A buy-stop order instructs a broker to purchase a security when it reaches a pre-specified price. Once the price hits that level, the buy stop becomes either a limit or a market order, fillable at the next available price.
This type of stop order can apply to stocks, derivatives, forex, or a variety of other tradable instruments. The buy-stop order can serve a variety of purposes with the underlying assumption that a share price that climbs to a certain height will continue to rise.
Basics of a Buy Stop Order
A buy-stop order is most commonly thought of as a tool to protect against the potentially unlimited losses of an uncovered short position. An investor is willing to open that short position to place a bet that the security will decline in price. If that happens, the investor can buy the cheaper shares and profit from the difference between the short sale and the purchase of a long position. The investor can protect against a rise in share price by placing a buy-stop order to cover the short position at a price that limits losses. When used to resolve a short position, the buy stop is often referred to as a stop loss order.
The short seller can place their buy stop at a stop price, or strike price either lower or higher than the point at which they opened their short position. If the price has declined significantly and the investor is seeking to protect their profitable position against the subsequent upward movement, they can place the buy stop below the original opening price. An investor looking only to protect against catastrophic loss from significant upward movement will open a buy-stop order above the original short sale price.