What is a limit order?

What is a limit order?

Looking for a limit order definition? A limit order is an order made with a brokerage firm or bank for the sale or purchase of a certain financial instrument at a designated price or better. A limit order will only be executed once the security reaches that price, or improves on it.

Limit orders are generally used as part of an overall strategy. Their use ensures that a tight rein is kept on that strategy and prevents an investor from buying too high or selling too low. They are also used as a means of controlling the price of a security or commodity.

Where have you heard about limit orders?

If you’ve ever dabbled in trading securities, it’s a phrase you’ll have already encountered. Limit orders are not dissimilar to market orders and they make up the basic building blocks of trading. When someone first begins learning how to trade on the stock market, limit orders are one of the first concepts an investor will learn about.

What you need to know about limit orders…

Limit orders vs. Market orders

There are two basic options when an investor makes an order to buy or sell stock: the order can be placed, “at limit” or “at market”. The former instructs brokers to execute the order only at or above a market selling price, or at or below a buying price. Market orders, on the other hand, are an instruction to execute at the present or market price as quickly as possible.

A market order is more concerned with the actual execution of the order, with the price of the security being a secondary factor. Limit orders place the price over the timing in terms of priority.

How a limit order works

Let’s say you want to buy stock in Zed Inc. at £30. At present, Zed stock is trading at £32, so you can create a limit order to buy at £30. It’s possible that the price could go up or go down, but with a limit order you know that as soon as the price hits that all-important £30 mark, the order will be executed, and you’ll buy at the price you stipulated.

So, you’ve bought your stocks in Zed Inc. at £30, now let’s say that you want to sell them at £35. As before, you place a limit order and simply wait. When Zed trades at £35, your limit order is executed, and your stock is sold at the target price of £35.

It’s worth noting that your trade won’t be executed if the price of the stock doesn’t ever reach the limit price. Also, bear in mind that some brokerage firms charge extra to use limit orders than they do for market orders.

In volatile market environments, limit orders are particularly useful. If, on a volatile day, a £30 stock is trading between £30 and £40, investors who are using market orders will be at a real disadvantage. This is because they have no control over the price at which they are bought and sold. By using a limit order, one can be protected against buying too high or selling too low.

Buy limit orders

A buy limit order deals with the purchasing of a specified quantity of securities at or below a stipulated price. Using buy limit orders is a common practice amongst investors and traders because it provides a mechanism, in the specified sale price, for them to guarantee profits and limit losses.

An example of buy limit orders

You’d like to buy 100 shares of XYZ Inc. You know that you don’t want to pay more than £10 per share for XYZ stock. By placing a buy limit order, you have instructed your brokerage firm to buy 100 XYZ shares at £10 or less each, meaning a total of £1,000.

Sell limit orders

A sell limit order is basically the other side of the buy limit order coin. It deals with the sale of a specified quantity of securities at or above a stipulated price. This price is known as the limit price.

An example of sell limit orders

Following on from the previous example, you’ve bought 100 shares of XYZ Inc. for a total of £1,000 (£10 per share), you would now like to sell them on. The shares are now currently trading at £12 each. Your broker advises you that they are not likely to reach much higher than £15 per share, so you set that price in a sell limit order. When the stock in XYZ Inc. reaches the specified price, they will be sold at that price or higher, so long as the stock’s price remains at or above £15 for the time it takes to fully execute the order.

In a few weeks, the price hits the £15 mark, and so long as it remains there or above, your shares will be sold for £15 each, a total of £1,500, giving you a profit of £500.

Stop-loss orders vs. Stop-limit orders

A stop-loss order, also known as just a stop order, is generally used to mitigate loss or protect profits on a stock that has been sold short. It is an order which instructs a broker to buy or sell a stock when it hits the “stop price”, which will have been specified previously.

A stop-limit order, as the name suggests, is a combination of the features of a limit order and a stop-loss order. When a stock hits the “stop price”, a stop-limit orderbecomes a limit order, and automatically executes to buy or sell at the pre-determined price. It enables investors to keep some level of control over the price at which buying and selling occurs. It is another order designed to mitigate losses.

An example of a stop-limit order

Internal issues with corporate management at XYZ Inc. have received widespread media attention and created volatility in the company’s shares, which you bought for £10 each. You’ve made calculations and worked out that you can afford to lose no more than £2 per share, so you create a stop-limit orderfor a stop price of £8. In the eventuality that the price falls to £8, the stop price will trigger a limit order to sell at £8. The stop-limit orderensures that your stock won’t be sold for less.

The big and important difference between a stop-loss order and a stop-limit order is that when stock in XYZ hits £8 and the stop price is triggered, a stop-loss order will become a market order, whereas a stop-limit orderbecomes a traditional limit order. So, with the former, if the price continues to drop and is at £7 per share by the time the market order is executed, then you’ll only receive that much per share.

Limit order books

A limit order book (LOB) is a trading tool used by most exchanges across the world. It is a register of all the orders that have been placed by buyers and sellers covering a security. It includes the parties interested in buying or selling, the number of shares and the specified price. The limit order book is constantly kept updated in real time over the course of the trading day. The information contained in the order book allows traders to make better informed decisions regarding their trades, as they are able to see which institutions are buying or selling and therefore by whom the market is being driven. The order book also provides hints as to the stock’s short-term direction because it shows order imbalances. If, for example, there is a large imbalance between buy and sell orders, it could indicate a higher move as a result of buying pressure.

The order book’s usefulness is, however, mitigated to some extent by the presence of the ominously named “dark pools”. These are groups of hidden orders kept by larger clients who want their trading intentions to be concealed from other traders. The presence of dark pools means that there is no real way of knowing if the information shown in order bookis truly representative of a stock’s actual supply and demand.

Find out more about limit orders…

WikiHow have a useful step-by-step guide for new investors on placing limit orders, that will take you through every stage; from the decision to use one, to choosing a type, to placing the order.