There are many different terms used in the world of trading. Two of the most common ones, which everyone should be familiar with, are Stop and Limit Orders. Before being able to understand what a Stop and Limit order are, one must know what an order is. When referring to trading, an order is a request sent to a dealer, broker, or exchange communicating how an individual or institution wants to buy or sell a financial instrument. Some orders have additional information attached which specifies execution, validity, or clearing instructions:
- Execution Instructions: instructions that indicate how an order should be filled.
- Validity Instructions: instructions that indicate when an order should be filled.
- Clearing Instructions: instructions that indicate how the order should be settled.
A limit order is a type of execution instruction given with an order that directs a broker, dealer, or exchange to buy or sell an instrument at a specified price or better. When limit order instructions are given with a buy order, the trade will not be filled at a higher price then specified. When limit order instructions are given with a sell order, the trade will never go off at a lower price than specified. The limit price is basically the absolute maximum or minimum limit you want to buy or sell an instrument at.
For instance, you want to buy shares of Apple (AAPL), which is currently trading at $163. However, you do not want to pay that current price. If you set a limit order at $160, and the price goes down to this amount, you will automatically buy a predetermined amount of shares. On the other hand, say you already own shares of AAPL and want to make sure you sell it at a profit. If the stock is currently trading at $163 and you place a limit order to sell the stock once it hits $170, you will be guaranteed that the stock will be sold at that price or more. One disadvantage of setting limit orders is the chance that the limit order will not be filled if the limit price is not reached.
A Stop order is a type of validity instruction and is similar to a Limit order where a buyer or seller sets a specific price that they want the trade to be filled at. Instead of setting a maximum or minimum price which is what a limit order does, the trade will be immediately executed at the stop price; think of the stop price as a trigger. Buy stop orders are typically set at stop prices above the current market price and are used to enter into a long position. Buy stop orders can also be used to protect a profit that has been earned on a stock the investor has sold short. A sell stop order is entered at a stop price below the current market price and is generally used to limit a loss or protect a profit on a stock that the investor currently owns.
For example, suppose a short seller has sold a share of AAPL at $178 expecting it to go down. In order to lock in some sort of profit, they enter buy stop orders at $160 so if the price ever reaches this amount, they are guaranteed $18 of profit per share (not taking into consideration trading expenses). Suppose a different investor holds shares of AAPL that they purchased for $145 and want to lock in some sort of profit. If they place a sell stop order for $170, a sell order will be executed granting $25 of profit per share (not taking into consideration trading expenses).
Using Limits and Stops Together
Because Limit orders are execution instructions and Stop orders are validity instructions, Limit orders and Stop orders and be used in conjunction. Consider this example: an investor has bought shares of AAPL at $127, which is currently trading at $163. To lock in some of his gains the investor places a Stop $160, Limit $155 sell order. What this means is that once the stock prices hits $160, a limit order will be triggered and only sell shares at a price over $155.