Understanding A Limit Order

A limit order is an order to buy or sell a security at a specific price, expecting that the market price will drop or rise. For example, an investor sets a limit order to buy 300 shares of company ABC at $44 per share when the market price is at $45. The market price may rise or fall, but as soon as the stock trades at $44, you can buy the 300 shares at the predetermined price. In fact, a limit order eliminates the possibility to buy at $45 and then suffer the losses if the stock price declines to $44.

How To Use A Limit Order

A limit order gives investors the prospect to control the maximum or minimum price at which they wish to earn or spend their money. For example, if an investor sets a limit order at $35 and a share limit at 200 shares, the maximum profit or loss is $7,000. So, a limit order actually protects investors against significant loss of money. A limit order is particularly useful in volatile markets. If a stock fluctuates sharply on the same trading day, investors may lose a lot of money using market orders because they don’t have control over the price at which they sell or buy the stock.

Buy or Sell?

You can place a buy or a sell limit order, but they are functioning in a different way. For example, placing a buy limit order at $50 implies that you are willing to pay maximum $50 per share; therefore, you execute the order for $50 or lower. Conversely, placing a sell limit price of $50 implies that you are willing to receive at least $50 per share; therefore, you execute the order at $50 or higher.

A quick example

You buy a security for $40 per share or less. You enter a limit order at $40, and you will buy the security if it trades at $40 or less. If the security rises above the limit price, you will not execute the buy limit order. Conversely, you sell a security for $50. You enter a limit order at $50, and you will sell the security if it trades at $50 or more. If the security drops below the limit price, you will not execute the sell limit order.

Besides setting the limit for the price, you have to set a limit for how long you want the limit order to be outstanding. Limit orders are instantaneous using the terms “fill” which means to fill the order or “kill” which means to cancel the order. Otherwise, they remain outstanding for a trading day, week or month. Usually, brokers give limit orders to market specialists. When the market price reaches the limit order, the specialist executes the order and informs the broker, who pays the specialist a small commission for rendering this service.

Potential Disadvantages of Limit Orders

If the market price never reaches the limit order level, you have to keep the stock until it does. In addition, you cannot use a limit order as an aggressive trading tool. If you are an aggressive investor, you will take the risk to scalp as many trades as possible. On the other hand, the protection that comes to controlling the execution price has its own price, which is missing potentially profitable trades.

Generally, investors use the limit orders on stock exchanges rather than in an over-the-counter market. The quickest rate at which market prices fluctuate on exchanges makes it possible to execute the limit order. On the other hand, the intense nature of the up or down price swings may cause a limit order to be cancelled.

Although the market may never reach the limit order, a limit order guarantees the opportunity to trade at the target price if the market moves in that direction. Limit orders should be used as part of a comprehensive investment strategy that includes widely diversified funds and the appropriate mix of stock and bonds. Make sure to know your investment horizon and goals, and use the limit order to manage market losses and capitalize on market opportunities.

 

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