As swing traders, it’s vital we understand the difference between stop loss vs stop limit orders. They form a critical part of our trading risk management. At its core, swing trading is the risk of a unit of money in return for a multiple of that unit.
Therefore as swing traders, we should know exactly how much we are prepared to lose on a single trade and that we can express this as a specific price at which we will exit our position.
Placing an order with our broker to sell or buy at that price can give us considerable reassurance that we can contain any losses on a trade within our risk management rules.
But there are some important points to be borne in mind if we’re to get the best results.
What’s the Difference Between a Stop Limit vs a Stop Loss Order?
Stop Loss Order
A stop-loss, or stop order, is an instruction to a broker, placed on entry to a trade. The order will be to buy or sell a position at a particular price.
So, let’s assume we are bullish and want to be long stock (or whichever instrument we’re swing trading. We may protect it with a sell stop order. If we are going short, we will enter a buy stop order.
In both cases, the key point to note is that a market order will trigger automatically when price hits the target. But it’s important to note that in the real world, stop-loss orders are seldom if ever executed (filled) at the exact target specified.
In practice, orders will fill at the best available price, which may be some distance above or below our target depending upon market conditions.
Stop Limit Order
Placing a stop-limit order, by contrast, means that a limit order triggers when price hits our target.
Our order will then execute only at our chosen price or better. For example, a swing trader is bearish wants to enter the market short. She has the option of entering using a market order to sell immediately
The distinction may seem like a technicality, but in deciding whether to use stop loss or stop limit orders, there are some important factors that traders need to understand.
What are the Advantages and Disadvantages of Stop Loss Orders?
The principal advantage of using stop-loss orders is that they compel us to determine our maximum loss and exit position before we even enter a trade.
“Set and forget” swing traders, or day traders who need to be away from their screens for periods during the day, also get some reassurance that their positions will be protected against sudden, dramatic price moves in their absence.
The problem is that stop-loss orders become market orders once the target price is hit – meaning that they will execute (fill) at the best price then available.
And whether or not we get out of the trade at our desired price will depend on there being enough traders prepared to buy or sell at that price.
So, in situations where price is moving rapidly, and new buy or sell orders are flooding in thick and fast, we may not get filled at our desired price.
In a long position, we may therefore find ourselves exiting the trade at a price below our target stop. If we are short, we may have to get out at a higher price.
In either case, our loss may be more than we had planned for – perhaps significantly more in volatile markets.
And having a stop-loss order taken out in this way will be especially frustrating if, as so often happens, price then immediately rebounds into the trade’s profit zone.
What are the Advantages and Disadvantages of Stop Limit Orders?
n contrast, the great advantage of stop-limit orders is that they guarantee that we need only exit a trade at our specified price or better. And this certainty is a great help in managing risk.
The problem is that in rapidly moving markets it may not be possible for orders to be filled immediately at the specified price. In these circumstances, our positions will remain open until price comes back to the limit price or we cancel the order.
Leaving a position open for too long is an unattractive option, as it may mean missing some excellent trade opportunities while we wait.
But the alternative, which is to override the limit order and exit at the prevailing market price, risks crystallizing a larger loss than is allowed for in our risk management rules.
When to Use a “Mental” Stop Loss or Stop Limit
For these reasons, there are traders, both professional and amateur, who are reluctant to place a stop-loss or stop-limit order at the time they enter a trade.
They prefer to use a so-called mental stop-loss, which simply means that they will keep in their heads the price at which they will exit a losing trade.
For some, it’s because they believe that their stops will become visible in the market, and therefore liable to be deliberately taken out by large institutional traders or even their own brokers.
It’s only fair to point out that there are reputable sources within the industry who deny that any such practice occurs.
But, whatever the truth, many experienced traders prefer to exercise fingertip control, and to enter an immediate market order when they decide that a trade has run its course.
It’s a strategy that can work well for agile day-traders with the time and dedication to remain at their screens for hours at a time. But in volatile markets, it’s a high-risk strategy, particularly on the shorter time-frames, and not one recommended for beginners.
And for swing traders, who will be away from their screens for prolonged periods, it’s highly unlikely to be a viable strategy.
What are Trailing Stops and How to Use them?
Another alternative to placing a fixed price stop-loss or stop-limit order is to use a trailing stop.
With this technique, we will set our stop at a percentage or dollar figure above or below the market price. The stop will therefore move in line with changes in price and will lock in profits for as long as the trade continues to move in a profitable direction.
The idea of automatically locking in profits even while away from the trading screen is naturally attractive, and it can be a very effective strategy in trending markets.
But in volatile, choppy, conditions it can be difficult to determine in advance the appropriate percentage or monetary amount to apply. In this event, it’s of course possible to move stop-losses manually. But this requires great care to ensure that we do not depart from our risk management rules.
It’s also important to note that we can enter trailing stops as either stop-loss or stop-limit orders. And the advantages and disadvantages of both need to be carefully considered in exactly the same way as when placing a fixed price stop.
Whether to use stop-loss or stop-limit orders, mental or trailing stops, is to some extent a matter of trading style and personal preference. And there are arguments both for and against each of them.
What is certain, however, is that some plan for mitigating losses by applying one or more of these options is essential for long-term trading success.