What is a stop-limit order?
Stop-limit order is a core risk management tool used by traders to minimise losses and maximise returns. The tool allows traders to set the highest or lowest asset price that they are willing to accept. The stop-limit order combines features of a stop-loss and limit order.
It is a form of conditional trading that takes place over a specific timeframe and allows traders control over when the order should be executed. Put simply, for traders a stop-limit order means locking in profits or limiting losses. It’s important to note, however, that even with efficient risk management, all trading contains risk.
How do stop-limit orders work?
Before executing a stop-limit order strategy, traders should know what market scenario is needed for it to work.
The process requires two price point settings: stop and limit. The stop price point marks the beginning of a specific price target for the trade, while the limit gives us the outside of the price target. A trader must then select a timeframe in which the stop-limit order can be executed.
After the stop price is triggered, the limit order takes over. This ensures that the order is not executed unless the price is at the limit price or better than the limit price specified by the trader.
There are two main stop-limit orders that traders can use:
Buy stop-limit order – used to purchase an asset if the price hits a specific point
Sell stop-limit order – used to sell an asset when its price falls down to a specific level
Stop-limit order example
Let’s go through an example for more clarity. A trader holds shares of X company at $100 per share. According to their analysis, if the price falls to $98, it could continue to move lower. So, with the intention of limiting downside risk to $2, the trader sets a stop at $98 and places a limit at the minimum price they are willing to sell the shares; let’s consider that to be $95.
The stock closed at $100, however, an after-hours earnings announcement showed the company’s performance was disappointing, pushing the stock price lower. Next day, the stock opened at $90.
As the trader had set a stop-limit order, the stop order was triggered, but it did not get executed as the price did not hit the limit of $95. The price rebounded and the limit price helped the trader to avoid greater loss.
In another example, a trader may want to put a stop-limit order to buy 100 shares of Y company, when the price hits $10, with an upward limit of $10.5. In this case, $10 is the stop level, which triggers a limit order of $10.5.
The stop-limit order tool can be helpful for day and swing traders who cannot watch the markets all day, or for those who trade stocks with thin trading volumes.