Stop Limit Order

What is a Stop Limit Oder?

A stop-limit order is a risk management tool that combines features of a stop order (also known as a stop-loss order) and a limit order. Traders typically use it to have more control over execution prices and avoid trading on unfavorable terms during periods of higher volatility in the markets. A stop-limit has two components:

• Stop price – this is the price that would trigger an order to become active.
• Limit price – this is the specific price at which (or better) the trade can be executed. Unlike stop orders, which guarantee a sale once the stop price is reached, a stop-limit will only execute at the limit price or better. This could be a risk on its own since there could be a market gap or a scenario in which the price of a stock moves too quickly and the order cannot be filled at all.

How Does it Work?

To place a stop-limit order a trader needs to specify:

1. The stop – i.e. the bottom point at which the loss limit starts
2. The limit – defined as the top end of the price target
3. Time frame – the traders has to determine for how long the limits would be active for

When the above three points are decided, usually after performing a fundamental and/or technical analysis, then the trader puts a request with the broker (for example a trading platform) and the order is consecutively sent to the exchange. It would remain active until it is triggered, cancelled or expired.

Traders can also opt in for the order to be “good-‘til-cancelled” (we provide more details on the different order types in the table below), which means it will remain valid until it is filled or cancelled. Same as stop losses, stop-limits are typically disabled outside market hours (for example the New York Stock Exchange’s core hours are between 9.30am and 4pm), which means they are not active during after-hours, overnight or pre-market trading.

Please note that this example reflects the process of a stop-limit order to sell a security.

Data source: Investing.com

Stop-limit Order Example

A trader thinks that one of their positions might decline in price over the next few days. The current price is $114 per share.

A stop-limit order to sell 10 shares is placed:

• Stop price of 112
• Limit price of 111.50
• Expiry in 10 days

If an execution occurs at $112 or below, the order will be activated and become a limit order to sell at $111.50 or higher.

The next trade occurs at $111.70, and the trade is executed (since it is better than the limit price of $111.50).

However, if the stop and the limit prices were the same, let’s say $112, should the market be moving quickly, the order may not be filled at all if the next trade occurs at any price below $112. This creates a risk of further losses if the stock price continues to go down.

Pros and Cons

Stop-limit orders are popular with traders for a few reasons:

• Unlike stop-loss orders, stop-limits allow for greater price control and won’t execute if the market price is below the limit price. This would avoid trading at unfavourable prices.
• Stop-limits are more flexible as traders can choose their stop and limit prices and adjust their investment strategy accordingly.
• In more volatile markets, stop-limit orders can protect against slippage (a situation where the execution price differs from the requested price as it takes for the broker to process the order, but the original price set is no longer available) and avoid an order to be filled at unfavourable price.
• They are also suitable for traders who want to lock in profits from certain positions.

On the other hand, there are a couple of disadvantages related to stop-limits:

• They are more complex for inexperienced traders since it is required to set both a stop price and a limit price (along with other components such as the duration of the order or in some cases quantity).
• Stop-limits do not guarantee execution and if the market price moves below the limit price (after triggering the stop) the order will not be filled, and a trader may be exposed to further losses.
• During periods of market stress, prices tend to move up and down more quickly. Therefore, similar to stop-loss orders, stop-limits may prevent investors from benefiting from a quick recovery in the price of a security.
• Stop-limit orders may not be suitable in less liquid markets (such as the emerging markets small caps or frontier markets) as low trading volumes may leave the order unfilled if there isn’t a sufficient number of market participants to buy or sell at the limit price.

Stop-Limit vs. Stop-Loss

The primary objective of both stop-limit and stop-loss order is risk management and loss prevention but they differ in the level of flexibility they offer. While a stop loss is an order that contains an instruction to sell a security once its price reaches a certain point (typically this is a price below the purchase price) and guarantees execution, a stop limit is an order with two specific price components that have to be defined – the price that triggers the stop and the limit below which the order cannot be filled. If the stop and the limit are set up too close, this creates a risk that in a rapidly declining market execution may not be possible, which can respectively lead to further losses.

Conclusion

Stop-limit orders combine the features of a stop-loss and limit orders. They are used by traders to control the risk of losses but also provide flexibility and allow for a more precise price execution since an order can only be filled if the price is the same or above the pre-set limit.  However, stop-limits are relatively more complex than stop losses and could also expose traders to further losses in less liquid markets since they don’t guarantee execution.

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