When making investments in assets like stocks, the price you buy and sell at has a clear and direct impact on your total returns. Yet many people don't look too closely into optimizing the execution price on their trades. You might think that buying a stock for $100 vs. $101 isn't a big deal, for example, but if you're dealing with 100 shares, that's a $100 difference. When adding up these small differences over many trades over many shares across many years, the results can be dramatic.
So, one way that investors can potentially gain more control over their trades and better manage risk is to use stop-limit orders, rather than market orders.
Both have their place, but market orders simply execute trades at whatever the next market price is that a broker can fill your order. The market price is based on what other investors are offering to buy or sell securities at. Maybe the stock market is falling and you want to liquidate some positions, so you put in a market order to quickly execute a trade. However, if the market price changes rapidly, that could mean that you end up selling for less than you'd ideally like.
Another option is to use stop-limit orders to add more control over your order. A stop-limit order combines the features of a stop order and a limit order.
A stop order, also known as a stop-loss order, specifies the price at which you want to trigger an order. For example, if a stock is trading at $101, maybe you're not ready to sell yet, but if it falls to $100, you would be. Once a stop order price is reached, the order turns into a market order, meaning your trade would go through at the next market price your broker can fill.
However, stop orders carry some of the risks of regular market orders, as you might not get the price you want. In the scenario above, maybe the stock falls below $100 but crashes so quickly that your broker can only execute the trade at $95.
Meanwhile, a regular limit order specifies the minimum price at which you'd sell or the maximum price at which you'd buy a security. For example, a sell limit order of $99 means you'd sell a stock at any price of $99 or better. However, if you put that limit order in while the stock is trading at $101, for example, it would execute at $101, because that's better than the limit you set. But if you put in a stop-limit order of $100 as the stop price and $99 as the limit price, then the trade would only execute if the stock falls to $100 or below, yet can be executed at $99 or above.
In other words, a stop-limit order helps you set the parameters for when you want to trigger an order along with the price at which you're willing to execute that order.
How stop-limit orders work
Stop-limit orders combine the features of stop orders and limit orders to create a powerful strategy for investors to control costs. Investors need to set two price points:
- The stop price
- The limit price
The stop price you set triggers what's essentially the start of the order. If the stock hits or passes through that price, then the broker will execute the order if — and only if — the price is also within the limit you set. This can be used for both buy and sell orders, such as if you set a stop limit to buy a stock as it's rising or a sell stop-limit order to control the maximum loss you'd take.
"When trading, you can observe the market price and decide to buy or sell at any given moment, or you can condition the process so that it only activates once the price hits or exceeds the price point A (the stop) but does not break through the price point B (the limit). The latter option is called a stop-limit order," explains Adam Garcia, founder of TheStockDork.com. "So you're basically looking to buy the stock once it starts getting on an upward trajectory. On the other hand, there's only so much that you can afford to pay, which is why you need to cap it."
Order activation
Stop-limit orders activate based on two main triggers.
First, the stop price must be reached. Once that happens, the order essentially becomes a traditional limit order. That means the trade will only execute if the price hits the limit price or better (either above or below, depending on if it's a buy or sell order).
Let's say you have a stop price of $50 and a limit price of $49 on a sell stop-limit order for a stock currently trading at $51. If the stock starts falling and hits $50 or below, an order would be triggered if the broker can execute the trade at $49 or above. But in select cases, the stock might drop too quickly for the stop-limit order to go through. If the stock gaps down from $50.01 to $48.99 essentially instantly, for example, then the order wouldn't go through, because even though it's below the stop price, it falls outside of the limit.
Important: Just because you place a stop-limit order doesn't mean it'll actually go through. The market conditions must activate the order set by your stop and limit prices.
An investor can execute a stop-limit order on their trades through their investment brokerage firm, though not all brokerages may offer this option. Additionally, brokerages may have different definitions for determining if a stop or limit price has been met, such as with some using the last trade price and others using real-time market quotes.
Traders set a period of time when the stop-limit order is effective or can choose the good-til-canceled (GTC) option through some brokers. Through these options, the stop-limit order is active until the price is triggered to buy or until the transaction expires. Stop-limit orders are generally only executed during market hours, as opposed to market orders that sometimes occur during after-hours trading.
