There is risk involved when investing in the stock market, especially for active investors who trade securities frequently. A stop limit order is one of the trading tools that active investors can use to limit their risk.
This tool enables you to trade securities automatically, without having to place buy and sell orders manually. It gives you more control over the price at which stocks are bought and sold.
A stop limit order is kind of a hybrid trading tool that utilizes the features of a stop loss order and a limit order. A stop loss order is an order to trade a stock when it reaches a certain price, which is referred to as the stop price. An investor would enter a buy stop order at a stop price higher than the current price in order to limit loss or to protect profits on a stock he or she has sold short. Conversely, an investor would enter a sell stop order at a stop price lower than the current price in order to limit loss or to protect profits on a stock he or she currently owns.
A limit order is an order to trade a stock when it reaches a certain price (the limit price) or better. A buy limit order is executed at or below the limit price, while a sell limit order is executed at or above the limit price. The limit order guarantees that an investor will not pay more than a set price for a given security.
By using a stop limit order, you gain greater control over the execution of a security’s trade. The following example helps illustrate how a stop limit order works:
John has been following the stock of ACME Corporation, but doesn’t want to buy it until it gains some momentum and reaches a certain price. However, he doesn’t want to pay too much for the stock, either, if the price rises too high. ACME Corp. stock is currently trading at $50 per share and John decides that he wants to buy at $53, so he enters a stop limit order to buy if it hits this price.
However, John thinks that $55 is too steep for ACME Corp. stock, so he sets a limit price of $55. If the price exceeds this amount, the buy order is cancelled. In effect, the buy order is only executed if the price of ACME Corp. stock is between $53 and $55.
The main benefit of a stop limit order is that is it guarantees that you will not pay too much for a stock. The main drawback is that there is not a guarantee that the trade will be executed. This could result in investment losses if the stock price is especially volatile.
Stop limit orders are fairly sophisticated trading tools used primarily by active investors buying and selling individual stocks. If you are this type of investor, you might want to learn more about stop limit orders and how they could give you more control over the prices at which you are buying and selling securities.