What is Hedging In Finance? Learn the Basics with Examples
Trading guides, webinars and stories
Trading guides, webinars and stories
Stop-loss and stop-limit orders are common strategies used by traders and investors looking to limit losses and also to protect gains. A stop-loss is a transaction triggered when a futures contract hits a certain price level. It has no limit on the eventual trading price. Stop-limit orders also trigger when the contract price hits a certain level. When they do, it activates a market limit order at a predefined minimum price. In this article, we talk about stop-loss vs stop-limit orders and why and how you can use it to improve your trading skills.
When it comes to trading, we bow to the words of the legend that is Kenny Rogers:
“You’ve got to know when to hold ‘em, know when to fold ‘em, know when to walk away, know when to run”.
Table of Contents:
There are two types of stop-loss orders. These are the are sell-stop orders and buy-stop orders. In effect these are two sides of the same coin allowing traders to protect both long and short positions. In many ways this strategy takes the emotion out of trading. When the contract hits a certain level, BANG, your trade is executed. No second thoughts, no backtracking, done!
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Fear and greed dominate investment markets. They often cloud the judgement of investors striving to lock in that last dollar of profit. These emotions can also prick the ego of traders going against the market. Especially when they’re unwilling to accept they may have got it wrong. A sell-stop order strategy is a very basic strategy. If the contract falls below a particular level this will trigger a sale at the prevailing market price. There is also a major downside. In fast-moving markets the actual execution price could be very different to the sell-stop limit level. It is probably easier to show an example of this strategy in action….
In recent times, we have seen extremely volatile markets. This has caused immense activity on the E-mini NASDAQ-100 Index (NQ) futures. As you will see from the one-month and the six-month NASDAQ-100 Index graphs below, this volatility has presented a number of short/medium term trading opportunities. If we put aside the gearing impact of futures contracts and look at the index movements in isolation there have been numerous suitable occasions to use sell-stop orders to protect profits.
The six-month graph highlights an uptrend from 18 December (8580.62) to a peak on 19 February (9718.73). That equates to a 1100+ point move. Continuous adjustment of a stop-loss limit may well have seen a sell-stop order prematurely activated towards the end of January. Most likely when there was a short-term dip (9216.98 to 8952.18) but even that would still have produced an impressive profit.
Those with a long-term outlook may have been more cautious with their stop-loss limits, retaining their position until the peak of 19 February (9718.73). The market began to turn on the 20 February and in a worst case scenario a sale would probably have been activated on the 21/24 February. This would have allowed the investor to crystallise a very healthy profit before an even greater collapse. So, whether maintaining a tight or wider stop-loss limit, investors using this approach would have crystallised large profits and avoided the worst of the 2700 point fall to 20 March.
On the flipside of the coin, as you can see above, the collapse of the NASDAQ-100 between the 10 and 11 June (a fall from 10,094.26 to 9588.48) would likely have wiped out much of the short-term gains (flipping positions to a loss) from the previous uptrend. Unfortunately, due to the speed of the market collapse a sell-stop order may have seen futures contracts sold at a huge discount to the previous evening’s close and the prevailing stop-loss limit. Sell-stop orders work best in less volatile markets but you would not normally expect a 500 point fall on an index during a 24 hour period! However, in many ways this highlights a major downside for stop-loss orders.
If we look at the six-month there have been numerous opportunities to short the NASDAQ-100 index using E-mini NASDAQ-100 Index (NQ) futures. On the 19 February the market peaked at just over 9700 then began a downtrend which would bottom out at less than 7000 on 20 March. Imagine you had taken a short position at the peak – how might this have panned out? In all likelihood the serious volatility in the following days would probably have triggered the stop-loss limit of even the most adventurous of short traders. However, even a buy-stop order triggered on 27 February, the first market bounce, would still have benefited from a near 1300 fall in the index.
Those who maintained a position when the market bottomed out at just below 7000 on 20 March would have seen their stop-loss limits triggered fairly quickly when the market bounced. The beauty of using a buy-stop order, to protect a short position, is perfectly reflected in the fact that the index hit a new all-time high at just under 11,000 on 10 June 2020. This no-nonsense approach using buy-stop orders takes away the decision-making process when these triggers are breached.
This table gives you a basic idea of the differences between sell-stop and buy-stop orders:
To get a clearer understanding of both strategies, let’s take a look at the following comparison table:
|Sell-stop orders||Buy-stop orders|
|Target price||Below current price||Above current price|
|Upside||Protect long position||Protect short position|
|Downside||Guaranteed trade but no guarantee on price||Guaranteed trade but no guarantee on price|
Some people may see stop-loss orders and stop-limit orders as one and the same. They’re not, there are some very subtle but very important differences. With a stop-loss order, when the contract price hits that level a trade is triggered and executed at the prevailing market price. A stop-limit order is a two-stage affair with the initial price activating a stop-limit order and a second (minimum) price limit – allowing traders a degree of control over the actual transaction price. This ensures that in fast-moving markets, or sharp movements in contract prices on the open, investors are not committed to a sale at any price. Let us look at how this works in practice.
