What Is a Stop-Limit Order and How Does It Work?
Learn about an advanced trading order designed to manage market risk and achieve specific execution prices.
Understanding various trading orders is fundamental for individuals navigating financial markets. These instructions direct how and when to buy or sell securities, allowing participants to implement specific strategies and control their trades.
Understanding Stop Orders
A stop order is an instruction to buy or sell a security once its price reaches a predetermined level, known as the “stop price.” Its main purpose is to limit potential losses or protect accrued profits. Once the market price touches or passes the stop price, the stop order automatically converts into a market order.
This conversion means the trade will be executed at the best available price. While a stop order assures execution once triggered, it does not guarantee the exact price. In volatile markets, the actual fill price might differ from the stop price due to rapid changes, a phenomenon known as slippage. For instance, if a stock is trading at $50 and a sell stop order is placed at $48, if the price falls to $48, it becomes a market order and sells at the next available price, which could be $47.90 or lower.
Understanding Limit Orders
A limit order is an instruction to buy or sell a security at a specific price or better. For a buy order, it executes at the limit price or lower; for a sell order, at the limit price or higher. The objective of a limit order is to ensure a trade executes at a desired price, providing price control.
While the price is guaranteed with a limit order, execution is not. If the market price never reaches the specified limit price, the order will not be filled. This means an investor might miss a trade if the market moves away from their desired price. For example, a buy limit order at $50 for a stock trading at $55 will only fill if the price drops to $50 or below.
The Mechanics of a Stop-Limit Order
A stop-limit order combines features of both a stop order and a limit order, offering more control over trade execution. This order type involves two distinct prices: a “stop price” and a “limit price.” The stop price acts as the trigger, while the limit price sets the acceptable execution price.
When the market price reaches the stop price, the stop-limit order transforms into a limit order. This limit order then attempts to execute at the specified limit price or a more favorable price. For example, a sell stop-limit order with a stop price of $90 and a limit price of $89 means if the stock falls to $90, a limit order to sell at $89 or higher is placed. This mechanism limits potential losses while preventing execution at an undesirable price, which can happen with a standard stop order in volatile markets.
Placing a Stop-Limit Order
Placing a stop-limit order on a trading platform involves a few specific steps. First, an investor selects the “stop-limit” order type from the available options. Next, the quantity of shares or contracts to be traded must be entered. The investor then specifies the predetermined stop price, which will activate the order, and the limit price, which dictates the acceptable execution price range.
For a buy stop-limit order, the limit price is typically set at or above the stop price, while for a sell stop-limit order, the limit price is usually set at or below the stop price. In addition to price parameters, investors also typically set a “time in force” instruction for the order. Common time in force options include “Day,” meaning the order is active only until the end of the current trading day, or “Good ‘Til Canceled” (GTC), which keeps the order active until it is filled or manually canceled by the investor, often for a period of up to 90 days. Once all parameters are set, the order can be reviewed and submitted to the brokerage.