Stop-loss orders are a part of the daily routine of a stock trader. But many traders struggle with the different types of orders which they can use to place their stop-loss. The two most common types of stop-loss orders used by stock traders are either market orders or limit orders. But which one should you use for your trading?
The short answer : Always use market orders as stop-loss orders. Now that we know the answer, let’s understand both of these orders in detail & why market order is better than limit order for stop-loss.
What is a market order?
Market order is a type of order which allows a trader to enter or exit the trade instantly at the best available price. A market order doesn’t ensure that the trader will get the entry or exit at his/her pre-determined price, instead the best available price is decided by the market.
Suppose you place a market order to buy 100 quantities of a stock which is currently trading at Rs. 500, your order will be executed instantly. Let’s say that only 25 stocks are available at Rs. 500 & remaining 75 stocks are available at Rs. 501 (the seller is exhausted at Rs. 500), then you will get 100 shares at an average price of Rs. 500.75. The buying price of your stock gets decided by the market.
What is a limit order?
Limit order is a type of order which allows a trader to buy a stock at the exact price which the trader has specified. A buy limit order will not get executed even if the price is 25 paisa above your specified price.
Suppose you place a limit order to buy a stock at Rs. 500. The stock comes down to Rs. 500.1 & then goes back higher, your order will not get executed because the stock price never came to your specified level. The buying price of your stock gets decided by you, not the market.
Why should you use market orders as Stop-loss orders?
A stop-loss order by its nature, should be instant! Stop-loss order is not your typical order where you are looking to exit the stock slowly. Instead a stop-loss order should be a quick & dirty exit out of a losing trading position! This is the reason why market orders should always be used for a stop-loss order.
If you buy a stock at Rs. 500 with a stop-loss at Rs. 475, it simply means that you are bullish on the stock as long as the price is above Rs. 475. When the price goes below Rs. 475, you have been proven wrong & you no longer expect the stock to increase in price. It means that you are looking to exit the trade as soon as it hits Rs. 475 or under. This quickness is only provided by a market order even though there might be small slippage which can occur when exiting the trades. (Slippage refers to the difference between your specified price & the price at which the market gets you out of the trade!)
What can happen if you use limit order as Stop-loss orders?
A limit order only executes if the price reaches exactly your specified price. So, if you have placed a sell limit order at Rs. 400, it will only execute if the price reaches exactly Rs. 400. But what happens if the price skips the Rs. 400 mark & heads lower! Don’t think that’s possible?
In this example, the stock price went from Rs. 219 to Rs. 212 between consecutive candles creating a huge gap. Everyone who has limit orders placed under the low of the candle got crushed & got their trading accounts destroyed as the stock kept on crashing!
A market order prevents such problems! Even if your specified price gets skipped, a market order will ensure that you get out of the bad situation with as few scars as possible.
Conclusion
Always use market order for stop-losses. The minor slippage which you suffer from using market orders is much better than an account destroying loss which you can suffer by using a limit order. However, the final decision on trading depends entirely upon the reader!
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DISCLAIMER : I am not a financial advisor. I am not for or against any company which I have mentioned in this article. All the information provided here is for education purposes. Please consult a financial advisor before investing.
Contact me at investmentabshuru@gmail.com
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