When you trade securities on the stock market, you usually do so at the spot price. In other words, the broker executes your orders at the prevailing market price when you place the order.
But in some cases, it can be convenient to place orders that execute at a time in the future, especially if you anticipate sharp price changes. This is where buy limit orders and stop loss orders come in. These orders are only executed when the price of an asset reaches certain levels.
A buy limit order is used when an investor wants to open a long position in a stock at a certain price, while a stop order is used by an investor who wants to lock in profits or limit losses by exiting a position. A stop order is also known as a stop loss order if it is being used to limit the amount of losses on a stock trade.
Key Takeaways
- Limit and stop orders are orders to buy or sell an asset when the price meets certain conditions, rather than the spot price.
- A buy limit order is an order to buy an asset, but only if the price is at or below the limit price.
- A stop loss order is an order to sell an asset, but only if the price falls to a certain level.
- Both types of orders can be used to avoid emotional trading.
- They are also useful for investors who cannot continuously monitor the market price.
Buy Limit Orders
A buy limit order is an instruction to your brokerage to buy an asset, but only if the price is at or below a certain level. For example, if you expect the share price of XYZ Corp. to drop from $50 to $40, you might place a buy limit order at $42 in order to buy the dip.
It is important to note that if the stock never falls to the limit price, the order will not be filled. Moreover, if only a small number of shares are available at the limit price, the order may be only partially filled. Further, many investors place time limits on how long the limit order is in effect. Limit orders can be canceled automatically if not filled during a set time.
Further, many investors place time limits on how long the limit order is in effect. Limit orders can cancel automatically if not filled during a set time. used when an investor wants to open a long position in a stock at a certain price, while a stop order is used by an investor who wants to lock in profits or limit losses by exiting a position. A stop order is also known as a stop loss order if it is being used to limit the amount of losses on a stock trade. A stop order can be used to exit a long or short position in a security. It does not only apply to long positions.
Buy limit orders are not guaranteed to fill. If the stock never falls to the limit price, the order is not filled. Further, many investors place time limits on how long the limit order is in effect. Limit orders can cancel automatically if not filled during a set time.
427 billion
The number of financial events that occur in U.S. markets every trading day, according to the Financial Industry Regulatory Authority.
Stop Loss Orders
A stop order is used by an investor who wants to lock in profits or limit losses by exiting a position. A stop order can be used to exit a long or short position in a security. It does not only apply to long positions.
A stop order is also known as a stop loss order if it is being used to limit the amount of losses on a stock trade. This is an order to sell a stock once the price falls to a specified price, known as the stop price.
When the stop price is reached, a stop order becomes a market order.This is an important distinction since, once triggered, market orders can execute either close to the stop price, or possibly significantly below or above the strike price, especially when trading in extremely volatile market conditions.
This can help an investor who cannot monitor a stock position closely. A stop order may also take some of the emotion out of trading by allowing the investor to exit or enter a position automatically, once a stock reaches a certain price.
When a stop loss becomes a market order, it can result in a substantially worse fill. It's common for a stock to gap above or below the prior day’s close. Therefore, investors need to understand the risk associated with different order types.
Why Would Someone Consider Using a Limit or Stop-Loss Order?
Stop and limit orders place trades according to future price movements. A stop loss order is an order to sell an asset if the price drops below a certain level, and a limit order to execute the trade at the limit price (or better).
What's the Disadvantage of Using a Limit Order?
The main disadvantage of a limit order is that there is no guarantee that the order will be filled. If the spot price does not reach the limit price, or if only a small number of shares are available, then the trader may lose out on a potential opportunity.
What Is the 7% Stop Loss Rule?
The 7% stop loss rule is a rule of thumb to place a stop loss order at about 7% or 8% below the buy order for any new position. If the asset price falls by more than 7%, the stop-loss order automatically executes and liquidates the traders' position. This level is chosen because it is relatively rare for a strong stock to lose more than 8% of their value.
The Bottom Line
Stop and limit orders offer a convenient way to automate future trades and avoid panic selling or buying. Rather than having to meticulously watch current price movements, the trader simply places an instruction to buy—or sell—a security when the price reaches certain conditions.
