A stop order is a special type of order to sell or buy a stock when the price of that stock reaches a pre-determined stop price. It is used by investors to limit the loss that an investor might encounter or to attempt to lock in a profit on a stock. Investors can issue a stop order to their stock broker to automatically sell the stock if the price of the stock drops to a specific price, called a sell stop order. In a buy stop order, the investor purchases the stock once it hits a specified price, hoping it will continue to rise.
As an example, consider an investor who owns 100 shares of ABC company and has purchased them for $10 US dollars (USD). The price is now at $12 USD per share. The investor may give the broker a stop order to sell if the price of ABC stock drops to $11 USD. In this way, the investor is assured of a $1 USD profit per share and does not need to continually watch the market to ensure that a stock price decrease will cause the profit to be lost.
If a short time later, the investor notes that the price is now increased to $13 USD, the investor could cancel the first stop order and place a second stop order at a stop price of $12 USD to ensure that a profit of $2 USD per share is realized. As the stock moves up in price, the stop order can be continually changed until eventually the price declines and the stop order is executed and the stock is sold.
Stop orders can also be used to limit a loss in the event that the stock prices declines after a purchase. In the previous example, if the investor purchases ABC stock at $10 USD per share, a stop order could be placed with a stop price of $9 USD in an attempt to limit the loss to just a $1 USD per share.
A buy stop order is placed on stock not yet purchased. The idea with this type of order is to purchase a stock that is beginning an upward trend. Once the stock rises to a pre-determined price, it is purchased. In this way, an investor can try to buy the stock just as its price is beginning to go up, with the hope that the price will continue to rise.
Stop orders are not always executed at the stop price. If the stock drops very suddenly by a large amount, the sell stop order may be triggered and the stock sold. Since the stock is always sold at market price, however, the price may be below the stop price. Sell stop orders are entered into a computer trading system and are automatically executed whenever the price is at or below the stop price.
If there are a lot of stop orders that are triggered by a specific stop, the price of the stock can plummet very quickly. Fortunately, this is fairly rare. Stop orders are very frequently used by active investors as they allow a quick and automatic response to stock price movements. Buy and hold type investors are unlikely to use this type of investment strategy.
