Limit and Stop Orders

When buying and selling stocks, the investor generally has three types of orders they can place: market orders, limit orders, and stop orders. When working with a broker, it's important to understand both the trades that are possible as well as the firm's policies and procedures.

In this article, we're going to discuss the three basic types of stock orders, with emphasis on limit and stop orders.  As part of that discussion, we'll start with a brief overview of each trade type.  Next, we'll talk about one of the more useful variations of these orders:  the stop-limit order.  Finally, we'll provide some examples that illustrate how each trade is used by knowledgeable investors.

Stock Market Orders

There are three fundamental types of stock market orders that every investor should be familiar with before working with a broker:

Market Orders

This is an order placed by an investor to buy or sell shares of stock at the best available price.  It's called a market order because it's an order to buy or sell shares at the prevailing market price.  Since this type of order does not specify a trade price, the order is executed immediately.  When placing an order, the investor should always keep this point in mind:

A market order allows the investor to have control over the timing of the trade, but it does not allow the investor to control the price at which the trade takes place.

Limit Orders

Attempting to "time the market" is never a good idea, but there may be situations when an investor would like to have more control over the price paid for a particular company's stock.  Stop and limit orders allow the investor to have greater control over the price of the trade than a market order.

Buy and sell limit orders allow the investor to execute the trade at the limit price or better.  A buy limit order will only be executed when the stock's price falls below the limit price, thereby specifying a maximum price paid for a stock.  Sell limit orders will only be executed when the stock's price rises above the limit price.  The sell limit order allows the investor to lock in a minimum profit when the stock is sold.

Stop Orders

Also referred to as a stop-loss order, a stop order is an order to buy or sell a stock when the price of a share reaches the stop price.  These orders will only be executed when a stock's price falls below the stop price.  Sell stop orders can be used to limit the loss on a stock or lock in a profit.  Buy stop orders will only be executed when a stock's price rises above the stop price.  These orders are typically used when an investor has sold a stock short and they wish to limit a loss or protect a profit.

While a market order guarantees the investor execution of their trade, it does not guarantee price.  Stop and limit orders allow the investor to have better control over the price of the trade. However, the investor is not guaranteed the order will ever be executed.

A summary of the above two order types appears in the table below:

Stop and Limit Orders

  Limit Order Stop Order
Buy Trades: When the stock’s price falls below the limit price.
Use: Establishes the maximum price paid per share.
Trades: When the stock’s price rises above the stop price.
Use: Limit a loss or lock in profit when shares are sold short.
Sell Trades: When the stock’s price rises above the limit price.
Use: Locks in minimum profit.
Trades: When the stock’s price falls below the stop price.
Use: Limits a loss when prices are falling.

Stop-Limit Orders

Many brokerage houses also provide investors with the option of placing stop-limit orders.  This type of order combines the features found in both stop and limit orders.  With this kind of order, once the stop price is reached, the trade becomes a limit order.  As we'll see in the examples below, the stop-limit order gives the investor more control over the price of the trade than a stop or limit order.

Limit and Stop Order Examples

Now that we've discussed the basic types of buy and sell orders, we're going to illustrate how each trade type works, using an example.  To simplify the examples that follow, we'll always start by referencing stock in Company XYZ, with a current market price of $50.00 per share.

Buy Limit Order Example

In this first example, our investor would like to purchase shares of Company XYZ's stock.  The investor feels the current market price of $50.00 per share is too high, so a buy limit order is placed with a limit price of $45.00.  In this example, the buy limit order will convert to a market order to buy shares of Company XYZ's stock, if the priceper share falls to $45.00.

Sell Limit Order Example

In this second example, our investor would like to sell shares of Company XYZ's stock.  The investor would like to lock in their profit when the market price reaches $55.00 per share, so a sell limit order is placed with a price of $55.00 per share.  In this example, the sell limit order will convert to a market order to sell shares of Company XYZ's stock if the price per share increases to $55.00.

Buy Stop Order Example

In this third example, our investor would like to purchase shares of Company XYZ's stock.  The investor believes the market price of Company XYZ's stock will fall, so they have sold the stock short, hoping to repurchase the borrowed shares in the future at a lower price.  The investor also wants to limit their loss if the market price of Company XYZ's stock rises, so a buy stop order is placed with a stop price of $55.00 per share.  In this example, the buy stop order will convert to a market order to buy shares of Company XYZ's stock if the price per share increases to $55.00.

Sell Stop Order Example

In this fourth example, our investor would like to sell shares of Company XYZ's stock.  The investor is concerned the market price of Company XYZ's stock will decline below $45.00, so a sell stop order is placed with a stop price of $45.00 per share.  In this example, the sell stop order will convert to a market order to sell shares of Company XYZ's stock if the price per share falls to $45.00.

Stop-Limit Order Example

In this last example, our investor would like to purchase shares of Company XYZ's stock.  The investor only wants to buy shares of Company XYZ if their market price rises to $55.00 per share.  The investor is not interested in purchasing shares if the price rises quickly to $60.00 per share, so they place a buy stop-limit order with a stop price of $55.00 and a limit price of $60.00.  In this example, the buy stop order will convert to a buy limit order if Company XYZ's stock rises to $55.00.  The buy limit order will convert to a market order to buy shares of Company XYZ's stock if the price per share is below $60.00.

Final Words:  Stop and Limit Orders

In a volatile market, prices of stocks can vary considerably, even in the short term.  When a stop price is reached, the order becomes a market order.  In a volatile market, the stock's trade price can vary significantly from the stop price.  This possibility is what makes the stop-limit so valuable.  Even if the stop price is reached, the limit price may prevent the order from ever being executed.


About the Author - Limit and Stop Orders - Copyright © 2011 - 2016 Money-Zine.com (Last Reviewed on March 16, 2015)