What is a Limit Order?
A limit order is a conditional order to buy or sell a stock below or above a certain price point or better. Limit orders are the opposite of market orders, which are orders executed immediately and at the current market price. Limit orders are useful tools for trading in stocks that do not have much liquidity and are volatile. They can also help individuals plan for and reach investing goals by setting price targets for stocks.
How Are Limit Orders Used?
If a trader sets a limit order of $100 to buy a stock that is trading at $120 at that time, then the order will not be executed until the stock’s price falls to $100 or below. The trader can attach an expiration date to the order to ensure that it is deleted, if the stock’s price fails to move in the desired direction.
Limit orders can be used to buy or sell stocks (and other securities):
- Buy limit orders are stock purchase orders that are not executed until its price falls below a desired price.
- Sell limit orders are stock sale orders that are not executed until the stock’s price rises above a desired price. For example, if a trader sets a sell limit order of $150 for a stock that is trading at $120 at the time of the order, then the order will not be executed until the stock’s price reaches $150 or higher.
While limit orders will only be fulfilled by the order’s specified price, it does not guarantee execution since the order is executed only when a given condition is reached. Limit orders also work on a first in, first out basis. Hence, an order’s execution depends on the number of orders ahead of it.
Research has found that informed traders make less use of limit order as compared to uninformed traders. Informed traders, in this context, refers to institutions and trading firms which employ specialized experts with several years of trading experience. Uninformed traders refer to individual traders who do not have as much experience or access to information at their disposal as institutions.
The difference in trading patterns for use of limit orders is primarily due to the flow of information. Institutions are privy to greater information regarding a stock and, as it flows through the market, are able to leverage it to their advantage through the use of limit orders. In contrast, uninformed traders are driven by liquidity in placing their limit orders. For example, they often use limit orders to garner profits from stocks with low liquidity. Or, they might use limit orders to ride the momentum of increased trading in a stock.
Limit Orders Vs. Stop Orders
Limit orders are similar to stop orders, but stop orders are executed as a market order once a stock’s price moves past a certain price point. Because a stop order is executed as a market order, the actual price shares are bought and sold for might be worse than the price chosen to trigger the order. Limit orders, in contrast, will only be fulfilled at the price specified by the limit order. If a limit order is placed for 1,000 shares at $10 and the price drops to $10 but only 500 shares are available at $10, a limit order will only purchase 500 shares. A stop order would, by contrast, purchase 1,000 shares as soon as the price of the stock reaches $10, even if only 500 shares are available at $10 and the remaining 500 shares are bought at a price higher than $10. Additionally, limit orders are visible to market stakeholders but stop orders remain invisible until the price point specified in the order is met.
Limit Orders Vs. Put Options
Put options are contractual promises to sell a security at a pre-determined price and within a given duration of time. The seller pays a premium to an option’s writer for the promise to purchase a given security at a future date. Put options resemble limit orders in that both enable traders to purchase a stock at a pre-determined price and profit from a change in its price direction.
However, there are a couple of differences between the two. First, put options cannot be cancelled at a trader’s discretion unlike Limit orders. For example, if you sell a put option for a stock to go from $50 to $40 in the next 30 days and its price starts rising in that timeframe instead of declining, then you cannot cancel the option. You will have to let the option expire worthless. There is also monetary loss involved, in the form of premiums, for the seller. This is unlike limit orders, which can be canceled at will if a security moves in the wrong price direction.
Put options can also curtail losses and profits. Suppose the security’s price, in the example above, moved in your desired direction, i.e., it fell below $40, and then started rising again. But it did not occur within the timeframe for your option. Placing a limit order would have triggered a purchase of the security. In contrast, the put option sale would have expired worthless. Therefore, you were unable to profit from your trade. The opposite of this situation is also true. Suppose that the security’s price does not fall. The downside risk in this situation for the option’s writer is mitigated partially because they can still eke out a profit from the premiums paid by the seller.