Stop Loss Orders - Market or Limit?
The Pros and Cons of Limit and Market Stop Loss Orders
Stop loss orders are designed to limit the amount of money that is lost on a single trade, by exiting the trade if a specific price is reached. For example, a trader might buy a stock at $40 expecting it to rise, and place a stop loss order at $39.75. If the price goes against the trader's expectations and reaches $39.75, the stop loss order will be executed, limiting the loss to $0.25 per share.
Professional traders utilize some form of a stop loss strategy.
They may not actually physically place a stop loss order, but they do know where they will get out if the trade doesn't go as planned. It is highly recommended that all new traders utilize a stop loss. The stop loss order is placed as soon as the trader enters a position. Markets can move very quickly, and a stop loss serves to limit the possibility of a loss getting out of hand. Actually placing a stop loss also avoids the issue of the trader having to get out of a trade themselves if the price goes against them. Sometimes it can be hard to get out a losing trade, and the stop loss serves to take the guesswork out of cutting a loss.
There are different types of stop loss orders. "Stop loss" is a general term used to describe an order that gets a trader out of a losing trade if the price moves against them. A stop loss can be placed as a limit order or a market order. Both of these stop loss order types are described in more detail below.
Stop Loss Market Orders
Stop loss market orders use stop market orders as their underlying order type. This will make sense after reading through this section.
Stop market orders are placed at a specific price. If the market price reaches that order price, the order will become "live" and execute as a market order.
Market orders are always filled if the price reaches the price specified. This means that with a market order a trader will always get out of the losing trade. However, market orders are filled at the best available current price. That means that the stop loss could be filled at potentially any price, and not necessarily right at the price specified. When a market is moving quickly, a stop loss market order may fill or execute at a way worse price than expected.
For example, assume a trader buys a stock at $30 and places a stop loss at $29.90. Major news is released about the stock, and all the buyers pull their bids from around the $30 region. No one is willing to buy, except at $29.60, where someone still has an order to buy at that price. Once the price drops below $29.90 the stop loss market order will seek out anyone willing to buy at $29.90 or below. Since the nearest buyer is at $29.60, that is where the stop loss market order will fill. In this case, the trader was only expecting to lose $0.10/share, but instead, they lost $0.40. This is called slippage.
Such events do occur, but slippage is less likely to occur while day trading assets with high volume. Avoid holding positions during major news releases related to the asset being traded, as such news events can cause significant slippage.
While slippage is a possible problem with stop loss market orders, at least the trader gets out of the position and is protected from further potential losses. Also, slippage doesn't occur all the time. Under normal conditions, a stop loss market order will get the trader out at the price expected.
Stop Loss Limit Orders
Stop loss limit orders are stop loss orders that use stop limit orders as their underlying order type. Stop limit orders are placed at a specific price, and if the market price reaches the order price, the order will be executed as a limit order.
Limit orders are only filled at the order price (or at a better price if one is available). However, limit orders are not always filled. That means the stop loss limit order may not get the trader out of a losing trade. When a market is moving quickly (or if a market has a large bid/ask spread), a stop loss limit order can remain unfilled indefinitely, exposing the trader to larger and larger losses.
It can also, on occasion, save the trader some money.
For example, assume a trader buy a stock at $26 and places a stop loss limit order at $25.90. This means that the stop loss limit will try to sell the position at $25.90 or higher, if the price reaches $25.90. Imagine a big sell order enters the market, absorbing all the buy orders all the way to down to $25.80. Since the stop loss is a limit order, it will not execute at $25.80, rather it will only try to sell the position at $25.90 (or above). A few moments later the price may bounce back up to $25.90, getting the trader out at the price they desired. If the stop loss was a market order, it would have taken any price it could get, resulting in the trader getting out at $25.80. In this case, the limit order would have saved the trader $0.10/share.
That only works if the price comes back to the stop loss limit order price. If the price keeps going the wrong way, using a stop loss limit order won't get the trader out of the trade, and the loss on the trade will mount. In the above example, if the price drops to $25.80 without filling the stop loss limit order, and then the price keeps dropping, the traders face indefinite losses.
Which Type of Order Should be Used?
In general, stop loss orders should be market orders. The entire point of a stop loss order is to exit a trade, and a stop market order is the only type of order that will always accomplish this. The additional losses that are incurred from slippage are minimal compared to the potential loss that can arise from a trade that is not exited at all (due to an unfilled stop loss limit order). In addition, slippage can typically be avoided by trading high volume assets, and not holding positions during major news events which can cause sharp movements (which often cause slippage). In other words, the problem of slippage on a market order can typically be avoided, where as the problem of a stop loss limit order not filling is a much bigger issue...especially if you are not at your computer to get out of the trade if the loss keeps mounting!
Updated by Cory Mitchell.