The Use of Stop-Limit Orders in Trading

What is a stop-limit order?

A stop-limit order is a combination of a stop order and a limit order, a trading tool used by traders to reduce trading risks when trading assets, such as securities, currencies, or commodities, in financial markets. A stop-limit order, commonly referred to as a stop-limit, enables a trader to set a stop price with a stop order, instructing a broker to buy or sell a certain number of an asset when its price reached a specific level. (The spot price refers to the current market price at which a given asset can be bought or sold.) Simultaneously, the trader places a limit price via a limit order, ordering the broker to purchase or sell a specific number of an asset when its price reaches a specified price. A stop-limit order is executed when the price of an asset reaches a specified price, when the stop-limit becomes a limit order, buying or selling the asset at the limit price or better. Bear in mind, when a stop order is triggered at the specified price, it will be executed at the current market price, implying that it could be filled at a price significantly different from the stop price. In contrast, a limit order will only be filled at the specified limit price or better.  

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Trading with stop-limit orders

Traders use stop-limit orders to exercise complete control over the execution of a trade. Although, stop-limits are not guaranteed to be filled. They are a viable choice if a trader wants to buy or sell an asset, but not at any cost. Furthermore, stop-limit orders enable traders to generate profits or lessen downside losses. When placing a stop-limit, traders are required to specify a time frame in which the stop-limit order is valid and considered executable. Traders can also choose a good-till-cancelled (GTC) option. Otherwise, a stop-limit order is active until the spot price is triggered to buy or until the transaction ceases.  

Two stop-limit orders frequently placed by traders

A buy stop-limit order and a sell stop-limit order are the two stop-limits most frequently placed by traders.

• Buy stop-limit order

Traders use a buy stop-limit order to buy an asset when the price reaches a certain level. It allows traders to control the purchase price of an asset after they have decided on an appropriate maximum price for the given asset. Once a trader has indicated the highest price he or she is prepared to pay for the specific asset, a stop price and limit price are set. The stop price refers to a price that is placed above the market price of the asset, while the limit price is the highest price a trader is prepared to pay for the asset. For instance, a trader plans to purchase HHH Limited shares, currently traded at R100 per share, expected to increase in value during the trading day. The trader decides to place a stop order at R110, meaning that once the share price hits R110, the trade is filled, and the order becomes a market order. If the limit order’s limit price is R115, the order is executed after reaching R110. However, if it rises above R115, it is not executed.  

• Sell stop-limit order

A sell stop-limit order is an order by a trader to a broker on condition to sell a particular asset when its price reaches a specific price, referred to as the stop price. A sell stop price includes two prices - a stop price and a limit price. A stop price refers to a price level at which the limit order to sell is triggered, while the limit price is the lowest price that the trader is prepared to go along with. A sell stop order instructs a broker to sell the specified asset if its price falls to the stop point or below, although only if the trader receives a specific price for the asset. For example, if the current market price of a share of HHH Limited is R120, the trader can place a stop order at R110 and a limit order at R105. The order is filled when the price drops to R110, but not lower than R105. Below the price of R105, the order will not be executed.  

What is the difference between a stop-limit order and a stop-loss order?

Stop-limit orders and stop-loss orders are both orders that are triggered when a given asset reaches a certain price level. A stop-loss order becomes a market order when the price of a given asset reaches the stop price. However, because of market volatility, the order may not be filled at the spot price, but at the next available market price, which could be significantly below the stop-loss level. A stop-limit order is a stop-loss order that, instead of becoming a market order, becomes a limit order when the stop price is reached. The limit order will only be filled at the limit price or better.  

Pros of stop-limit orders

• They allow traders to exercise more control when trading assets in the financial markets.
• Stop-limit orders combine the features of a stop-loss order with those of a limit order, enabling traders to execute effective risk management to mitigate risk when buying and selling assets in the financial markets.
• Buy stop-limits as well as sell stop-limits can be used to get the best price for a given asset.
• Traders can decide how long stop-limit orders are valid in a particular market.

 

Cons of stop-limit orders

• The execution of stop-limit orders is not guaranteed because the market price may never outdo the limit price.
• They can result in partial fills, meaning only a part of the orders is actually executed.

  This article does not intend to provide investment or trading advice. Its aim is only informative.

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