Stop orders – maximum uncontrolled risk

Essentially, a stop order is an order to buy or sell the specified amount of the asset at the specified price or worse.

You may ask at this point: why on Earth would I want to buy or sell at a price worse than I’d like to?

The answer is very simple: both better and worse are just references to where the order price is relative to the current market price.

For example, if the current price of EURUSD is 0.99673 and I send a buy-stop order at 0.9989, then my order will be executed at any price equal to or greater than 0.9989. Similar to limit orders, a stop order will reside in the broker’s order app until the market price touches the order price and then converted into a market order. Note that, unlike limit orders, stop orders are never sent to the order app immediately, even if you trade with an exchange. This is quite natural, in fact: if I send a limit order to the order app, then I improve the liquidity in the market as others may become my counterparties and then I become a liquidity provider to them in a certain sense. But if a stop order had been sent to an order app, it would just immediately match one of the limit orders there and move the price immediately by an unpredictable distance.

Indeed, let’s consider an example. Say we have an order app for EURUSD and the current market price (best bid/ask) is 1.00000/1.00005. There are some limit orders to buy at 0.99999, 0.99998, and so on, and some limit orders to sell at 1.00006, 1.00007, and so on. Now, imagine someone sends a stop order to buy at 1.0020 and this order is sent to the order app. Of course, sellers (those on the ask side) will be more than happy to sell at 1.0020 and not at 1.0010 or 1.00008. So, a stop order sent to the order app would trigger the order app level that is the most distant from the current best bid/ask, which is strictly opposite to the very idea of an order app.

Note

Not all execution venues support stop orders. Many institutional liquidity pools support only market and limit orders (and some of them only market orders). So it’s always a good idea to emulate stop orders locally.

So, going back to the question about the reason why we may want to use a stop order, now we understand that we can use it when we want to do one of these two actions:

• Enter the market at a price that is greater than current if we want to buy, and at a price that is less than current if we want to sell.
• Exit a position when the price goes against it – that is, with a loss. It happens if the current price is less than the entry price for a long position (buy) or the current price is greater than the entry price for a short position (sell).

If we use a stop order to exit from a losing position, then it is called a stop-loss order.

Note

Quite frequently, stop orders are confused with stop-loss orders. However, stop orders can be used to both enter and exit the market, while stop-loss orders are always used only to exit from a losing position. In other words, stop order is a term with a more broad sense that pertains to general trading, and stop-loss is a narrow term pertaining to just trade logic. From the trading venue’s standpoint, there is no difference between a stop order used to open a position or to close it, so stop-loss orders may be mentioned only in a particular broker’s documentation, not that of a trading venue.

Now that we know that stop orders are somewhat artificial and actually executed as conditional market orders, we can understand the typical issues with their execution.