In the realm of finance, stop limit orders are essential tools at an investor’s disposal for ensuring the maximization of profits, and minimization of net losses.
Because it directly assists with these fundamental market goals, understanding them is key to a sound investment approach.
These orders combine the prudence of market participants with the dynamic power of automation, to allow for sound investment decisions.
Without such orders triggered automatically, traders would be compelled to constantly monitor minute price movements.
If you are interested in learning more about this game-changing market tool, look no further. In this article, we explore everything there is to stop limit orders while simplifying all the technical jargon that relates to the concept.
Limit Orders vs. Stop Orders: An Overview
A stop-limit order is simply a type of order that a trader makes to a broker, giving instructions to buy or sell a particular stock trading in the market.
Unlike regular market orders, stop limit orders specify precise points at which the purchase or sale is to be carried out.
Types of Orders
There are two types of orders that make up stop limits, each with a slightly different function and exercising approach. Understanding both these wings are essential to learn how to use stop limit orders.
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Limit orders:
These orders only execute at precise points
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Stop orders:
These send out regular market orders after a price threshold is crossed
Stop limit orders – Aspects To Keep In Mind
There are several aspects that relate to limit orders and stop orders, which makes them such essential tools in finance. These are as follows:
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Precise Control
Because stop limit orders allow for price execution at specific prices that the investor has pre-determined, they allow for precise control over their trading strategies.
With this precision, they stand far more capable of maximizing gains and limiting their losses.
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Limit Downside Losses
Stop orders and limit orders set safety points for those that exercise them, and thus limit their downside losses.
By selling a stock after it has fallen by a relative margin, traders could potentially save themselves from incurring a further loss, by exiting on time.
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Conditional Trade
Both stop orders and limit orders are examples of conditional trade, in the sense that they lay out conditions to the broker as to when a transaction is to be executed.
These conditions are typically price levels after which buying or selling is to be initiated.
Conditional trade is empowering for any market participant, as it frees them up from constantly monitoring price levels day and night.
With conditions set, traders can simply wait for the ideal price points to achieve and buy or sell in an automated manner.
Difference Between Limit and Stop Order
Knowing the distinction between limit and stop orders is essential for understanding stop limit orders to one’s advantage in the market.
While both types of orders generally function in the same way, they are flip sides of the same coin, and thus show core differences from each other.
Discussed below are some of the most important differences between stop orders and limit orders, which come together to form stop limit orders:
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Difference in trigger point
Limit orders are essentially the least acceptable price points that traders are willing to buy and sell a particular security at, giving it a specific trigger point.
Stop orders are regular market orders sent to the broker when a certain price level has been surpassed.
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Difference in function
Limit orders allow market traders to buy or sell a security at a predetermined market price, limiting one’s losses and maximizing value opportunity.
This ensures that the trader can automatically adjust their position without having to actively monitor prices.
Stop orders are similar to limit orders, allowing entry or exit at a specified activation price.
However, the functional difference is that stop orders send out regular market orders at predetermined prices, ensuring more flexibility in the buy or sell points.
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Difference in transparency
It is important to note that the data on limit orders is available to the market, with any participant able to determine what price points on each stock is such an order placed on.
Stop orders, however, are hidden, and not disclosed in this manner to the market.
How Stop Limit Orders Work
In order to break down how stop limit orders work, we go over each of the steps that a trader may take when wanting to exercise a limit order.
Described below are each of the five stages that help explain how such orders work:
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- First step is to identify which stock is a good one to pick or sell at a particular price point that will either enhance value opportunity or protect the trader from loss if its price were to fall.
- In order to place a limit order, one must get in touch with a stockbroker, and specify to him or her the particular stock and the price level at which that stock is to be bought or sold. The trader will also mention the number of stocks to buy or sell, at that level.
- After being sent to the market, stop orders will remain active until they are executed, upon the determined price point being triggered. This is due to them being automated action calls that are on standby and executed only upon the price point coming to pass.
- In the case of a limit buy order, once a stock’s price falls to a certain point, the limit order will activate, and the stock will be bought at the price the trader had planned. In the case of a limit sell order, a stock will be sold to limit one’s losses.
- In the case where the specified price point does not occur, the order may never be executed but will remain in the market until its close, or when the order is canceled by the trader.
From the five stages seen above, we understand that limit orders work as automated action calls that are activated when price conditions have been specified by the trader.
Real-World Example of a Stop Limit Order
In order to truly contextualize how stop limits actually function, we turn to take a look at a real-world example of how exactly these tools are used in the market.
This would elaborate on each of the critical dimensions that relate to such orders.
