Stop-Limit Orders: A Comprehensive Guide for Risk Management

A stop-limit order is a tool that traders use to mitigate trade risks by specifying the highest or lowest price of stocks they are willing to accept. The trader starts by setting a stop price (order to buy or sell a stock once the price’s reached a specific point), and a limit price (an order to buy or sell a specific number of stocks when the price reaches a specific point).

A stop-limit order provides greater control to investors by determining the maximum or minimum prices for each order. When the price of the stock achieves the set stop price, a limit order is triggered, instructing the market maker to buy or sell the stock at the limit price. It helps limit losses by determining the point at which the investor is unwilling to sustain losses.

Summary

• A stop-limit order is a trade tool that traders use to mitigate risks when buying and selling stocks.
• A stop-limit order is implemented when the price of stocks reaches a specified point.
• A stop-limit order does not guarantee that a trade will be executed if the stock does not reach the specified price.

How Stop-Limit Orders Work

When a trader makes a stop-limit order, the order is sent to the public exchange and recorded on the order bookOrder BookAn order book is a list of orders that presents different offers from buyers and sellers for a specific security. It shows the prices and volumes. The order remains active until it is triggered, canceled, or expires. When an investor places a stop-limit order, they are required to specify the duration when it is valid, either for the current market or the futures markets.

For example, if an investor specifies the validity period to be one day, the order will expire at the end of the market session if it is not triggered. The trader can also select the order validity period to be good-til-canceled (GTC), which remains valid in future market sessions until it is triggered or canceled.

Generally, stop-limit orders will only trigger during a standard market session that lasts between 9:30 a.m. to 4:00 p.m. EST. It means that stop-limit orders will not trigger outside the standard market session – such as after-hoursAfter Hours TradingAfter hours trading refers to the time outside regular trading hours when an investor can buy and sell securities. The main exchanges in the United States, NASDAQ and NYSE, hold standard trading sessions that start at 9:30 a.m. and end at 4:00 p.m. or pre-market hours, weekends, market holidays, or when the stock halts.

Why Traders Use Stop-Limit Orders

Traders use stop-limit orders when they are not actively monitoring the market, and the order helps trigger a buy or sell order when the security reaches a specified point. Once the price is attained, the order is automatically triggered. The following are the two main stop-limit orders that traders place:

1. Buy Stop Limit

A buy stop limit is used to purchase a stock if the price hits a specific point. It helps traders control the purchase price of stock once they’ve determined an acceptable maximum price per share. A stop price and a limit price are then set once the trader specifies the highest price they are willing to pay per stock. The stop price is a price that is above the market price of the stock, whereas the limit price is the highest price that a trader is willing to pay per share.

For example, if John intends to buy ABC Limited stocks that are valued at $50 and are expected to go up today, he can put a stop price at $55. It means that once the price reaches $55, the trade is executed, and the order is turned into a market orderMarket OrderMarket order is a request made by an investor to purchase or sell a security at the best possible price. It is executed by a broker or brokerage service.. If the limit order is capped at $60, the order is processed after reaching $55, and if it exceeds $60, it is not fulfilled.

2. Sell Stop Limit

A sell stop limit is a conditional order to a broker to sell the stock when its price falls up to a specific price – i.e., stop price. A sell stop price has two price components – i.e., a stop price and a limit price. A stop price is a price at which the limit order to sell is activated, whereas the limit price is the lowest price that the trader is willing to accept.

A sell stop order tells the market maker/broker to sell the stocks if the price decreases to the stop point or below, but only if the trader earns a specific price per share. For example, if the current price per share is $60, the trader can set a stop price at $55 and a limit order at $53. The order is activated when the price falls to $55, but not below $53. Below $53, the order will not be fulfilled.

Risks of a Stop-Limit Order

While a stop-limit order can limit losses and guarantee a trade at a specified price, there are some risks involved with such an order. The risks include:

1. No Execution

A stop-limit order does not guarantee that the trade will be executed, because the price may never beat the limit price. If the limit order is attained for a short duration, it may not be executed when there are other orders in the queue that utilize all stocks available at the current price.

2. Partial Fills

Partial fills may occur when only a part of the shares in the stock order is executed, leaving an open order. Executing parts of a single order for each trading day the execution occurs will involve multiple commissions, which reduces the overall returns of a trader.

More Resources

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In order to help you become a world-class financial analyst and advance your career to your fullest potential, these additional resources will be very helpful:

• Buy Side vs Sell SideBuy Side vs Sell SideBuy Side vs Sell Side. The Buy Side refers to firms that purchase securities and include investment managers, pension funds, and hedge funds. The Sell Side
• Market MakerMarket MakerMarket maker refers to a firm or an individual that engages in two-sided markets of a given security. It means that it provides bids and asks in tandem with
• Stop-Loss OrderStop-Loss OrderA stop-loss order is a tool used by traders and investors to limit losses and reduce risk exposure. Learn more about stop-loss orders in this article.
• Trade OrderTrade OrderPlacing a trade order seems intuitive – a “buy” button to initiate a trade and a “sell” button to close a trade.