A limit order is an order placed with a brokerage to execute a buy or sell transaction at a specified price or better. This type of order gives traders and investors control over the price at which the trade will be executed, but it may not guarantee execution.
Placing a Limit Order
When placing a limit order, traders or investors specify a price they are willing to accept for a security. If the market price reaches the specified limit price, the order is triggered and executed at that price or better. However, if the market price does not reach the specified limit price, the order may not be executed.
Buy Limit Orders
A buy limit order specifies a price that is below the current market price. Traders use buy limit orders when they believe the market price will decrease before increasing again. By setting a lower limit price, traders aim to buy the security at a discount when the market price reaches their specified price.
Sell Limit Orders
A sell limit order specifies a price that is above the current market price. Traders use sell limit orders when they believe the market price will increase before decreasing again. By setting a higher limit price, traders aim to sell the security at a premium when the market price reaches their specified price.
Advantages of Limit Orders
Limit orders provide several advantages over market orders. Firstly, they give traders and investors control over the price at which their trades are executed. Secondly, they allow traders to specify the maximum price they are willing to pay or the minimum price they are willing to accept, helping to manage risk. Lastly, limit orders can be used in conjunction with other trading strategies, such as stop-loss orders and take-profit orders, to automate trading decisions.
Limit Orders vs. Market Orders
Unlike limit orders, market orders are executed at the current market price. While market orders guarantee execution, they do not guarantee a specific price. Market orders are suitable for securities with high liquidity and narrow bid-ask spreads, where price volatility is low. However, for securities with low liquidity and wide bid-ask spreads, market orders may result in unfavorable prices.
Limit Order Examples
For example, suppose an investor wants to buy shares of Company XYZ, which is currently trading at $50 per share. The investor believes the stock price will decrease before increasing again, so they place a buy limit order at $45 per share. If the market price reaches $45 per share, the order is triggered and executed at that price or better.
Conversely, suppose a trader wants to sell shares of Company ABC, which is currently trading at $100 per share. The trader believes the stock price will increase before decreasing again, so they place a sell limit order at $110 per share. If the market price reaches $110 per share, the order is triggered and executed at that price or better.
Limit Order Risks
While limit orders offer control over trade execution prices, they also carry risks. For instance, if the market price does not reach the specified limit price, the order may not be executed, leaving traders and investors without their desired transaction. Additionally, limit orders may not be suitable for fast-moving markets or highly volatile securities, where the market price may quickly move beyond the specified limit price.
