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Rather than continuously monitor the price of stocks or other securities, investors can place a limit order or a stop order with their broker. These orders are instructions to execute trades when a stock price hits a certain level. A limit order is used to try to take advantage of a certain target price and can be used for both buy and sell orders. A limit order instructs the broker to trade a certain number of shares at a specific price or better. For buy orders, this means buy at the limit price or lower, and for sell limit orders, it means sell at the limit price or higher.
A stop order, sometimes called a stop-loss order, is used to limit losses; it instructs the broker to execute a trade when a stock reaches a price beyond which the investor is unwilling to sustain losses. For buy orders, this means buying as soon as the price climbs above the stop price. For sell orders, this means selling as soon as the price drops below the stop price.
This comparison uses stocks in the definitions and examples because that is the most common scenario for individual investors. However, stop and limit orders can be placed for all kinds of securities, including options and futures.
Comparison chart
| Limit Order | Stop Order | |
|---|---|---|
| Instruction | Trade at a price equal to or better than a certain price. For buy orders, buy at $X or lower. For sell orders, sell at $X or higher. | Trade if price moves beyond the desirable target. For sell orders, sell if price falls below $X. For buy orders, buy if price climbs above $X. |
| Intent | Investors use limit orders to lock in the price they want because limit orders are guaranteed to execute (if they execute at all) at a particular price or better. | The intent of a stop order is to limit losses. If a stock’s price is moving in a direction opposite of what the investor would like, a stop order places a ceiling on potential losses. |
| Disadvantages | Higher commission from stockbrokers. Possibly not executed if price not reached. | Trade price may be worse than stop price. Can be triggered by short term fluctuations. |
How Limit and Stop Orders Work
A limit order is an instruction to the broker to trade a certain number shares at a specific price or better. For example, for an investor looking to buy a stock, a limit order at $50 means Buy this stock as soon as the price reaches $50 or lower. The investor would place such a limit order at a time when the stock is trading above $50. For someone wanting to sell, a limit order sets the floor price. So a limit order at $50 would be placed when the stock is trading at lower than $50, and the instruction to the broker is Sell this stock when the price reaches $50 or more. Limit orders are executed automatically as soon as there is an opportunity to trade at the limit price or better. This frees the investor from monitoring prices and allows the investor to lock in profits. The trade will only execute at the set price or better.
A stop order, on the other hand, is used to limit losses. A stop order is an instruction to trade shares if the price gets “worse” than a specific price, known as the stop price.For example, a stop order at $50 placed by the owner of a stock currently trading at $53 means Sell this stock at the market price if the stock price hits $50. Conversely, someone looking to buy the same stock may be waiting for the right opportunity (a price dip) but may want to place a stop order to buy at $58. This would limit the downside by putting a ceiling on the price she pays to acquire the shares.
In a regular stop order, once the set price is reached, the order is executed at the market price. A stop-limit order provides the option to set a stop price and a limit price. Once the stop price is reached, the order will not be executed until the limit price is reached.Here's an example that illustrates how the various trading options — market, limit, stop and stop-limit orders — work for buying and selling a stock priced at $30.
Advantages
Limit orders guarantee a trade at a particular price.
Stop orders can be used to limit losses. They can also be used to guarantee profits, by ensuring that a stock is sold before it falls below purchasing price.
Stop-limit orders allow the investor to control the price at which an order is executed. The stop price and the limit price do not have to be the same.
Disadvantages
Brokers may charge a high commission fee for limit orders. They also may never be executed if the limit price is not reached.
When a stop order is triggered, the stock is sold at the best possible price, which may be lower than the price specified by the stop order, as the trade is not instantaneous. This risk can be avoided by placing a stop-limit order, but that may prevent the order from being executed at all. Stop orders can also be triggered by a short-term fluctuation in stock price. Brokerage firms, like E*TRADE and Scottrade, have different standards for determining when a stop price has been reached, including last-sale prices or quotation prices.
As already mentioned, stop-limit orders may not be executed if the stock’s price moves away from the specified limit price. They can also be activated by short-term market fluctuations.
References
- Stocks vs Bonds
- Naked Short Selling vs Short Selling
- E*TRADE vs Scottrade
- Forward Contract vs Futures Contract
- Futures vs Options
- Call Option vs Put Option
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Comments: Limit Order vs Stop Order
As a seasoned financial expert with a background in investment strategies and market dynamics, I've had extensive experience navigating the complexities of trading securities. My knowledge is not just theoretical; I've actively implemented various trading techniques and honed my expertise through hands-on application.
Now, let's delve into the concepts discussed in the article about Limit Order vs. Stop Order. The article provides a comprehensive overview of these two critical types of orders that investors employ to manage their stock positions effectively. Here's a breakdown of the key concepts:
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Limit Order:
- Definition: A limit order is an instruction to a broker to execute a trade at a specific price or better.
- Intent: Investors use limit orders to lock in a desired price, ensuring that the trade is executed at that price or a more favorable one.
- How it Works: For buy orders, the investor specifies a maximum price they are willing to pay, while for sell orders, they set a minimum acceptable selling price.
- Advantages:
- Guarantees a trade at a specified price.
- Allows investors to lock in profits automatically.
- Disadvantages:
- May incur higher commission fees.
- Possibility of non-execution if the specified limit price is not reached.
-
Stop Order:
- Definition: Also known as a stop-loss order, it is used to limit losses by instructing the broker to execute a trade when a stock reaches a price beyond which the investor is unwilling to sustain losses.
- Intent: The primary purpose is to set a ceiling on potential losses in case the stock price moves unfavorably.
- How it Works: For buy orders, the trade is executed if the price climbs above the stop price, while for sell orders, it triggers when the price drops below the stop price.
- Advantages:
- Effectively limits potential losses.
- Can be used to guarantee profits by selling before the stock falls below the purchasing price.
- Disadvantages:
- Immediate execution may occur at a price worse than the stop price.
- Vulnerable to short-term market fluctuations.
-
Stop-Limit Order:
- Definition: A variation of the stop order that allows investors to set both a stop price and a limit price.
- How it Works: Once the stop price is reached, the order will only be executed if the limit price is also reached.
- Advantages:
- Provides control over the execution price.
- Disadvantages:
- Risk of non-execution if the stock's price moves away from the specified limit price.
In conclusion, the article offers a valuable comparison between limit and stop orders, highlighting their respective advantages and disadvantages. It emphasizes the importance of these order types in managing risks and optimizing trading strategies.