Let’s take a look at the stock price of the weapons manufacturing giant, Lockheed Martin (NYSE: LMT) over a few days:
As can be seen in the graph above, the price of LMT opened at almost $482 and closed above $475. The green dotted line represents a predetermined price of $468 that has been set as a buying trigger by means of a stop limit order.
At a certain point during the 16th of February, the stock undertook a hard plunge taking it down to $467. This dip was temporary, and LMT rebounded to above $476 in a short span of time.
For the trader that had set this limit order at $467, the stock is bought at that price and brings a tremendous gain, despite LMC closing far below its opening price. Because of the order, the trader has gained $8 on every share.
In the above real-world example, we see that through stop limit orders traders can gain without having to wait, and time their positions on their own. They also stand to gain when most traders incur price losses.
What is the difference between a stop-loss order and a stop limit order?
Stop loss orders and stop limit orders are both fundamentally stop orders, but their difference lies in their execution after the trigger price arrives.
While the former is executed, it acts out as a market order, whereas the latter will function fully as a limit order.
Key Differences Between Stop-Loss Order And A Stop Limit Order
As a result of this intricate difference between both forms of stop orders, a few key differences between the two arise. These are as follows:
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Number of price points
The stop-loss order will typically carry one price point, known as the stop price, after which the triggered sale action would be carried out.
Stop-limit, on the other hand, has two price points, with the first being the stop price, at which the order will be sent out, and the second being the limit price, where the action will be executed.
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Circumstances of use
Normally, stop-loss orders will more often be used in cases of high liquidity, where stop prices can instantaneously be executed given the high demand from both buyers and sellers with relative ease.
Alternatively, stop-limits are generally used when the particular stock is defined by a low level of liquidity, and cannot be bought and sold the moment the order is executed. This is why there is a gap between order and execution.
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Trader mindset
Due to the intricate distinction between stop limits and stop loss orders, they are typically used by traders of different mindsets.
Stop-loss orders are usually used by optimistic market participants who do not require instantaneous exit from their positions.
Stop limit orders, however, are more likely to be used by pessimists who have zero tolerance for deviation from their price limit.
Do stop limit orders work after hours?
By their very nature, stop limits are only functional during the standard trading session, and thus cannot activate during price movements during after-hour trade sessions. Due to this limitation, they also cannot function during bank holidays.
Normally, trading hours across most markets span from 9:30 am to 4:00 pm, and stop-limit orders can only work during this daily window.
In the case where the order is not executed, it will pass over to the next trade session, unless it is canceled.
What is an example of a stop limit order used for a short position?
There are often instances where short-sellers turn to use stop limit tools for a precise timing of their positions, to restrict losses from price rises. The order used for these instances by market bears would be buy-stop limit orders.
To demonstrate an example, we can assume a market player has a short position on a stock that is currently trading at $100. To limit their losses, the trader can establish a cap of a 15% loss on the particular stock.
With a 15% margin, the buy-stop limit order will automatically initiate a buy action once the particular stock hits the $115 mark. This limits losses without the trader having to actively switch his position.
How long do stop limit orders last?
In the stop limit mechanism, traders initially establish a duration for the order which can range from a single day to several months. Following this duration, the order becomes expired, unless it is canceled beforehand.
As already mentioned above, when a trader is using stop limit orders, and the current trade session comes to a close, the order will be pushed on to the next day, and will remain inactive during after-hours and pre-market hours.
The trader also has the option to set the validity period as good-til-cancelled (GTC), which implies perpetual existence until it is directly canceled by the trader.
Conclusion
Stop limit orders are extremely useful tools that market participants can turn to, for the purposes of maximizing their gains, or putting a cap on the losses they anticipate.
The stop limit mechanism has two fundamental sides to it, which are the stop order and limit order. Each has its distinct set of characteristics, which are selected on the basis of each trader’s preference and approach.
Given what stop limits and similar orders allow in trading, they empower market participants to dynamically execute actions without having to constantly monitor stock prices for long stretches of time.
FAQs
How do trailing stop limit orders work?
The trailing stop limit functions by placing an order of minimum acceptable risk while keeping the possibility of a price gain limitless. This keeps the position open, capturing gain while the price movements remain favorable.
How to use stop loss and stop limit orders?
Stop loss and stop limits can be used by communicating the order to a broker, and specifying the trigger price points, and the duration of the order.
How to make automatic stop losses on limit orders?
To make a fully automatic stop-loss system on limit orders, traders would need to set the stop-loss order to trigger at the same time as the limit order. After this trigger is met, the stop-loss will trigger automatically.
