Disclosure: Open to the Public Investing, Inc. does not offer stop-limit order types. Information presented in this article is for educational purposes only and is not an investment recommendation.
Table of Contents:
- How does a stop-limit order work?
- Stop order vs. limit order vs. market order
- Stop-limit order example
- Pros and cons of a stop-limit order
- The bottom line
A stop-limit order is an instruction a trader gives to their broker that tells them that if the price of a stock reaches a certain level, then the stock should be traded (possibly bought, possibly sold), provided it can be traded for a price that is at least as favorable as a certain price. Favorable means higher if you are selling and lower if you are buying. This is a kind of conditional trade, which is a trade only made when certain conditions are met.
For example, Jamie bought stocks at $100, hoping their price would rise. Jamie decides that if the price goes to $90, they will accept that they aren’t going to make a profit and are willing to sell. As a result, Jamie sets a stop price at $90. However, Jamie doesn’t want to receive less than $90.05 per share, so they set a limit price at $90.05. Jamie goes away on a holiday leaving instructions to their broker to follow that plan in their absence.
Investors can use stop-limit orders to mitigate some of the risks associated with trading stocks while understanding that investing itself is risky and the chance of losses can’t be eliminated.
The stop-limit order is an order type that combines the traits of the stop order and the limit order. To initiate a stop-limit order, the investor must first set the stop price and then the limit price.
Stop-limit orders don’t come without risks. They decrease the probability of loss but increase the potential amount of loss.
- A stop-limit order is a conditional trade that investors can use to manage (but not remove) the risks associated with trading stocks.
- A stop-limit order doesn’t allow investors to engage in after-hours trading.
- Stop-limit orders combine both stop orders and limit orders. Stop-limit orders are an important concept to pay attention to when learning how to invest in stocks.
How does a stop-limit order work?
When an investor wants to implement a stop-limit order, they must make 4 decisions.
- Whether they are buying or selling and how much.
- Their stop price.
- Their limit price.
- The period of time for which the order is valid.
Once the trader has decided these values, they send the order to their broker. Nothing happens until:
- The stock has been traded beyond the stop price.
- The broker is able to make a trade for a price at least as favorable as the limit price.
Then the broker trades as much stock as they can at the most favorable price they can, provided it’s better than the limit price. This may mean stopping and starting trading as the price fluctuates. Once the period ends, the broker stops.
When you decide the period for which your order is valid, there will be some limitations depending on the broker. The period doesn’t need to end the same-day, and you can set it to “good ’til canceled” (GTC).
Stop limit orders only execute during regular stock market hours, which normally run from 9:30am to 4:00pm Monday through Friday Eastern Standard Time.
Stop order vs. limit order vs. market order
A stop order is an instruction to wait until the price goes beyond or below a particular level and then buy/sell immediately at the best available price. If the trader is buying, then it is called a buy-stop order. If they are selling, then it is called a sell-stop order.
A limit order is an instruction to buy/sell at the best price possible provided that price is at least as favorable as a particular price specified in the order. If the trader is buying, it is called a buy-limit order. If they are selling, it is called a sell-limit order.
A market order is an instruction to immediately buy/sell a particular stock at the next available price. Traders do not know exactly what this price is when they make the order, but recent trades are probably a good approximation.
So, a stop-order is triggered by the prices other traders are trading at passing a particular value, and a limit order is triggered by the price you are able to trade at passing a particular point.
Stop-loss order vs. stop-limit order
A stop order used to limit a loss is called a stop-loss order.
Let’s go back to Jamie: Jamie could have used either a stop-loss order or a stop-limit order. The only time the difference would matter is if the price dropped to $90. Assuming this happened, then there are two scenarios moving forward:
- The price rises and goes above $90 within the time frame that matters to Jamie.
- The price does not rise above $90 within the time frame that matters to Jamie.
In the first case, the stop-limit order is more favorable. In the second case, the stop-order is more favorable.
Stop-limit order example
Now that you have a good grasp of a stop-limit order, let’s look at how to set it up and how it works in the real world.
Say that Pear company is trading at $100, and you want to buy once it begins to trend upward. So you put in a stop-limit order at $105 and set the limit price at $110. If the price of Pear stock moves above the $105 stop-limit price, then the order will be activated and becomes a limit order. If the order can be executed for below the $110 limit order, it will be filled. However, it won’t be filled if the stock moves above the limit order price.
A stop-limit buy order can be placed above the stock market price, while a stop-limit sell order would be set below the stock market price.
Pros and cons of a stop-limit order
As you can see, stop-limit orders have their place as part of an investment strategy and make sense in both bull and bear markets.
The pros include:
- More flexibility and control over costs associated with investing in the stock market.
- Setting stop-limit orders can help to reduce the risks of paying more than you’d like to for stocks.
The cons include:
- If the price doesn’t reach the stop price during the given time period, the order may be partially executed or not executed at all.
- Even if your stop-limit order, which was made to protect you against a loss, is fully executed, it is still a loss—just less of a loss than it could have potentially been.
- Trades will only be executed during regular stock market hours.
Stop-limit trading strategies
- Consider the volatility of the stock when setting up a stop-limit order. When setting the limit amount, it is important to know how volatile a stock is. Setting the limit amount too wide may cost more than necessary, but setting the limit amount too narrowly increases the chance that the order will be fulfilled.
- Have a good understanding of how stocks work. The stock market is unpredictable, and making intelligent decisions can take some time and experience. It’s essential to understand the basics before issuing any type of order.
The bottom line
Using stop-limit orders is a great way to manage your investments and mitigate some of the risks and costs of investing in bull and bear markets.
It’s relatively easy and a good tool for investing for any trader, including beginners, since you set the limits for buying and selling. You also get to choose the ranges for both the time period and costs in which those orders are executed.
There is a lot to learn when it comes to investing, and although there may be times when it feels overwhelming, the good news is that you have time. None of it needs to be mastered in a day.
There are always risks involved in investing in the stock market, so it’s important to learn all you can before you invest. The Public app can help you get started and offers plenty of information that can help you learn everything you want to know. Download the Public app to get started today!