Robert Steinadler, a month ago

Stop Loss vs. Stop Limit – How to use both order types

Order types are basic tools for traders. They allow to add conditions to each order that determine under which circumstances they are executed. This opens up a door to more trading opportunities since conditional orders execute upon events that can change the direction of a trade or even the whole market.

What are stop orders? What different types are available on LiteBit and how can you use them for your trading?

What are stop-loss orders?

A stop-loss order is either meant to protect a long position with a so-called sell-stop order or a short position with a so-called buy-stop order. In both cases, the order type is limiting losses by either buying or selling an asset and in effect closing the trade.

Stop loss and stop limit orders are both meant to mitigate the chance that a trade could go wrong, but they are very different from one another.

Sell-stop orders

Opening or taking a long position means that a trader expects an asset to appreciate in price. For example, he buys Bitcoin at 15,000 EUR and wants to sell at a higher price. Let’s say our trader bought 2 BTC for 30,000 EUR and likes to protect his capital in case the price is going down. He calculates that a loss of 2,000 EUR is the maximum he would like to risk. Therefore, he sets a sell-stop order for 2 BTC at a price of 14,000 EUR.

If the price drops to 14,000 EUR, the order will get executed, and 2 BTC will be sold at the current market price. The sell-stop order that gets triggered is effectively a market sell order, which means that if the price drops further, the BTC might be sold way lower than 14,000 EUR.

Buy-stop orders

A buy-stop order is meant to achieve the opposite and is often used to protect a short position. The order triggers as soon as the current market price exceeds the predetermined price level.

Stop-limit order

A stop-limit order is very different. It consists of two prices that have to be determined. The first one is the stop price. Once the stop price is reached, it will trigger the order. The second price is the so-called limit price, effectively executing a limit order.

Let’s take a look at another example. Assume that our trader bought 2 BTC for 30,000 EUR again. This time he sets a stop-limit order with a stop price of 14,500 EUR and a limit price of 14,000 EUR. The idea behind this setup is that if the price falls to a certain level, his 2 BTC will definitely be sold for the limit price or above, but never below. Of course, there is the possibility that the price drops so sharply in a short amount of time that the limit order won’t get executed or is not filled fully. In this case, the trader hopes the price will get back up so that the limit order gets filled.

A stop-limit order can also be used to buy a crypto asset and protect a short position or to enter a long position once a price trigger is reached. Such a scenario might be a breakout trade where the trader aims to buy when a certain price level is exceeded with the hope that the upward trend will continue.

Pros and cons of stop order types

Stop orders can help preserve capital by protecting trade with a fallback plan that minimizes loss. Another option is to use these order types to engage in the market as soon as predetermined price levels are reached that appear to provide a good entry for a trading position.

A stop-loss order executes as a market order, and there is a risk that the order will be executed partially or fully above or beyond the chosen price level. A loss may be limited, but there is no saying to what extent, and in some situations, the order may only be executed after a significantly higher loss than planned. This can be avoided by using a stop-limit order that only gets executed at the predetermined level. However, if the order cannot be executed fast enough during high volatility, the market will move further, leaving the limit order unfilled. This can lead to a situation where the order remains unexecuted while the price keeps on dropping. Eventually resulting in an even higher loss than using a basic stop order. In conclusion, both order types have their own merits but also carry certain risks.

Is using a stop order recommended?

This strongly depends on one’s perspective. Some traders would never enter a trade without determining their stops and possibly even where and when to take profit. Others believe that market volatility should be considered by solely managing position size. When using a stop order, traders risk getting stopped out only for the market to turn around in the right direction. With crypto being highly volatile, this effect is especially painful since short-term volatility can result in a loss if the stop is set too tightly.

How to determine where to set the stop?

It is difficult to estimate the lowest and the highest point of price movement, if not impossible. Many traders define the risk-reward-ratio of each trade that they are taking beforehand. They look closely at the potential outcome when losing a trade and when winning it. Once the optimal ratio is determined, they know how much they are willing to lose, and this automatically sets the conditions where to place the stop order in terms of price and size.

Stop orders are available on the LiteBit Exchange.

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