Using Limit Orders When Buying or Selling Stocks
Take more control over your trading outcomes
When managing your stock market trades, many techniques and tools exist to help you make a profit or reduce a loss. One of these toolkits can be accessed while placing an order. Understanding your order options will help you choose the right tool for the job at hand.
One of these order tools is called a limit order. This helps you control how much you spend or earn on a trade. Many traders find the limit order to be one of the most important and useful tools in their arsenal.
How Limit Orders Work
Limit orders can be set for either a buying transaction or a selling transaction. They serve essentially the same purpose either way, but on opposite sides of a transaction. A limit order gets its name because using one effectively sets a limit on the price you are willing to pay or accept for a given stock. You tell the market that you'll buy or sell, but only at the price set in your limit order.
Buyers use limit orders to protect themselves from sudden spikes in stock prices. Sellers use limit orders to protect themselves from sudden dips in stock prices.
The opposite of a limit order is a market order. A broker will execute your buy or sell transaction with a market order as soon as possible, regardless of price. If you're new to trading and have been using the default setting on brokerage apps, you've most likely been placing market orders. For stable stocks with high volume, market orders often execute at a price that's close to the trader's expected order. However, volatile stocks with low volume experience more rapid price swings, and there's a possibility that you could end up paying much more than you expected for a buy, or earning far less than you anticipated from a sell.
One thing to keep in mind with limit orders is that they may or may not go to the top of the list for execution by your stockbroker. If the price on your limit order is the best ask or bid price, it will likely be filled very quickly. If not, it will get in line with the other trade orders that are priced away from the market. As other orders get filled, your order may work its way to the top. On the other hand, orders priced closer to the current market may come in and push your order down on the list.
Although they do have some flaws, some consider limit orders a trader's best friend, because they provide certain assurances for traders. Your order will only be filled at the price you set, or better.
Placing a Trade With a Limit Order
Your broker will ask you to specify five components when placing any kind of trade, and this is where you'll identify the trade as a limit order:
- Transaction type (buy or sell)
- Number of shares
- Security being bought or sold
- Order type (this is where you'll specify that this is a limit order, as opposed to a market order or another type of order not discussed on in this piece)
For example, let's say you want to buy 100 shares of a stock with the ticker XYZ, and the maximum price you want to pay per share is $33.45. In that case, you'd use a limit buy order, and you would express it like this:
Buy 100 shares XYZ limit 33.45
This order tells the market that you will buy 100 shares of XYZ, but under no circumstances will you pay more than $33.45 per share for the stock.
Limit orders are not absolute orders. Your limit order to buy XYZ at $33.45 per share won't be filled above that price, but it can be filled below that price—and that's good for you. If the stock's price falls below your set limit before the order's filled, you could benefit and pay less than $33.45 per share. On the other hand, if the price goes up and the limit isn't reached, the transaction won't execute, and the cash for the purchase will remain in your account.
The transaction works the same way for a limit sell order. If you enter a limit sell order for $33.45, it won't be filled for less than that price. In other words, your stock won't be sold for any less than $33.45 per share. If the stock rises above that price before your order is filled, you could benefit by receiving more than your limit price for the shares. If the price falls and the limit isn't reached, the transaction won't execute, and the shares will remain in your account.
Benefits of Experience
It takes some experience to know where to set limit orders. If you set limit buy orders too low, they may never be filled—which does you no good. The same holds true for limit sell orders. With some experience, you'll find the spot that gets you a good price while making sure your order actually gets filled.
An Example of a Potential Issue
The simple limit order could pose a problem for traders or investors not paying attention to the market. For example, let's say you enter a $30 sell limit order on XYZ stock before taking a week off for vacation. You check in your portfolio the next Monday and find that your limit order has executed. You made a small profit off the sale, and you're happy with that, but then you see that XYZ's current price is $45.
So what happened? Well, while you were on vacation, XYZ became a merger target, and the stock's price spiked. Your order executed at $30 that day, but the price kept rising on the rumors of a lucrative merger. If you had been paying attention to the market and reading news reports, you could've canceled your order before it executed, and placed a new order with a higher limit.
You can imagine the reverse of this hypothetical scenario—the stock dropped like a rock on bad news while you weren't paying attention, and your buy limit order filled as the stock was in a free fall.
The Bottom Line
Limit orders make excellent tools, but they are certainly not foolproof. The same function that protects you from extreme losses can also prevent you from realizing unexpected gains. In a highly volatile market, limit orders like the example above may cause you to lose out on additional profits or shares, because the limit orders execute too soon.
If you want to buy or sell a stock, set a limit on your order that is outside daily price fluctuations. Ensure the limit price is set at a point at which you can live with the outcome. Either way, you have some control over the price you pay or receive.