WHAT IS A LIMIT ORDER AND WHY SHOULD YOU USE IT
A limit order is an essential trading tool for investors to gain control over their trade executions.
This article explores what you need to know about them, their benefits, and how to use them effectively in various market conditions.
Last Update
3.7.24
What Are Limit Orders?
A limit order is an instruction to buy or sell a security at a specific price or better. This type of order ensures you will get the price you want or a better one. However, it also means that your order won't be executed if the market price does not reach the specified limit price.
How They Work
When placing a limit buy order, you set the maximum price you will pay for a stock. Conversely, when placing a limit sell order, you set the minimum price you are willing to sell. The order will only be executed if the market price reaches your specified limit price.
For example, if you want to buy a stock currently trading at $50, you can place a limit order at $48. The order will be executed only when the stock price drops to $48 or lower.
Differences Between Limit and Market Orders
A market order is executed immediately at the best available price, while a limit order is executed only at a specific price or better. Market orders prioritize speed, making them suitable for quickly entering or exiting positions. In contrast, limit orders prioritize price, even if it means waiting longer to execute the order.
Market orders can result in unexpected prices, especially in volatile markets, while limit orders provide price certainty but do not guarantee execution.
Types of Limit Orders
You can use several types of limit orders to fine-tune your trading strategy. These include limit-buy orders, limit-sell orders and stop-limit orders. Understanding the specifics of each type can give you more flexibility in managing your trades.
Limit Buy Orders
A limit buy order allows you to buy a security at a specific price or lower. This type of order can be particularly useful when you believe the price of a stock will drop to your desired level before rising again.
For example, if a stock is trading at $50 and you place a limit buy order at $48, you are willing to buy the stock at $48 or any lower price.
Limit Sell Orders
A limit sell order allows you to sell a security at a specific price or higher. This type of order helps you lock in profits by selling your holdings when they reach your target price.
For example, if a stock trades at $50 and you place a limit sell order at $52, your shares will be sold only when the price reaches $52 or higher.
Stop-Limit Orders
A stop-limit order combines a stop order and a limit order. When the stop price is reached, the order becomes a limit order instead of a market order. This gives you better control over the execution price, but with the risk that the order will not be filled if the price does not reach your limit.
For example, a stop-limit sell order with a stop price of $45 and a limit of $44 means that the order will only be executed when the stock price drops to $45 but not below $44. This can help you avoid selling at a price that is too low.
When to Use Limit Orders
They are particularly useful in volatile markets where prices can fluctuate significantly quickly. Limit orders help protect against unexpected market movements and make the trading process more efficient by ensuring that trades are executed at pre-set prices.
Investment Protection
Limit orders are an excellent way to protect your investments in a declining market. By setting a limit sell order below your purchase price, you ensure that you can exit a losing position before the losses become too significant.
Consider a scenario where you have bought a stock at $100 per share. Setting a limit sell order at $90 ensures that your maximum loss will be limited to 10% of your investment if the market declines.
Locking in Profits
Investors can also use limit orders to secure profits. For example, a stop-limit order can help you lock in gains without constantly monitoring the market. The trailing stop will adjust as the stock price increases, helping you capture a higher selling price.
Implementing a Trading Strategy
Limit orders are a critical component of any robust trading strategy. They can help automate your buy and sell decisions, ensuring that trades are executed when market conditions meet your predefined criteria. This can remove some of the emotion from trading and allow you to stick to your investment plan consistently.
Imagine having a rule where you sell any stock that drops 15% from its peak. Placing a stop-limit order can automate this strategy, selling the stock if it reaches your stop price without your constant intervention.
A limit order is an instruction to buy or sell a security at a specific price or better. This type of order ensures you will get the price you want or a better one. However, it also means that your order won't be executed if the market price does not reach the specified limit price.
Common Mistakes and How to Avoid Them
Even experienced traders can make mistakes with limit orders, leading to suboptimal results. Understanding and avoiding common mistakes can help you optimize your trades and achieve better outcomes. This section will explore some prevalent errors and how to avoid them.
Knowing the pitfalls to avoid can significantly improve the efficiency and effectiveness of your limit orders.
Setting Unrealistic Price Limits
One of the most common mistakes is setting unrealistic price limits that are unlikely to be reached. This leads to missed trading opportunities and unexecuted orders. How can you avoid this mistake?
Analyze the Market: Conduct a thorough market analysis before setting a limit order. Use technical analysis tools, historical data, and current market conditions to set realistic price limits. Consider using chart patterns, moving averages, and other technical indicators to determine informed price targets.
Adjust to Current Conditions: Market conditions change, and so should your limit orders. Regularly review and adjust your limit orders based on market trends and information to stay aligned with market dynamics.
Set Incremental Targets: Instead of setting a single limit order at an extreme price point, consider setting incremental targets. This approach lets you capture profits or enter positions at different price levels, increasing the likelihood of execution. For example, if your goal is to sell a stock trading at $50, set multiple limit sell orders at $52, $54, and $56 to capture gains at various stages.
Overlooking Execution Costs
Fees and commissions can reduce your profits, so it is essential to account for them in your trading strategy when using limit orders. How can you avoid this mistake?
Understand Fee Structures: Different brokers have different fee structures. Review your broker’s fee structure before placing limit orders to ensure you account for all costs in your trading strategy.
Include Fees in Price Limits: Include the expected fees and commissions in your price calculations when setting limit orders. This ensures that your trades remain profitable after considering all costs. For example, if your goal is to achieve a net price of $50 after fees, set your limit sell order slightly higher to cover those additional costs.
Use Zero-Commission Platforms: Many brokers now offer commission-free trading. While these platforms can reduce costs, it is crucial to understand the potential trade-offs, such as wider spreads or different order execution priorities.