In the volatile derivatives market, using stop orders is a crucial factor for investors to preserve capital and achieve optimal profits. Not only does it help control risks, but stop orders also allow you to be more proactive in trading without having to monitor the market constantly. Let’s explore stop orders, their popular types, and how to use them effectively in this article with SFVN!

Stop orders are a critical risk management tool to optimize profits in derivatives trading

What is a Stop Order?

A stop order is an automated trading tool that allows you to pre-set a specific price level at which a buy or sell order will be triggered. When the market price reaches or surpasses the stop price, the order becomes a market order and is executed immediately.

Example: If you are trading an asset like corn and are concerned that prices might drop sharply, you can place a stop sell order at a price below the current price. If the price falls to this stop level, the order will be executed to protect you from further losses.

Stop orders not only help in risk control but are also a way to optimize profits in highly volatile markets such as derivatives trading.

Stop orders are a vital tool to control risks and enhance profits

Types of Stop Orders

Stop orders can be categorized into trade orders, each suited to specific trading strategies and goals. Here are the most common types:

Stop Market Order

This is the most common type of stop order. When the price reaches the stop level, the order is executed at the current market price. This ensures the trade is carried out immediately, helping you avoid greater risks as prices continue to fluctuate.

Example: Suppose you are monitoring the price of oil, and the current price is $1,500 per barrel. You are concerned that the price may drop significantly, and you want to sell oil if the price falls to $1,450 per barrel to prevent further losses.

• You place a stop sell order at $1,450 per barrel. This means you want to sell oil when the price decreases to $1,450 per barrel.

• When the price of oil drops and hits the $1,450 per barrel level, your order will be triggered and executed automatically. However, the order will be filled at the current market price, which could be $1,450 per barrel or slightly lower if the price drops rapidly.

Stop Limit Order

This type allows you better control over the execution price. After the price reaches the stop level, the order is only executed if the market price is within the limit range you set.

Example: 

• The current price of coffee is 2,000 USD per ton. 

• You want to sell coffee if the price drops to 1,950 USD per ton, but you don't want to sell for less than 1,930 USD per ton, as you don't want to incur too much loss.

How a Stop-Limit Order Works

• Setting a Stop-Limit Order: You set the stop price at 1,950 USD/ton. This means that when the price of coffee drops to 1,950 USD/ton, your order will be triggered and converted into a limit order.

• Placing a Limit Order: After your stop order is triggered, you want to sell coffee at no less than 1,930 USD/ton, so you place a limit order at 1,930 USD/ton. This means you only want to sell coffee if the price remains at or above 1,930 USD/ton.

  
  

How the Stop-Limit Order Works in Practice:

• When the price of coffee drops to 1,950 USD/ton, your order will be activated and become a limit sell order at 1,930 USD/ton.

• If the price of coffee continues to drop, your order will only be executed if the price does not go lower than 1,930 USD/ton. If the price drops below 1,930 USD/ton, your order will not be executed, as you have set the limit price at 1,930 USD.

• If the price fluctuates within the range of 1,930 USD to 1,950 USD or higher, your order may be executed immediately at the best available price within that range.

Trailing Stop Order

This order automatically adjusts the stop price according to favorable market movements. It is an excellent tool to secure profits when the market moves in your favor.

Example:

• Buy Price: You buy soybeans at 600 USD per ton.

• Trailing Stop Order: You place a trailing stop order with a 20 USD decrease. This means the stop level will always maintain a 20 USD distance below the highest price the market reaches.

How a Trailing Stop Order Works:

Step 1: You buy soybeans at 600 USD/ton.

Step 2: You place a trailing stop order with a 20 USD drop. This means that if the price rises, the stop level will automatically adjust upward and always maintain a 20 USD distance below the highest price reached.

Step 3: The price of soybeans increases to 650 USD/ton.

• Your stop level will automatically adjust to 630 USD/ton (650 USD - 20 USD = 630 USD).

Step 4: If the price continues to rise, your stop level will automatically move up as well. For example, if the price reaches 670 USD/ton, the stop level will automatically adjust to 650 USD/ton.

Step 5: If the price of soybeans drops below 650 USD/ton, the trailing stop order will be triggered, and you will sell automatically at 650 USD/ton or the nearest available price.

Different stop orders offer flexibility and efficiency for various trading strategies

How to Use Stop Orders Effectively

To use stop orders effectively in derivatives trading, follow these steps:

• Understand your investment goals: Determine whether you want to use stop orders to protect capital, lock in profits, or both. Clear goals will help you choose the right type of stop order.

• Analyze the market thoroughly: Use technical analysis tools to determine a reasonable stop price, avoiding orders placed too close or too far from the current market price.

• Set appropriate price levels:

  • To protect capital: Place a stop sell order below the purchase price.

  • To lock in profits: Place a stop buy order above the current price.

• Monitor the market: Although stop orders automate trading, you still need to monitor and adjust them when the market changes rapidly.

Advantages and Disadvantages of Stop Orders

Advantages:

• Better risk control: Limit potential losses in highly volatile markets.

• Automates trading: No need to monitor prices continuously.

• Protects profits: Locks in gains when the market moves in your favor.

Disadvantages:

• Slippage risk: Stop market orders may be executed at prices significantly different from the stop price, especially in highly volatile markets.

• Not suitable for all conditions: In stagnant or slightly volatile markets, stop orders may not be effective.

• Dependent on stop price selection: Incorrect stop price levels may lead to early activation or missed execution.

When to Use Stop Orders

• In highly volatile markets: Stop orders help protect capital during periods of significant price swings.

• When you cannot monitor the market constantly: If you cannot follow the market, stop orders will automatically trigger when the price reaches your desired level.

• To lock in profits or cut losses: Use stop orders to lock in profits when the market moves in your favor or to minimize losses when prices go against expectations.

>>> Read more: What is a pending order? Classification and usage in trading

Conclusion

Stop orders are indispensable tools in derivatives trading, enabling investors to automate trades and control risks effectively. However, to use them optimally, you must understand each type of order and the conditions for application.

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