What is a Stop Order?
To understand what a Stop Order is, let’s first remind ourselves of the better-known Market Orders and Limit Orders:
- A Market Order is an order to immediately buy or sell an asset at the current market price. Its advantage is the immediate execution of the transaction; however, it does not guarantee the specific price you will buy/sell the asset.
How it works: For example, you want to buy Bitcoin for $10,000. Instantly. Here and now. Assume that the current BTC market sell rate is $10,000 for 1BTC. Ideally, the exchange transaction will get you 1BTC. But! The sale takes place at the best available price in the current market. There may not be any offers for one bitcoin at this price in the order book from other exchange participants. Your order will automatically buy bitcoin from more expensive orders, with the price progressively growing until BTC has been purchased for the whole amount you specified.
Therefore, you will instantly get Bitcoin, but the final buy price will be different from the market price that was current when you clicked the ‘Buy’ button. In our example, you may get 0.95BTC instead of 1BTC, while the average buy rate is $10,526 for 1BTC.
- Unlike a Market Order, a Limit Order simply helps you enter your own buy/sell order at a fixed price. However, your order will not be executed instantly, but only when the market reaches the price you set. Also, the amount of funds specified in the order is debited from your available balance and reserved in the order.
A feature common to both Market Orders and Limit Orders is that they both act here and now. The first places an order in the order book, and the second executes the orders already placed there.
But what should a trader do if they currently have 1BTC, expect bitcoin growth, and are not willing to sell right away? The trader is worried that the rate may fall and does not want to lose their funds if the rate falls steeply. This is where Stop Orders come in handy.
A Stop Order does not create an order immediately. In fact, a Stop Order is your instruction to the exchange (a market order) that says something like: If the price of my asset falls below XX, sell the specified amount of my asset by executing a Market Order (a request to sell at the best available price in the current market).
If the price changes and reaches XX, your STOP Order will create a Market Order that will sell your asset in accordance with the market order rules.
Here is a formal definition:
A Stop Order is a form of a pending market order to automatically execute the sale or purchase of an asset (for a specific asset amount) when the market price reaches a specified price (Stop Price) to hedge exchange rate risks in case the rate turns downward.
This is true for both asset buy and sell orders, called Stop Sell Orders and Stop Buy Orders.
- A Stop Sell Order is an order to sell an asset if its market price falls to a specified level (Stop Price). Traders use this kind of order when they expect the asset price to grow but hedge their assets from a possible price decline. A Stop Sell Order is entered at a stop price below the current market price.
Please note: The Stop Sell Order will be executed for the specified asset volume; however, it does not guarantee that the final amount will be equal to that calculated when the order was created.
- A Stop Buy Order is an order to buy an asset if its market price increases to a specified level (Stop Price). Traders use this kind of order when they expect the asset price to fall but hedge their assets from a possible price increase. A Stop Buy Order is entered at a stop price above the current market price.
Please note: The Stop Buy Order will be executed for the specified total order amount and not the asset volume specified by the user.
What are the Advantages of Using a Stop Order?
- Limit risks: With stop orders, you can proactively set the price level that helps fix losses for each placed transaction.
- Automatic transaction execution: When using stop orders, the trader does not have to monitor open market positions and rate fluctuations continuously and manually.
Let’s look at the most common cases for using Stop Orders.
How is a stop order used?
Case 1: We have 1BTC, the current BTC/USD price is $10,000, and we expect the rate to grow
Part 1: To complete the picture, assume that we bought this bitcoin at $9,500, meaning that we are already $500 up but would like to earn more. However, if the rate falls, we do not want a loss.
Therefore, we place a Stop Sell Order at $9,700 and peacefully enjoy a cup of tea while waiting for the Bitcoin price to increase. Now we are not worried that we will lose our deposit, because if the price falls to $9,700, our bitcoin will be sold, and at least we will not incur a loss but earn just under $200*.
Part 2: Assume that we returned to trading a couple of hours later, and the price has not fallen but increased to $11,000. We do not want to sell our Bitcoin but still expect it to grow. So, what’s preventing us from moving our Stop Order a little closer to the current price? We place our Stop Sell Order at $10,700. Now we can relax, because if the price increases, we will earn more, and if it decreases, we have fixed our profit at the price of $10,700, meaning we have already pocketed $1,200*.
Case 2: We have $10,000, the current BTC/USD price is $10,000, and we expect the BTC rate to fall
With dollars in hand and expecting the BTC rate to fall, we obviously don’t want to buy right away but would like to buy at the lowest price possible. So, we take steps like the previous case but the other way around:
We place the Stop Buy Order at $10,300 in case we are wrong and the rate rises (because if the rate increases, it is unlikely to stop at our Stop Price of $10,300, and we will be able to jump onto the ascending trend right on time and start earning on the rate growth).
During that time, we wait for our expectations (the rate decline) to be fulfilled, occasionally moving the stop order downward as the rate decreases. As soon as the rate increases, you will be ‘on board’.
Case 3: Trading part of the asset
Assume we have 1BTC that we bought at $10,000. We expect the rate to grow to $12,000. At the same time, we don’t want to be stuck in front of the monitor waiting for it to increase. Instead, we want the transaction to be executed at $12,000, while hedging our assets from a falling rate.
In that case, we enter a Limit Order to sell 0.5BTC at $12,000 and place a Stop Sell Order for 0.5BTC at $9,500. By doing this, we will make a profit if the rate increases and diversify risks if it decreases.
Case 4: Minimizing risks when offline
Assume you wish to protect your investment from significant fluctuations (or collapse) in the market while you are offline. You might have gone for a coffee, gone offline until tomorrow, or are just a HODLer who is not going to trade but does not want to lose most of the deposit. Your best and only tool to hedge your assets from major rate changes is to place appropriate stop orders.
* These examples do not take into account slippage, but as long as the order is executed at the best available price in the current market, a buy/sell transaction will be performed based on the order book, and the actual price will be different from the Stop Price.
There is nothing unusual about risks when trading in financial markets! They have always existed and are not going away. A Stop Order is the main tool to deal with such risks systematically and responsibly. There is not a single professional trader who does not use Stop Orders.
EXMO provides you with this vital tool, and your ability to use it effectively will demonstrate your high level of expertise. Enjoy successful trading!