The stock market offers multiple methods for investors and trading to grow their wealth. Some of those methods include intraday trading, futures and options trading, or fundamental investing. At the same time, investors and traders can use various tools at their disposal to help them find success in the markets. One such tool we will cover in this article is the stop order.
A stop order is one of the three main types of orders you can place in the securities market. It is the order your broker allows you to set through your trading account, similar to market and limit orders. The key characteristic that distinguishes a stop order from other types of orders is that it is always executed in the same direction in which the price moves. So if the price of an asset is falling, using a stop order, you can sell the asset below its current market price. Does the previous statement ring a few bells? If yes, that is because the popular “stop-loss order” is a type of stop order.
Depending on the trend and your trading strategy, you can implement different types of stop orders. However, first let us understand the most widely used one: the stop-loss order.
As the name suggests, a stop-loss order or stop order stops your losses regardless of whether it is a long or short position. It does that by exiting your open position at a pre-decided level if the security’s price moves against your position. Hence, you can set a stop-loss order only once you have an open position. Implementing a stop-loss order in your trades can protect your capital from volatile market moves, news, and other events.
For example, you spot an intraday trading opportunity and go long on a stock that trades at ₹2,000. Now, you expect the price to appreciate and book profits ₹2,050. However, there is always a chance that the trend may break and the price may move in the opposite direction. So, to preserve your capital in such a scenario, you could implement a stop-loss order to cut short your losses before it is too late. For instance, setting a stop-loss order at ₹1,990 would automate an exit if the price of the security touched ₹1,990, thus, preventing further losses.
The second type of stop order is the stop-entry order. The stop-entry order helps an investor or trader to execute an order in the direction the price is currently moving. Let us go back to the intraday trading example above, but now assume that the price kept fluctuating in the sideways range of ₹1,995 and ₹2,010. So consider ₹2,010 level to act as a resistance level. It would not be in your best interest to enter a trade before the price cuts above the resistance level. That is because there is a high probability of it reversing at the resistance, only to fall back to ₹1,995 or even lower.
Hence, it would be wiser to take a position once the price crosses the ₹2,010 mark. To do that, you could use a stop-entry order wherein you could automate an entry if the price crosses the resistance. You could set the stop-entry order at ₹2,011 to avoid a margin of error. Once the range is broken, you can ride the trend and book your profits at the desired target. At the same time, remember to set your stop-loss order to protect your capital from unanticipated reversals.
Trailing Stop-Loss Order
The third type of stop order is the trailing stop-loss order. If we continue the above intraday trading example, the price is on an upward trajectory. Your goal is to book profits at ₹2,050. However, the prices started consolidating in the range of ₹2,035-2,040. This consolidation could lead to two possible scenarios: continuation of the upward trend or a reversal. In the event of a reversal, you would want to hold the position until the price triggers your initial stop-loss order at ₹1,990. So you could either manually move your stop-loss up to ₹2,030.
Another thing you could do in this situation is set a trailing stop-loss order of ₹6 of the current market price. So suppose you set a trailing-stop loss of ₹6 at the current market price of ₹2,040. Your trailing stop-loss will exit your position if the price touches ₹2,034. However, if the price makes a new high of ₹2,046, your trailing stop-loss order would be a difference of ₹6 from the new high. So in simple words, your trailing stop loss rises with it.
So, now we have seen how implementing stop orders in your trades can benefit you; where exactly should you place your stop orders? The stop order levels for a position trading set-up would not be the same as an intraday trading set-up. So, a stop loss of a position trader would likely be under the ₹1,990 mark, and their targets would be way beyond ₹2,050 as their holding period is much longer.
At the same time, the stop-loss orders of two traders looking at the same intraday trading set-up will also differ based on their risk appetite. While one trader is willing to accept a minimum loss of ₹10, another might not want to incur a loss that exceeds ₹5 per share. Likewise, it is the case for the other types of stop orders. A trader may also reference technical indicators and levels to set stop orders to improve efficiency and manage risk.