By Kristoff De Turck - reviewed by Aldwin Keppens
Last update: Apr 28, 2023
A "stoploss order" will ring a bell with most investors, the majority will answer that such orders are used to limit the loss on a position or to protect accumulated profits. Correct! But do you also know the "Buy Stop order"? This is a much lesser-known type of order and has nothing to do with the classic stoploss order... Yet this is one of the most important orders because it allows you to determine your entry very precisely.
In this article you will read all about this order which is exclusively used to open positions. It is, as it were, an "entry order" and not an order whose sole purpose is to protect the open position. However, we will show that - despite its totally different character from the classic stop loss order - such an order can also save us a lot of trouble!
Take a look at the graph below of the Vermilion Energy Inc share on date of 08 November 2021.
The last candle shows a breakout above the existing sideways trading range with increased volume. If you assume a further rise you can consider a long position the next day with for instance a defensive stoploss below the existing trading range (just below the blue rectangle).
Traders who are not yet fully on board with the complete arsenal of possible entry orders in their platform will usually simply buy the shares at the then current market price the following day when the market opens. On the chart below you notice that the market opens at $11,95. So with a simple "Buy Order at Market Price", this would have been approximately the purchase price (we do not consider spread and slippage in this article for the sake of simplicity).
Where the stoploss is placed will be different for everyone, but in this example let's assume that we use a fairly wide stoploss, just below the red horizontal line as shown in the chart below.
Unfortunately, the price continues to fall and a few days later the stoploss was hit.
In this case however, if we had used a "Buy Stop Order at Market Price" instead of a regular "Order at Market Price" this position would never have been bought. The difference lies in the fact that the "Buy Stop Order at Market Price" will only be executed when a predefined price is reached.
Below is the VET chart again, on which we have marked the high of the breakout candle:
Instead of just buying the next trading day at the opening price we set a 'Stop Price' just a few cents higher than the existing high of the previous day. This price level must first be reached before the "Buy Stop Order at Market Price" becomes valid. In this case, for example, we determine that the price must first rise to $12,10. Only then the order will become valid.
For some readers this will undoubtedly seem strange because ultimately this means that whoever uses such a "Buy Stop Order at Market Price" is prepared to pay more than if he or she buys the following day at "Market Price". Nevertheless, it is wise to abandon the mere orders at market price. The big advantage of the "Buy Stop Order at Market Price" is that we will not hold any shares if the rise does not continue and the price falls again, as was the case in the first example... Moreover, the order serves as an additional confirmation of the initial break-out. After all, the price first has to rise at least a few cents above the high of the break-out candle before this order becomes valid.
A "Buy Stop Order at Market Price" does not, of course, offer a watertight guarantee that we will not be taken out at a loss because, even with this order, the price can simply fall again after entry and reach the set stoploss level. This type of order is particularly interesting for those who mainly buy shares that 'break out'. By using this order you 'react' after a break-out instead of 'anticipating' it.
There is, however, one small catch which applies to both this 'Buy Stop Order at Market Price' and the ordinary 'Order at Market Price'.. The 'Buy Stop Order' does give us better control over the price level from which the order will be valid, but we do not (yet) have certainty about the price at which the position will actually be bought... And this too can lead to unpleasant surprises.
But don't worry, there is also a solution for that, which is tailor-made for investors who do not have the time or the inclination to spend whole days sitting in front of a screen following the stock market in real time and it is called the 'Buy Stop Limit Order'.
Below is the same graph of Vermilion Energy Inc, however now on date of December 22, 2021. The price has again broken out above the applicable range and the highest price that day was $12,61. Let's assume that for the next trading day (2021/12/23), a "Buy Stop Order at Market Price" is placed at $12,66.
The next day the price opens at $12,44, initially too low to trigger our order. The order remains valid however, and during the trading day VET rises above the "Buy Stoplevel". This puts the order into effect and the shares are purchased at "Market Price".
However, imagine the following situation:
Edison International stock breaks out of an ascending triangle pattern on the date of December 03 with a high at $66,67 and a closing price of $66,61. Again using our "Buy Stop Order at Market Price", we want to buy shares the next trading day as soon as the price hits $66,72.
The following day, December 04, 2021, the opening price of EIX is $67,56, which is well above our set "Buy Stop Price".
Because the price opened above the "Buy Stop Price", the order will take effect immediately and the shares will be purchased at the prevailing market price. Suppose the stoploss was placed at $65,25, now suddenly the risk becomes much higher because you have just paid 84 cents more for the shares (difference between the buy stop @ $66,72 and the opening price @ $67,56).
To avoid this, there is the "Buy Stop Limit Order". This is completely similar to the "Buy Stop Order at Market Price" but with an added "Limit Price".
Same example as the chart above but this time using a a "Buy Stop Limit Order":
The "Buy Stop" part remains exactly the same, the order only becomes valid once the price reaches at least $66,72. However, an additional condition is set once the "Stop Price" is reached, namely that the maximum price we are willing to pay for the shares is $66,85.
So if the price unexpectedly opens a lot higher, the order will not be executed because the "Market Price" is above the set "Limit Price". If the price drops during the trading session to at or below the "Limit Price" (in this case $66,85) then the order will be executed immediately.
Compared to the regular "Buy Stop Order at Market Price", the "Buy Stop Limit Order" not only gives us control over 'when' to enter the market but also allows us to define exactly 'up to what price level' we are willing to hold the shares.
This type of order thus offers us maximum control and is the instrument of choice for investors whose strategy is based on closing prices. The order can be perfectly set in the trading platform after the trading day has ended and will automatically become valid the next day with the set conditions as soon as the market opens.
Correct order usage is of utmost importance for those who do not want to be confronted with unpleasant surprises. They allow you to fine tune the entry down to the last cent and can save you a lot of headaches!