Stock prices can rise and fall quickly, sometimes fluctuating every second. These rapid price movements can make life difficult for traders. It can be difficult to predict what price they will receive if they buy or sell a stock. This problem is exactly what limit orders can help solve.
Limit orders allow traders to specify a price at which they want to trade, rather than simply buying or selling their shares at whatever the market price is. In other words, limit orders put traders and investors in control and allow them to determine the price at which they are willing to execute trades.
How does a limit order work?
Limit orders allow traders and investors to specify a price for the stocks they want to buy or sell. When purchasing shares, a limit order will not be executed unless the stock falls below the specified price. When selling, the order will not be completed until the price rises above the specified price.
When traders place a limit order, they can specify how long the order should remain open, for example a week or a month or ‘good until cancelled’, although the latter usually only means three or six months, although this varies between brokers. The limit order remains open until it is filled or until it expires.
For example, suppose you want to sell 10 shares of TUVWXYZ Corporation, at a price of $15 per share. However, you think the price will rise to $18 per share in the next month. You can then open a sell limit order for 10 shares for $16, which lasts for a month. As a result, your shares won’t be sold until the price reaches $16 per share. If that happens in the next month, the order will be filled. If the price does not reach that level before the order expires, your shares will not be sold.
Limit order vs market order
Limit orders are a popular order type, and the other major type is called a market order. While limit orders let traders specify their price, a market order executes the trade as quickly as possible at the next available price, regardless of what that price is.
The price of limit orders is therefore guaranteed, but the execution of the transaction is not. In contrast, trade execution of a market order is guaranteed if there is a counterparty but the price is uncertain.
That’s the main difference between limit orders and market orders, but each belongs in an investor’s toolbox and using one or the other can save you money depending on the exact situation. Here’s when to use each type of order and why.
Limit order vs stop order
Traders can use both limit orders and stop orders to limit potential losses, but there are subtle differences in how limit orders and stop orders work.
With a limit order, traders specify the highest price they are willing to accept for a purchase or the lowest price they are willing to accept for a sale. The order will only be executed when the specified price is available. However, a stop order is a trade that is executed at the market price once the stock has traded at a certain price, known as the stop price. The stop order is a type of conditional order that is only activated once the condition – reaching the stop price – has been met.
The purpose of limit orders for traders is generally to lock in the price at which they want to trade. Conversely, stop orders can help traders prevent further losses or boost a stock’s momentum if a stock is moving in a certain direction. For example, a trader might use a stop order on a stock that has risen and may continue to rise. The stop order could allow the trader to buy only once the stock has ‘broken out’ of a trading range. But the trader could use the same tactic on the downside, setting a sell stop order that will be triggered once the stock falls to a certain level.
When should you consider using limit orders?
While market orders can provide instant gratification, sometimes a limit order can be a good idea.
Consider using a limit order if:
- You believe the price will rise – or fall. You can use limit orders when buying and selling. If you think the stock price will rise and you sell, you can place a sell limit order so that you only sell when the price rises to the price you specified. If you think the price will drop and you buy, you can place a buy limit order so that you only buy when your price is reached.
- You are not actively trading. Some traders monitor stock charts all day long and place orders regularly. If you don’t want to look at a particular stock chart until the stock reaches the price you want, a limit order may be the way to go.
- You want to trade a stock with low volume. Trading stocks on low volume can be problematic with market orders because the bid-ask spread can be wide. When trading volume is low, a single order can significantly change the stock price, which can often happen in after-hours markets. A limit order allows you to avoid paying too much for a purchase or selling too little because it allows you to specify your price.
In short
Limit orders allow traders to buy or sell a stock only when it reaches a certain price. While traders can use market orders to achieve immediate trade execution, it can often make sense to set a limit order – even on liquid stocks – so you know exactly what price you’re getting.
Editorial Disclaimer: All investors are advised to conduct their own independent research into investment strategies before making any investment decision. In addition, investors are advised that the past performance of investment products does not guarantee future price increases.
