What is a stop order?

• A stop order is one type of order that allows investors to set a price in which an order should be executed.
• Stop orders include a stop price that triggers an order to buy or sell a security.
• If the stop price is met, the stop order becomes a market order.

You can choose from various types of orders when you invest. If you've ever done this in your own brokerage account, you may be perplexed when it comes to order types. You see various options, but what do they mean and how can you choose? One type of order is referred to as a stop order, which is set to execute an order once a stock reaches the specified stop price.

What is a stop order?

A stop order is a type of order investors can place when they want to buy or sell a stock at a certain price, which is referred to as the stop price. Once that price is met, the order changes to a market order and trades right away.

"When the price of a security goes past a certain point, a stop order is placed to buy or sell it. A stop order is intended to increase the likelihood of hitting an entry or exit price, reduce losses, or lock in profits," explains Paul Sundin, a CPA and Tax Strategist at EstateCPA.

The trade occurs immediately and is executed at the next best price that is available at the time of the trade. That means it can be different from the stop price especially during volatile market conditions.

Quick tip: A stop order is only one type of order. Before making a decision, review other types of orders such as a limit order, market order, or stop-limit order.

Understanding how stop orders work

As an investor, you can use stop orders when buying or selling a security, such as a stock. When placing a stop order, you'd need to set a stop price. And if and when that price is reached, an order will trigger at the next best price on the market.

"Investors and traders can use a variety of order strategies to execute their buying and selling orders to limit potential losses. The underlying market order fulfills the order at the current market price of the security. Conversely, when an investor or trader wants to execute an order after the security reaches a certain price, a stop loss order is placed," says Justin Nabity, CFP® and CEO at Physician's Thrive.

A stop order isn't guaranteed to go through; if the stop price isn't met, the price the order is executed at could be different from the actual stop price. There can be many shifts in a fast-paced market, which means that you could end up buying at a higher price or selling at a lower price depending on the market conditions when the trade takes place.

Stop orders vs. limit orders vs. market orders

Stop orders are just one type of order you can place to exert control over your trades.

Stop orders, which are also commonly referred to as a stop-loss order, have a stop price that triggers an order to buy or sell. When the stop price is met, an order is activated and turned into a market order which trades immediately. There can be a buy stop order, which is a price higher than the current market price, or a sell stop order which is below the current market price. Investors use these types of orders to limit the degree of losses as well as secure their profits on a particular investment.

Limit orders are similar to stop orders in that they're triggered by a price to execute an order to buy or sell. However, the main difference is that the order must be at the limit price or better. So if you want to buy a certain stock for $30, you can set that as the limit price and the order would take place only if and when the price of your desired stock actually hit $30 or less.

Market orders are a type of order for buying or selling securities right away. Stop orders or limit orders must meet certain prices to execute, but market orders go through regardless. This type of order can guarantee an order goes through but won't ensure you get a specific price.

Stop orders and limit orders are similar in that they are activated by price; however, limit orders give you the opportunity to control costs more. This can be advantageous when there are many price fluctuations. There's a hybrid order called a stop-limit order as well that combines the best of both worlds.

Quick tip: Depending on your buy stop order or sell stop order, you may pay more in commission on your various transactions. Be sure to research costs and factor them in ahead of time.

Pros and cons of stop orders

As with any type of order on your investments, there are pros and cons to take into consideration before placing this type of order.

"The nicest part about stop orders is that they are entirely free to put in place. It's like free insurance. Another benefit of stop orders is that you don't have to constantly check the market to make decisions," says Sundin.

Quick tip: Each brokerage may have a different definition of when a stop price has been met, so find out how your particular brokerage firm sets the price that triggers a stop order.

The financial takeaway

Having greater control over your investments can be a good thing, and stop orders can maximize some of that control. However, due to the fluctuating nature of the stock market, your order may not be executed if it doesn't meet the stop price.

"Stop-loss orders are not always triggered. Although they can avoid large losses under normal market conditions, they are by no means bulletproof. Extremely low liquidity and market lockdowns are just some of the examples of when a stop-loss order may not be of any use to you," notes Nabity.

On top of that, if it does meet the stop price, your trade will occur at the next available price which could be higher or lower than you want. You can also consider a stop-limit order to cap costs even more. You also want to be aware of how commission costs may add up if there are various transactions.

Understanding different order types and how they play into your investment goals can help you build a strategy to get the most out of your investments while minimizing costs.