The above scenario is a good example of a stop-limit order working to the benefit of an investor:
“The collapse of the NASDAQ-100 between the 10 and 11 of June would likely have wiped out much of the short-term gains (likely flipped the position to a loss) from the previous uptrend. Unfortunately, a sell stop-order would have seen futures contracts sold at the open on 11 June. Probably at a huge discount compared to the previous evening’s close and prevailing stop-loss limit. Sell-stop orders work best in less volatile markets. The reason is that you would not normally expect 500 point fall in the index overnight. However, in many ways this highlights a major downside stop-loss orders“
Let us assume that a trader acquired futures contracts when the market stood at 9331.93 on 18 May 2020. This uptrend ended abruptly on 10 June 2020. That day, June 11th 2020, the market fell from 10,094.26 down to 9588.48. A fall of more than 500 points. Moving a stop-loss limit higher and higher as the market rose from 18 May to 17 June let’s assume there was a stop-loss at around 9900. Even outside of trading hours it is likely the markets moved so quickly it would have been difficult to activate a stop-limit order and carry out any transactions within say a minimum level of 9800. This would therefore leave the position open. Using stop-loss orders, as mentioned above, the position would have been liquidated much lower with no control over the transaction price. However, the situation with a stop-limit order is very different.
The investor could leave the 9800 minimum limit active which would result in the futures contracts being sold when the index hit this level – on the way back up. Alternatively, they could have reassessed the situation and made changes to both the initial activation level and the minimum price for any resulting sales. Using the one-month graph for the NASDAQ-100 we can see that between the 16and 17 June the index passed back through the 9800 minimum sale point. So, while the stop-loss order transaction could have been liquidated on an index level as low as 9588.48 the stop-limit order would have benefited from the gradual recovery over the three days following the sharp correction.
The use of a stop-limit order worked perfectly in this scenario. Conversely, if the markets had continued to fall there is no telling when the index would eventually, if ever, have reached the original 9800 minimum sale point.
The same type of strategy is also used by short sellers looking to buy back contracts to close open positions. However, there’s a downside. If a purchase could not be completed within the limit price range then there is a risk that the market would continue to rise. That leaves an open-ended liability on the open position.
There is no one size fits all when it comes to stop-loss/stop-limit trading strategies. Allthough, there are ways of mitigating potential dangers for different strategies. Let’s take a look at how each strategy might impact short-term traders and long-term investors.
Short-term/day traders have one thing in common, they tend to cut their losers fairly quickly and run their winners. As they focus on relatively volatile contracts, sell-stop orders tend to be the preferred strategy and the pricing can be relatively tight. This will see losing trades jettisoned fairly quickly to focus on those moving in the right direction. Short term traders tend to have little interesting in medium term contract recoveries therefore even a quickfire sale below their initial stop-loss limit would not be the end of the world.
By their very nature, long-term investors take a more long-term approach to their investments. As a consequence are perhaps more suited to the stop-limit order strategy. They will often have a target index level in their mind. Assuming the fundamentals don’t change they may be happy to wait. That is not to say that they won’t continuously reassess the prospects for their investments, but they are less susceptible to short-term, often volatile, price movements. They tend to trade on the philosophy that fair value will prevail in the end.
There are various advantages and disadvantages when using stop-loss orders and stop-limit orders which include:-
Hopefully we have covered the vast majority of questions you may have regarding stop-loss orders and stop-limit orders. However, the following questions have been asked on numerous occasions:
When looking to buy/sell contracts is there any scope in using both the stop-loss and the stop-limit strategies? The simple answer is yes.
Let’s assume you have a stop-limit order which kicks in when the index falls to 9900 with a minimum limit of 9800. An additional stop-loss order at 9500 would act as further insurance in the event that the futures contract price moved too quickly to complete your order at a minimum of 9800. If the initial order was executed then you would obviously cancel the stop-loss order and vice versa.
Stop-limit orders and stop-loss orders both have their own pros and cons and ultimately it will depend upon the individual investor. Traders, often trading volatile contracts in the short-term, tend to look towards stop-loss orders allowing them to cut their losers and run their winners. Those with a longer term approach to their investments may appreciate stop-limit orders where the “fair value” of the index, based on fundamentals, tends to prevail in the end.
Both strategies can be impacted by volatile short-term movements in contract prices. Two particular investment theories spring to mind in the shape of the “Gann 50 Percent Retracement Theory” and the unfortunately named “Dead Cat Bounce Theory”.