Introduction
A stop limit order is an instruction to execute a trade when the price reaches a certain target. This is used with the aim of securing an increase at the point when the trader’s predetermined goal is reached. This helps to avoid missing the optimum opportunity as may happen without using a limit order. It also eliminates the need for constant monitoring, which many traders do not have time to do, or do not wish to do.
A stop limit may be placed on both orders to buy and orders to sell shares or options. The basic premise of a stop limit order is that there is a price designated as a ‘stop’ price. The stop price is generally marginally lower than the limit price for a sell order, and slightly higher than the limit price for an order to buy. When the stop price is reached, which means that it has risen in the case of a sell order, or dropped in the instance of a sell order, it converts to a limit order. This means that the shares or options will be sold at or above, or purchased at or below, the limit price.
Benefits of Using a Stop Limit Order
One of the primary benefits of using a stop limit is that the target profit is more likely to be attained, without the trader needing to constantly monitor the price. It is also possible for the order to be executed faster and more effectively at the right price, than if the order to buy or sell was placed manually when the target was reached.
A stop limit can also eliminate indecision, or judgment clouded by emotion. Without a predetermined execution point, a trader may buy or sell too soon as a result of fear, or wait too long because of greed or overconfidence.
Cautions on Using a Stop Limit
A stop limit order provides a certain level of likelihood that an order will be filled at the desired price, assuming that the price moves according to expectation. There are, however, some situations in which this outcome will not occur.
There is a possibility that the price reaches its target, but that the order will still remain unfilled. There must always be a counterparty in order for an order to be executed. A willing buyer must be in existence for a sale to be made, and a seller available to enable a purchase. There is no guarantee that this will always be the case, and if the price drops below or rises above the stop price before the order can be executed, it will not be filled.
Another situation which may potentially occur is that the price does not reach the limit level. It may come close, and then fail to move the final increment, or it may fall a long way short. It may even move in the opposite direction, in which case, the stop limit order will not be of any benefit. A limit order does not offer protection against possible loss, but rather, seeks to secure potential gain.
To overcome this shortfall, some traders utilize a stop loss order in addition to a stop limit. It is important to note that whether this may be done depends on the broker that a trader uses. With many, but not all brokers, it is possible to use both a stop limit order to secure profit, and a stop loss order to limit loss.
In Conclusion
A stop limit order can be a very useful method of securing a desired amount of profit, and negating the need for constant monitoring of price. It can also help to take emotion out of the equation close to the point of execution, as the decision has been made at the outset. There are also drawbacks to using a stop limit, which include the possibility of failing to reach the desired outcome due to a small or large variance in price, or the inability for the order to be executed. Considering the use of a stop loss in addition to a stop limit may provide the best possible results whichever way the price moves.