Stop Loss vs Stop Limit Orders: Differences, pros and cons explained

Stop loss and stop limit orders are to a falling share price what the auto-eject function is to an aeroplane that’s struggling for altitude. But while there may be advantages to automatically bailing out of an investment when prices tumble, there’s also a risk of exiting the market prematurely and locking in a loss.

Canstar spoke to Andrew Page, Founder and Managing Director of private investing club Strawman.com, who explained how stop loss and stop limit orders work and what to consider before using them.

What is a stop loss order?

A stop loss order is a tool available to investors that instructs your broker to sell your shares, in part or in full, in the event that the market price of those shares falls below a predetermined level set by you. The idea is to limit your potential losses.

For example, let’s say shares in XYZ Ltd are currently trading at $1 on the ASX, and you’d like to be sold out in the event they ever drop to 90c. You could place a stop loss order at 90c, which tells your broker to sell your shares on the market as soon as the share price hits 90c.

Stop loss orders usually have an expiry date, after which they will no longer be active. The exact rules and conditions can differ between different brokers, so be sure to check with them first.

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What is a stop limit order?

Stop limit orders are very similar to stop loss orders, except that you also specify a minimum price you are willing to sell your shares for. In the case of a stop loss order, the broker simply looks to sell your shares on the market at whatever price is available. In a fast-moving market, or one with limited volume, this could be well below the stop loss price. A stop limit order, on the other hand, instructs your broker to place a ‘limit order’ once the trigger price is reached. A stop limit order, in the case of a sell, specifies the minimum price you are willing to accept.

Continuing our example from above, you could instruct your broker to place a sell order with a limit price of 80c, if and when the market price hits 90c. Generally speaking, in an orderly market, you’re still very likely to sell your shares at 90c. But if there are no bids in the market at or above 80c, your sell order will simply not go through and remain outstanding until your limit price conditions are met (or until it reaches an expiry date).

It’s worth noting that your broker is obliged to execute your order at the best available price on-market, so the limit only specifies the minimum.

What are the potential benefits of using a stop loss or stop-limit order?

The main benefit of these conditional orders is that they can limit your potential downside. In our example, you are locking in a 10% loss, but that could be a great move if the price continues to fall. For example, if shares end up dropping all the way to 20c, you’ll be really glad you sold out at 90c (or at or above 80c in the case of our stop limit order).

Because these orders are automatic, it also means you don’t need to be continuously watching the market.

What are the possible drawbacks of using a stop loss or stop limit order?

There are still a lot of risks with these kinds of orders. Remember, shares are volatile by nature, and even the very best investments will experience pullbacks or dips from time to time. In many cases, these fluctuations will have nothing to do with the long term potential of the underlying company. As such, the risk is that you end up selling out of great investments for no other reason than some short-term volatility.

Extending our example, imagine you purchased XYZ Ltd at $1 and placed a stop loss at 90c. If shares happened to drop to 70c a few weeks later, you’d probably be glad you managed to get out at 90c. But if shares then went on to recover, and climbed to $2 in the following year, you would have missed all the upside and be stuck with a 10% loss.

It can be a good idea not to set your stop-loss orders too close to the last traded price. The closer the stop loss is to the current price, the higher the chance you’ll be sold out due to some short-term fluctuation.

It’s also worth pointing out that every trade you do will likely incur a brokerage fee, and potentially trigger a taxable event. Overtrading can end up being a very costly endeavour.

Also, these conditional orders are usually not guaranteed. For low-liquidity shares (ones where the shares are infrequently bought and sold), and for those whose price ‘gaps down’ (the price opens lower than the previous day’s closing price with no trading activity in between) you may never get the chance to sell.

In our example, imagine the shares end the trading day at $1, and after-hours there’s an announcement that the company is going into administration. Those shares may never trade again, in which case your stop loss won’t offer any protection. Even if the situation is less dire than that, the company may release news that sees its shares reopen at 20c, without ever having traded at the intervening price steps. Again, your stop loss order offers no protection in such situations.

Finally, remember that you can always decide to manually sell if you feel you need to change your investment thesis.

How can an investor decide if using stop loss or stop limit orders is right for them?

In order to understand whether these conditional orders are right for you, it’s worth having a clear idea of your investment strategy. Are you a short-term trader, or a long-term investor?

If you’re in it for the long term, pull-backs, corrections and even market crashes are par for the course. If you sell out on every dip, you’ll never enjoy the benefits of long-term compounding. In fact, all you’ll end up doing is crystallising losses.

Sometimes the smart reaction to falling prices is actually to buy more. So long as you’re confident the underlying company’s prospects remain sound, you could see it as the market offering you a discount – that is, your shares just went on sale!

On the other hand, if you’re looking to trade the volatility of the market, it can be worthwhile trying to limit your losses. If shares fall 50%, they then need to double from there just to get you back to breakeven.

Another nice feature of stop loss and stop limit orders is that they remove the emotion from decision making. Often, even though we tell ourselves we’d sell if ever shares dropped to a certain level, when it actually happens we often rationalise our position, and continue to hang on while shares continue to plummet.

At the end of the day, smart investors have a keen sense of what they own, and what the ‘real’ value is. Remember, as Warren Buffett says, the market is there to serve you, not to inform you.

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