A stop order is an order, placed with your broker, to buy or sell a particular futures contract at the market price if and when the price reaches a specified level. Stop orders are often used by futures traders in an effort to limit the amount they might lose if the futures price moves against their position. For example, were you to purchase a crude oil futures contract at $15 a barrel and wished to limit your loss to $1 a barrel, you might place a stop order to sell an offsetting contract if the price should fall to $14 a barrel. If and when the market reaches whatever price you specify, a stop order becomes an order to execute the desired trade at the best price immediately obtainable.
There can be no guarantee, however, that it will be possible under all market conditions to execute the order at the price specified. In an active, volatile market, the market price may be declining (or rising) so rapidly that there is no opportunity to liquidate your position at the stop price you have designated. Under these circumstances, the broker’s only obligation is to execute your order at the best price that is available.
In the event prices have risen or fallen by the maximum daily limit, and there is presently no trading in the contract (known as a “lock limit” market), it may not be possible to execute your order at any price. In addition, although it happens infrequently, it is possible that markets may be lock limit for more than one day, resulting in substantial losses to futures traders who may find it impossible to liquidate losing futures positions.
Subject to the kinds of limitations just discussed, stop orders can nonetheless provide a useful tool for the futures trader who seeks to limit his losses. Far more often than not, it will be possible for the broker to execute a stop order at or near the specified price.
In addition to providing a way to limit losses, stop orders can also be employed to protect profits. For instance, if you have bought crude oil futures at $15 a barrel and the price is now at $19 a barrel, you might wish to place a stop order to sell if and when the price declines to $18. This (again subject to the described limitations of stop orders) could protect $3 of your existing $4 profit while still allowing you to benefit from any continued increase in price.
Reprinted with permission from the National Futures Association. Copyright 2002.