Traders use all kinds of strategies to maximize their profits and minimize their losses. They often actively watch the markets, waiting for the optimal time to buy or sell investments, but they also use strategies that allow them to set up a potential trade based on how a stock performs in the future.
These trades are contingent on a stock’s future performance, and they can happen whether or not the trader is actively watching the market. The stop-limit order is one of the many set-it-and-forget-it strategies used by traders to maximize their earnings. This guide explains how stop-limit orders work, and it provides a brief analysis of their risks and benefits.
What Is a Stop-Limit Order?
A stop-limit order is a tool that allows a trader to specify the highest and lowest price at which they are willing to buy or sell a stock. The trader sets up the order in advance. If the stock reaches the target price, the order is instantly triggered. The order never gets executed, however, if the stock never reaches the target price.
The transaction is executed automatically unless the limit price is reached before the trade can be completed. Stock values are constantly going up and down, and if the value goes beyond the limit set by the trader, the transaction gets halted.
How-Stop Limit Orders Work
Stop-limit orders combine the features of stop orders and limit orders. A stop-limit order allows a trader to identify a trade they would like to make if a stock moves in a certain direction.
The ability to set up the stop order in advance ensures that the trade happens even if the trader doesn’t personally notice the shift in price, but the limit insulates the trader against risk and helps to ensure that the transaction is as favorable as possible. Traders who want to initiate these types of trades must decide on the following elements.
The stop is the starting level of the chosen target price for the trade. Say a trader has a stock worth $170 and they want to sell when it reaches $180. They can set $180 as their stop, and the trade will be executed when the stock reaches $180 in value.
The trade will go through regardless of how much the price changes during the execution of the trade with a traditional stop order. Adding the limit component, however, changes this part of the process.
The limit refers to the least favorable price the trader is willing to accept for the trade, and it becomes active as soon as the stop order is triggered. Imagine the stock in the above example has reached a value of $180, triggering the stop order, but before the trade can be completed, the stock’s value drops to $169.
The investor would lose money if the trade went through at this value. The limit helps to prevent the risk of loss because it allows the investor to specify a limit at which they want to cancel the transaction. The trader in this example may want to set a limit of at least $171 to ensure they earn some profit with their trade, but in other cases, they may want to use their limit to minimize their potential losses.
The trader must also specify the timeframe during which the order is valid. They can choose to have the order valid for a day, for example, and the order expires at the end of the market session. Note that all stop-limit orders are executed during the day when the markets are open.
They can also opt for nearly any range of time in the future, and if desired, they can even set up a good-till-canceled (GTC) order that stays in effect until it is triggered or canceled.
The stop order is not visible to the market. The trader can set up these orders discreetly, but once the stop order is triggered, the limit becomes visible to the market. This visibility lets other traders see the prices a broker is willing to accept on a transaction.
Advantages and Disadvantages of Stop-Limit Orders
Stock-limit orders come with upsides and downsides, and they need to be used carefully if you want to protect your assets. You should understand these pros and cons before making a stop-limit order.
Ability to Buy or Sell
A stop-limit order comes with built-in flexibility. You can use these orders to buy or sell stocks, and as explained above, you can essentially set the order and forget it. You don’t have to actively monitor your target investments once you have set up the order.
The main disadvantage of a stop-limit order is that they are never guaranteed to go through. The order will never be triggered if the stop price isn’t reached, and it won’t go through if the stock’s value goes past the limit threshold.
The trader may end up holding stocks that have lost value, or they may end up missing out on a potentially lucrative buy. You must be very strategic about the numbers you select to ensure that your efforts to maximize profits and minimize losses don’t prevent you from benefiting from a lucrative deal.
Stop-limit orders can be partially filled. This happens when the order gets triggered, but there are not enough stocks available to meet your order. Part of the order will go through, but you will not be able to buy or sell the total number of stocks identified in the order.
Consider working with an independent broker or a financial advisor if you want to ensure that you’re using stop-limit orders as effectively as possible. They can help set up the order and guide you toward the optimal thresholds for it.
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