A stop order, like a limit order, is only executed once a specific price is reached, but the motivation for the transaction is different. Whereas the limit order is typically used to enter into a futures position at a specific price, a stop order is usually used to exit or close a futures position at a specific price. Stop orders are most often used to close a position that is losing money, and are hence regarded as a useful risk management tool. A stop order to buy has a price that is above the market price and would be used by a customer having a short futures position. If prices rise so that loss accrues on the customer's short position, the stop loss provides a limit to the loss - as soon as prices rise to the stop price, the order is executed as a market order. Similarly, a stop order to sell has a price that is below the market price and would be used by a customer having a long futures position. If prices fall so that loss accrues on the customer's long position, the stop loss provides a limit to the loss - as soon as prices fall to the stop price, the order is executed, thereby closing out the initial long position.
This order becomes a ‘market order’ only when the specified price level is reached. This order is used to either enter a new trade or to exit an open trade. The Stop Order does not guarantee that you are going to get in or out at that exact price, because as stated, when the price is reached or penetrated, the order becomes a market order. A buy stop is placed above the market and a sell stop is placed below the market. Stop orders are commonly used to enter a market when the market is moving in that direction, protect profits, or to attempt to limit losses. (Keep in mind, while trying to limit losses, a stop loss order may not limit your loss to the amount intended) A stop order is considered a day order unless you specify that you want the order to be a GTC order (Good till Canceled).
Entering a new position:
You call your broker and ask him where May Corn is trading. Your broker tells you it is at 275 per bushel. You are interested in buying a contract, but you don’t want to buy it until the market shows you some strength by getting up to 285. This would require you to place your order to Buy 1 May Corn at 285 ‘on a Stop’. This order tells the people in the pit that you are willing to Buy 1 May Corn if and only if the market goes up to that price and not before. When the market trades at 285, the order becomes a market order and you will get the next best price. If the market is trading at 284 ½ and the next trade is at 286 ¼, you may be filled at or around 286 ¼ not the 285 that you had as an order. Remember, on a stop order, you are filled at the market once it has traded at or through the specified price.
To Protect Profits
You call your broker because you are ‘Long’ 1 contract of May Corn at 250 per bushel. Your broker tells you that the current price is 265 per bushel. You are obviously excited at your $750.00 profit (this profit is unrealized because you haven’t sold it yet) and want to protect some of it in the event that the market reverses and you lose all of your hard-earned money. You decide to place a Stop Order at 260 per bushel. By doing so, you would tell your broker that you want to Sell 1 May Corn at 260 Stop. This means that if the market started reversing and got to 260, your stop loss would become a market order and you would be out at or near the 260 price. Therefore, you have locked in a profit of roughly 10 cents or $500.00.
Attempting to Limit Losses
You call your broker because you are ‘Long‘ 1 contract of May Corn at 250 per bushel. Your broker tells you that the current price is 245 per bushel. You are not happy because you realize you are down 5 cents or $250 on the trade. You are not willing to risk more than $500 dollars on the trade so you decide to place a Stop Loss Order with your broker. You advise him to Sell 1 May Corn at 240 Stop. Again, this does not guarantee you can’t lose more than $500 because as stated before, when the market trades at or through 240 per bushel, the stop loss order becomes a market order and you are filled at the best price the floor broker can get for you at that time. That may be 240, but don’t be disappointed if your broker gives you 239 ½ or worse.