What are stop-loss and stop-limit orders?

The mechanics of trading are often boiled down to the simplest dichotomy: “buy” and “sell.” However, there are many ways to buy and sell assets like stocks, bonds, and cryptocurrencies. These strategies have defined roles, ensuring traders have the utmost control of their trades and can manage risk accordingly.

Terminology

Trades can be broken down into buying and selling. Buying means obtaining assets like cryptocurrencies by exchanging them for another medium of value, such as fiat currency. Selling is the opposite: relinquishing assets in exchange for a return of value.

Buying and selling is most intuitively performed at the market price. Think of the chart of an asset like Bitcoin (BTC). The price varies, up and down, based on its demand among market participants. As more traders want to obtain it (i*.e.,* more buyers), sellers can charge a higher price for the exchange. Submitting a trade for an asset at its current price is called a market order. However, perhaps a trader only wants to buy BTC when it reaches a certain price. They can specify at what limit they are willing to buy an asset. In doing so, they place a limit order.

While market orders are generally filled quickly, the price can change between the submission of the trade and its execution. Limit orders, on the other hand, favor the accuracy of execution price over the expediency of the trade’s execution. They are used by traders in different scenarios, where either speed or price specificity is preferred.

Stop-loss and stop-limit orders

Note: To explain these complex terms, examples below will describe long positions. The mechanics are similar for short positions but reversed.

Stop-loss orders are instructions that say: “when the price goes below *x, *sell my assets immediately at the market price.” When a trader buys an asset at a certain price, they can place a stop-loss order below that level to stop their losses (hence the name). If the value of the asset falls below the stop-loss order’s designated price, then a market order is placed to exit the position.

Stop-limit orders are like stop-loss orders, but they execute using limit orders (rather than market orders). They are instructions that say: “when the price goes below x, sell my assets if they reach the lower price y.” Whereas stop-loss orders use a simple one-step method, stop-limit orders add one degree of complexity. When the price of an asset drops to a predetermined level, a stop-limit order places a limit order below that level, so that if the price drops any further (to that new price), then the order executes, and the position is closed.

How do these tools aid in risk management?

Stop-loss and stop-limit orders are conditional orders that give traders more control over how they manage risk. They can be used to reduce how much a losing trade can negatively affect a portfolio.

When buying assets, stop-loss and stop-limit orders place a maximum on how much a trade can lose. Most commonly, traders will implement these trading strategies on particularly volatile or high-risk trades, and they can specify exactly how much they are willing to lose on a trade by choosing a percentage or price level using technical analysis.

Every strategy has risks, even strategies like stop-loss and stop-limit orders, which are—by design—ways to reduce risk. By hedging using stop-loss orders, traders can sell their assets near the bottom of a downturn and potentially miss a rally in price that can recoup some of their losses. This is one of the problems that a stop-limit orders address. However, there are also downsides to stop-limit orders. For instance, they are complicated to set up, and when asset valuations “gap up” or “gap down” (which occurs when the opening price is higher or lower than the previous session's closing price), the limit price may not be the true execution price.

Finally, it is worth mentioning trailing stop orders. With trailing orders, unlike fixed orders, the price level at which a position is automatically closed moves with the asset. For example, a trader of Ethereum (ETH) can set a stop-loss 5% below their entry point, and as the price of ETH rises, the stop-loss level also rises and remains 5% below each new high.

How can stop-loss and stop-limit orders be used in crypto trading?

These strategies can be used by crypto traders to ensure they do not incur large, unintended losses. Cryptocurrency markets are notoriously volatile, and if traders are not careful, they can lose large sums of capital. Therefore, appropriate risk management is key. Most centralized exchanges and some decentralized finance (DeFi) protocols—including derivatives trading—offer functionality for stop-loss and stop-limit orders.

Examples

First, imagine a trader who buys BTC at $50,000. At the same time, they set a stop-loss at $45,000. Some possible scenarios are:

• The price of BTC varies, but slowly trends up, never decreasing to the stop-loss level of $45,000. Therefore, the stop-loss never triggers, and the trader chooses to close out for a profit some days or weeks later.
• The price of BTC initially increases, but ultimately it begins a slow trend downwards. When it drops below $45,000, the exchange executes the trader’s stop-loss order, ultimately closing the position at $44,998—for a minimal loss to the trader.
• The price of BTC drops precipitously, quickly eclipsing the $45,000 level. Because of the fast-moving target, when the stop-loss triggers, the market price is $43,050, and the trader incurs a larger loss than intended.

Now, imagine a trader who buys ETH at $2,000 with a stop-limit order specifying a stop at $1,800 and a limit at $1,700.

• The price of ETH rises above $2,000 and does not return to lower levels. The trader’s hedging order does not trigger.
• The price of ETH drops quickly below $1,800 but only as low as $1,760. Then, it begins a slow recovery. Because the price never reached the limit of $1,700, the trader maintains their position and can enjoy the rally back to higher valuations.
• The price of ETH decreases slowly, ultimately eclipsing both the $1,800 and $1,700 levels. Once it falls to $1,700, the stop-limit order triggers and the position is closed. The trader sells their ETH to cash.

Conclusion

• Stop-loss and stop-limit orders are ways to manage risk by placing trades with maximum loss potential.

• Stop-loss orders use market orders and favor execution speed over price, whereas stop-limit orders use multiple steps to close positions at a specific price at the cost of expediency.

• In the volatile crypto market, appropriate caution must be taken to limit losses and manage risk. Understanding—and using—stop-loss and stop-limit orders can help traders be more responsible with their capital.