What is a Limit Order?
A limit order is a type of order to buy or sell a security (such as stocks, bonds, or options) at a specified price or better. Unlike a market order, which executes at the current market price, a limit order allows investors to set a specific price at which they are willing to buy or sell a security. This price is known as the "limit price," and the order will only execute if the market reaches or surpasses this designated price.
Also Read: Market Order vs Limit Order: Key Differences and More
Terms that you need to know
Securities: It is a broad term for stocks, bonds, mutual funds, ETFs, or other types of investments that you can buy or sell.
Risk Mitigation: Process of reducing the risk in a trading strategy.
Brokerage: A brokerage is a firm or a company that provides a platform for traders and investors to buy and sell securities. They can charge a fee for their services.
Key Takeaways
- Limit orders allow traders to set specific prices for buying or selling securities.
- The limit price acts as a threshold for execution, and it triggers the order only if met or surpassed.
- Traders specify the security, quantity, direction (buy or sell), and order duration.
- Benefits of limit orders include price control and risk mitigation.
- Drawbacks include uncertainty in rapidly changing markets and execution delays.
How Does a Limit Order Work?
Here's a step-by-step breakdown of how a limit order works:
1.1 Placement of the Order: To initiate a limit order, a trader or investor submits their order to a brokerage or trading platform. The order specifies the following key parameters:
- Security: The specific financial instrument (e.g., a stock, bond, commodity, or option) that the trader wants to buy or sell.
- Quantity: The number of shares, contracts, or units of the security the trader wants to trade.
- Direction: Whether it's a buy or sell order.
- Limit Price: The price at which the trader wants the order to be executed. For a buy limit order, the limit price is the maximum price the trader is willing to pay, while for a sell limit order, it is the minimum price the trader is willing to accept.
2.2 Order Submission to the Market: Once the limit order is placed, it is sent to the relevant exchange or market where the security is traded. The order remains on the order book until it is executed, canceled, or expires.
3.3 Execution Conditions: For a limit order to be executed, specific market conditions must be met:
- Buy Limit Order: The market price must drop to or below the specified limit price for the order to execute.
- Sell Limit Order: The market price must rise to or exceed the specified limit price for the order to execute.
4.4 Time in Force: Traders can also specify how long the limit order should remain active. Common time-in-force options include:
- Day Order (DAY): The order is valid only for the current trading day. If it doesn't execute by the market's close, it expires.
- Good 'Til Canceled (GTC): The order remains active until it is executed or canceled by the trader.
- Immediate or Cancel (IOC): The order is executed immediately and in full, or it is canceled.
- Fill or Kill (FOK): The order must be executed in its entirety immediately, or it is canceled.
5.5 Monitoring and Potential Execution: Traders must keep an eye on their limit orders. If market conditions meet the criteria specified in the order, it will execute partially or in full. If not, it remains on the order book until canceled or expired.
6.6 Partial Fills: In some cases, a limit order may execute partially. For example, if a trader places a limit order to buy 100 shares at $50 per share, and the market only has 50 shares available at or below $50, the order will be partially filled with those 50 shares, and the remainder of the order remains active.
7.7 Canceling the Order: Traders can cancel their limit orders at any time before they are executed. This can be done through their brokerage's trading platform or by contacting their broker directly.
Why Should You Choose a Limit Order?
To avoid missing out on opportunities, traders can use limit orders to their advantage. These orders provide control over your investment portfolio, even if you're not actively monitoring the stock market. Imagine being at lunch during a highly volatile market period; in such situations, your brokerage (often handled by a computer) will execute the trades for you, ensuring you don't miss any opportunities.
Traders can employ limit orders when they perceive a stock's value is not reflected accurately. They may purchase the stock and set a limit order to sell it when the price rises, or alternatively, traders who think a stock is overvalued can set a limit order to purchase shares once the price drops.
Pros & Cons of Limit Orders
Pros
- Price Control: The most significant advantage of a limit order is that it allows you to control the price at which you enter or exit a trade. This can help you avoid unexpected price changes that might occur with market orders.
- Avoiding Slippage: Slippage occurs when the market moves quickly, and a market order executes at a different (often less favorable) price than expected. Limit orders help mitigate this risk.
- Patience: Limit orders are useful for patient investors who are willing to wait for their desired price. They can be especially valuable for long-term investors.
- Precision: Traders can fine-tune their entry and exit points, increasing the precision of their trading strategy.
Cons
- Execution Risk: There is no guarantee that a limit order will execute, as the market may never reach the specified limit price. This can result in missed trading opportunities.
- Delayed Execution: Limit orders may not be suitable for traders looking to enter or exit a position quickly, as they require waiting for the market to reach the desired price.
- Market Volatility: In highly volatile markets, limit orders may be less effective, as prices can quickly move away from the specified limit.
Limit Order Example
Imagine an investor wants to buy 10,000 shares of Acme Incorporated, but they believe the current price of $100 is too much. They set the limit price at $90 per share, and the order will execute if and when the price falls to $90, as long as 10,000 shares can be filled at that price.
If there are only 6,000 shares available at $90 each, and then the stock price goes up, the investor trying to buy 10,000 shares at $90 each will only get 6,000 shares. The remaining 4,000 shares they wanted to buy will stay in their order until the price drops to $90 again.
Limit Order vs Market Order
Limit orders are executed once the set limit price is hit, but a market order is executed at the current market price. Their key differences are as follows:
| Limit Order | Market Order |
|---|---|
| They are price specific orders. | They are time specific orders. |
| They will be executed once a particular price is reached. | They are executed at market price. |
| There is an uncertainty of execution. | Execution is mostly certain. |
| Proper analysis and more specifications are needed to fix the limit price for buy or sell. | It is easy to set during buy or sell. |
Bottom Line
Limit orders are valuable tools for traders and investors, offering precise control over trade execution and helping to mitigate risks associated with market volatility. By understanding how limit orders work and employing them effectively in your trading strategy, you can enhance your ability to achieve your financial goals while managing risk in the ever-evolving world of financial markets.
