Stop Orders: Factors to Consider During Volatile Markets

We all know investing in stocks comes with risk. But what you might not know is that stop orders — a tool for managing that risk — can come with their own set of risks.

Stop orders can limit your exposure if the price of a stock you have an interest in changes beyond a certain price point that you set — i.e., the “stop price,” also known as a “trigger” price. Generally, a sell stop order allows you to protect a profit position in a stock you own. If you have a short position, a buy stop order may be used to help limit losses in the event the stock’s price increases.

But placing a plain vanilla stop order triggers a market order once activated. That means that, if your floor for the stock’s price is $50, your broker will then seek to sell your stock at the best possible price reasonably available in the market as soon as the stock hits the $50 point. If the market’s moving fast, you could receive less — and potentially significantly less — than $50 a share by the time your order is executed.

As such, a stop order’s risks are more pronounced during periods of extreme market volatility when the prices of securities can fluctuate wildly.

These inherent risks have prompted major stock exchanges, including the NYSE, BATS and Nasdaq to cease accepting stop orders. Though your broker may still accept your stop order, before you decide to use one, be sure to understand the inherent risks of this type of order.

Stop Prices Are Not Guaranteed Execution Prices

When the stock reaches your pre-determined “stop price,” your stop order becomes a market order. Securities rules and regulations require your broker to execute a market order fully and promptly at the current market price. So while your broker may promptly execute your stop order, if the market is volatile and prices are changing rapidly, your stock may be bought or sold at a price that is significantly different from your stop price.

Short-Lived, Dramatic Price Changes May Trigger Your Stop Order

During periods of volatile market conditions, the price of a stock can move significantly in a short period of time and trigger an execution of a stop order. The stock may later resume trading at its prior price level. Keep in mind that if your stop order is triggered under these circumstances, your stock may be traded at an undesirable price even though the price of the stock may stabilize during the same trading day. Once the order is executed, you can’t undo that trade.

Sell Stop Orders May Exacerbate Price Declines During Times Of Extreme Volatility

If the market is volatile, and your sell stop order is triggered, your sell stop order may add downward price pressure on the stock. If your sell stop order is triggered during a precipitous price decline, the stop order also is more likely to result in an execution well below the stop price.

Placing A “Limit Price” On A Stop Order May Help Manage Some Of These Risks

In addition to the stop price, you can set a “limit price” beyond which you’re not willing to buy or sell. Your shares will only be bought or sold if your broker can obtain that limit price or better. As with any limit order, the potential downside is that there is no guarantee that your order will be executed. Consider using a limit order if your primary goal is achieving a desired target price rather than getting an immediate execution irrespective of the price.