Once the Stop Price is passed, the Stop Order would convert into a Market Order, and will be filled at the best available price in the market at that time.
Stop Order is also known as Stop Loss Order or Stop Market Order.
Stop Order is commonly used to limit / reduce losses on a position when the price moves sharply against the trader/investor, or to lock in profit from a position to prevent you from “giving your profit back to the market”.
Depending on the position on the market you have (long or short), there are 2 types of Stop Order:
a) Sell Stop Order
This is the stop order (to limit losses or to lock in profit) when you have a long position on a security.
In this case, the Stop Price is placed below current market price of the security.
b) Buy Stop Order
This is the stop order (to limit losses or to lock in profit) when you have a short position on a security.
In this case, the Stop Price is placed above current market price of the security.
When placing Stop Order for an Option, the order will be triggered based on the market price of the option, NOT the market price of the underlying stock. Therefore, the Stop Price should be set based on the option’s price as well.
Therefore, just remember how the price of Call and Put options are related to the underlying stock price:
For a Call option, the option’s price increases when the underlying stock’s price increases, and decreases when the underlying stock’s price decreases (positive relationship).
On the other hand, for a Put option, the option’s price increases when the underlying stock’s price decreases, and decreases as the underlying stock’s price increases (negative relationship).
Characteristic & Risk of Stop Order:
Stop Order will remain inactive until the Stop Price is passed. Once the Stop Price is passed, the order will be activated as a Market Order.
Therefore, the disadvantage of Stop Order is that while it guarantees execution, the order cannot guarantee that it can be filled at the specified price.
Basically, once the Stop Order has been triggered (i.e. when the price hits or passes through the Stop Price), it turns into a Market Order, which will be filled at the best available price in the market at that time.
This price may be “worse” than the predetermined Stop Price (i.e. lower for Sell Stop, or higher for Buy Stop), particularly during volatile price movement.
Hence, basically the same advantage & disadvantage of Market Order apply to Stop Order as well.
Suppose a Sell Stop order were placed to protect a long position on a Call option with a Stop Price at $2/contract. The current market price is $2.5/contract. This order would remain inactive, unless the price reaches or drops below $2. When that happens, the order would then be triggered and turn into a Market Order, and the option will be sold at the best available market price.
Hence, in case the market price gap down at $1, the price at which the order will get filled would be around that price, which is much worse than the stipulated Stop Price.
For the list of other types of order, go to: Types of Orders in Trading.
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