loss order, also known as a stop order, sets a threshold for an investor's loss on a security position. The order is placed with a broker to either buy or sell a stock once it hits a specific price – known as the stop (or strike) price, a threshold that triggers the execution of a stop-loss order.

Stop-loss orders are especially useful in CFD trading because they give the broker instruction to close all positions unprotected in the market. However, the necessity of maintaining an adequate margin due to leveraged losses makes CFDs risky.

Types of stop-loss orders

1) Buy-stop orders

A buy-stop order instructs the broker to purchase a security once its price hits the stop price, which is set at a level above the current market price. This guarantees that the investor pays the specified price or even less.

Buy-stop orders are often used to mitigate – even prevent – potentially unlimited losses of an uncovered short position. It is also applied as a stop-loss for short positions or as part of a breakout trading strategy.

2) Sell-stop orders

As opposed to buy-stop orders, the stop price is set below the current market price in a sell-stop order. Once the price falls to the stop price, the broker executes an order to sell at the prevailing market rate.

A sell-stop order is utilised to cap losses or protect a profit on a long position.

Stop-loss order example

Suppose you buy Dell (DELL) at $50 per share and set up a stop-loss order at $38. The stock then drops below $38. This means your shares will be automatically sold at the dominant market price. In this case, a sell-stop order has been used to reduce the loss.

Now imagine if the price of Azenta Inc. (AZTA) is between $70 and $72, and you bet on an increase beyond this range. You set a buy-stop order at $72.50. If AZTA hits the stop price, the broker purchases the stock at the next available price.

What is a stop-limit order?

A stop-limit order is similar to a stop-loss order, except it requires the investor to set a limit price in addition to the stop price. When an instrument hits the stop price, a limit order is activated instead of a market order. This limit order is conditional; it only executes at the stop-limit price or better.

In addition to its use for curbing losses, a stop-limit order allows a trader to establish new positions at price levels that indicate, from the trader's perspective, a new trend in the same direction.

Types of stop-limit orders

1) Buy stop-limit orders

A buy stop-limit order is set above the market price. It is used when an investor wishes to purchase a security as it begins moving upwards. Once the stock hits the identified stop price, the limit order is activated. The buy order is executed only while the price remains under the stop-limit price. If the stock rises above the stop-limit price, the buy order will not be executed.

This kind of stop-limit order comes in handy for short positions.

2) Sell stop-limit orders

A sell stop-limit order is set below the market price. When a stock drops below the stop price, a limit order is prompted. If the price remains within the defined limit, a sell order is triggered but not executed. Once the price drops below the limit, no sell order would be triggered.

Stop-limit order example

Say the market price of Shopify Inc. (SHOP) is $40. You can place a buy stop-limit order with the stop price at $42.00 and the limit at $45. When the stop price is reached, the limit order is activated. This will be executed provided the market price does not exceed the limit of $45.

Other types of stop orders

Stop-limit and stop-loss are not the only types of trading orders. A trailing stop order is a variation of a standard stop-loss order. It tracks positive market movements on the instrument on which it is placed. It works by setting a fixed percentage or value of loss below the market price, and it moves with the market as long as it moves in your favour.

The trailing stop order protects your assets against fast market swings by minimising losses.

Should I use stop-limit or stop-loss orders?

Both trading order types are an integral part of a strategy. They can protect against significant losses, especially in times of increased turbulence and uncertainty. However, deciding on which to use requires an insight into the difference between stop and limit orders. It also depends on the risk you are ready to take after thoroughly evaluating how the instrument is trading.

Stop-loss order disadvantages

• The order is set to be activated if the stop price is met, leaving you with almost no flexibility.
• The activated order executes at market price, which might be below the stop price.
• There is always the risk of other investors taking out your stop levels.
• Requires a good understanding of price determination practices to know where to set the stop price.

Stop-limit order disadvantages

• Does not guarantee execution even when the stop price is hit. This can incur a substantial loss, especially in a fast market, if the order is not executed before the market price drops past the limit price.
• You are at risk of other investors taking out your stop levels.
• If this service is not offered by the broker for free, the commission is likely to be high.
• Also requires a good understanding of price determination practices to identify where to set the stop and limit prices.

Stop-loss order advantages

• Prevents further losses when it comes to poorly performing securities.
• Guarantees the execution of a market order.
• Protects against short-term instability.
• Curbs losses if an asset moves against your position.

Stop-limit order advantages

• Hedges against severe price unpredictability.
• Ensures a market order is executed at a minimum price.
• Allows you to re-examine your position when the limit price is missed, thus providing a level of flexibility.
• Limits losses if an asset moves against your position.

If a security is unstable and unpredictable, with considerable price movement, a stop-limit order would be a good choice as it's associated with a price guarantee. If the order is not implemented, you can expect to wait a short while for the price to increase again.

Suppose there is bad news about a company, raising questions about its future. This means the stock price might not come back to its current level for months – or even years. A stop-loss order would be effective in this case, mitigating loss and taking the market price on sale. Since a stop-limit does not execute a trade order, it would incur a greater loss.

How to use stop orders as part of your trading strategy

If you're looking for ways to mitigate risks and limit losses, placing a stop order should be part of your trading strategy. Creating the relevant market order is quite easy with one of FXCM's platforms – Trading Station or MetaTrader 4. Read our guide to find the right one for you.

If you decide to use Trading Station:

1. Start by creating an FXCM account or opt for a free demo account first to get familiar with CFD trading.
2. If you decide to start trading, press "Trading," and then go to "Trading Station". You can also download the platform's app to your phone.
3. While on the "Simple Dealing Rates" window, left-click on the "Sell" or "Buy" price for the instrument you wish to trade.
4. You will then see the "Create a Market Order" window, which displays the details for the incomplete market order.
5. Click on "Advanced" then check the "Stop" box and enter your preferred rate.

If you wish to improve your trading skills, visit FXCM's education hub to explore our educational tools, live market webinars, and a free live online classroom to help you learn how to effectively place stop-loss or stop-limit orders.

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