"You need to specify the timeframe in which this trade is going to be executed. But considering that this trade is conditioned, there's no guarantee that it will actually happen. To make matters worse, this timeframe only includes regular trading hours. If a portion of your order gets executed today and the rest of it gets allocated across several days, your broker may charge several commissions instead of just one," warns Garcia.
Quick tip: Find out if your brokerage firm allows for stop-limit orders and how they set the parameters to execute an order. For example, some may use the last-trade price whereas others use real-time quotation prices.
Benefits of using stop-limit orders
Stop-limit orders provide several potential benefits such as:
Risk management
A stop-limit order can be a risk management tool in the sense that you're putting more control over the price at which you'd buy or sell a security. For example, you can limit losses on a stock you own by setting up a stop-limit order so that if the stock falls below a certain price, you can sell the stock to prevent further losses.
However, the limit portion of the stop-limit order adds further control in this sense, as maybe you only want to sell if you can execute at a certain price. If the stock ends up dropping too quickly below your limit price and can't execute, then perhaps that fits your risk management strategy, as you might prefer to hold onto a stock in that situation, rather than locking in larger losses by selling at the market price, as would happen with a traditional stop order.
Precision and control
A stop-limit order also allows you to more closely choose your execution price. For example, if buying a stock, maybe you'd set a stop-limit order so that if the stock starts rising, you can join in, but only if you can do so within the limit you set. Otherwise, you might end up paying more than you'd like for a quickly rising stock.
Automation
The clearly defined parameters of stop-limit orders essentially add automation to your trading. Instead of actively watching the market to see exactly when you can execute a market order at your preferred price, a stop-limit order allows you to set the order and walk away, and if the price ends up moving to within those parameters, it will execute without any further involvement from you.
Risks and limitations of using stop-limit orders
Although stop-limit orders offer several possible benefits, there are also some potential drawbacks to consider, such as:
No execution guarantee
Perhaps the largest risk of stop-limit orders vs. stop orders or market orders is that your order might not execute. For example, maybe you put in a stop-limit order to try to minimize your losses if a stock starts to fall, but if it gaps down too quickly below your limit, the order might not execute, leaving you with a stock you might not want to hold onto.
Partial fills
Another risk is that stop-limit orders could only lead to partial fills, such as if your broker can only sell half of your shares in fast-moving markets before the price drops below your limit. That could leave you in a position where your investment strategy is thrown off, as part of your order executed while you have to decide what to do about the remaining amount.
May require resets
Although there's an automation aspect to stop-limit orders, the reality is that sometimes you do still need to monitor market conditions, otherwise your order might never fill. For example, maybe you set a stop-limit for a buy that's way above the current market price. If the stock isn't moving in that direction, yet you still want to buy the stock, you may need to replace the stop-limit order with one at lower amounts.
How to place a stop-limit order
The specifics of how to place a stop-limit order depend on your brokerage, and not all even offer this functionality. However, many online brokers make it easy to place stop-limit orders by simply clicking a button or drop-down to switch from a market order to a stop-limit order.
You essentially go through with the trade as if you're placing a buy or sell order, but you'll check to make sure that you've selected "stop-limit." From there, you'll specify the stop price and limit price you want to use, and you can typically select whether the order is just for that trading day or if it will remain in place until you cancel it or it executes.
Be sure to check with your broker about their specific rules and processes for stop-limit orders, though, as these can vary.
FAQs about stop-limit orders
What's the difference between a stop order and a stop limit order?
A stop order, also called a stop-loss order, specifies the price at which a security must hit before a market order is triggered. A stop-limit order adds the element of a price limit at which the trade can execute if the stop is triggered, rather than automatically becoming a market order.
Can I cancel or modify a stop-limit order once it's placed?
Yes, typically you can cancel or modify a stop-limit order once it's been placed if the order itself has not been executed. The specifics can vary depending on your brokerage though.
Do stop-limit orders expire?
Some stop-limit orders expire after the market closes the day the order is placed, while others last for a longer duration or indefinitely until the investor cancels it or it executes. The answer depends on what the investor chooses and what the broker allows.
