What is a stop-limit order?
Stop-limit orders: discover key takeaways about how they work and read some examples of stop-limit orders on Fineco's Newsroom.
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Stop-limit order: the key takeaways
A stop-limit order is a particular type of limit order, a transaction that allows traders to better manage risk in trading activity. This tool shares features with stop-loss and limit orders as it only executes orders under specific circumstances.
It is an advanced function used to mitigate volatility in trading transactions, protecting capital against asset price fluctuations. Let’s discover in more detail what a stop-limit order is, how it works exactly and what the difference is with limit orders.
What is a stop-limit order?
Before looking at what a stop-limit order is, it’s important to know what limit orders and stop orders are. A limit order is an order with a purchase limit to buy or sell a security only at a specific price. The trader can impose a minimum price for buying or a maximum price for selling.
Once the limit order has been set up, the investment is automatically carried out only under certain specific conditions. In this way, you can buy and sell securities at the best price in order to pay less for a security you wish to buy and better sell a security you wish to dispose of.
A stop order is a buy or sell order that is activated when the price reaches a certain amount. In this case, the order is carried out by automatically performing the liquidation to protect possible profits or limit losses; however, the order may be carried out under less favourable conditions, depending on the market.
A stop-limit order integrates the features of both tools; indeed, when the stop price is reached, the stop-limit turns into a limit order. This mechanism allows traders to better control the price at which orders are carried out, based on the information obtained through technical analysis.
Stop orders vs limit orders
The difference between stop and limit orders is that the former aren’t visible on the market whilst the latter are. In fact, a limit order is a trader indicator whereby the broker is notified to buy or sell a security at a certain price or under better conditions. This order is visible on the market; however, it is not executed if the security doesn’t reach the requested, or more favourable, price.
However, a stop order is not visible on the market but is known only to traders and brokers. If the price reaches this value, the broker proceeds to execute the order, otherwise the transaction will remain open until the conditions requested by the trader arise.
Another difference is the type of order execution. The execution of a limit order only occurs under favourable circumstances, at or above the price limit for sell orders and at or below the price limit for buy orders. A stop order, on the other hand, takes place if the market price is reached. However, the execution is not guaranteed at the price set by the trader. If the market conditions were to change rapidly, the stop order could be executed at a less favourable price.
A stop-limit order is configured with both prices so you must set a stop price and a limit price. They can be the same or different, depending on your own strategy and trading objectives. A stop-limit order is a more precise tool compared to stop orders and limit orders, as it executes orders with more precision and reduces risks in trading transactions.
Stop-limit orders: an example
To better understand how stop-limit orders work, let’s look at a practical example. Let’s imagine that Tesla stock is quoted at £900. A trader has detected through technical analysis that the stock could be entering a bullish trend. However, they want to buy the shares at an advantageous and not too high price.
At this point, the trader sets up a stop-limit buying order, setting a price stop at £920 and a price limit at £940. If the Tesla stock reaches the price stop of £920, the order activates and automatically becomes a limit order.
If the quotation exceeds the price limit of £940, the order is either not executed or is only partially executed. Otherwise, if it remains in an intermediate price range of £940 or under, the order is executed in its entirety. In this way, the trader can purchase the stock at the asking price or at a more advantageous price.
The same happens with a selling stop-limit order. In this case, the trader has already purchased the Tesla security at £900; however, they wish to protect themselves from losses and set up a stop order of £880 and a limit order of £860. Once the price reaches £880, the stop order is activated and it becomes a limit order; therefore, the broker sells the stock at the price limit of £860 or at a better price.
Why use stop-limit orders?
By using stop-limit orders, you can execute orders more efficiently. This is especially true for controlling losses and investing more sustainably. To better understand the advantages of stop-limit orders, let’s take another look at our previous example.
Let’s imagine that the Tesla stock is quoted at £900, while a trader who has purchased shares sets up a selling stop order if the price falls to £880. When such a condition arises, the broker executes the order; however, they may not be able to sell at £880 as the market conditions could only allow for the order to be executed at a lower price.
In this case, the loss would be higher than the trader expected, a fairly common situation, especially for stocks with low liquidity. Whereas, if the trader sets up a limit order at £870 as well as the stop order, the broker will sell all the stock at no less than £870.
Therefore, stop-limit orders allow you to optimise your trading performance by improving profits and limiting losses using a more effective and accurate order execution. It is a very useful tool for investing, especially if combined with a good knowledge of technical analysis.
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