Stop Limit Orders: A Wise Risk Management Strategy

There are two main types of orders you can place in the market: market execution and pending orders. Market execution is where your trade is executed immediately at the present prices. Pending orders are when you instruct a broker to open a buy or sell order at a certain period when the asset reaches a certain price.

The pending order is further divided into several subtypes:

  • Limit order: it can either be a buy limit order or a sell limit order. A buy limit order is placed so that the asset is purchased at/below the set price. Similarly, a sell limit order instructs the broker to sell the asset at/above the specified price.
  • Stop order: it can be a buy stop order or sell stop order. With a buy stop order, the trade will be executed above the market price. The execution will only happen once the price hits the stipulated buy stop price.
    On the other hand, the sell stop order will be executed below the market price; once the price of the asset reaches the stipulated point.
  • Stop limit order: it can be a sell/buy stop limit order. The trader sets a stop price and limit price. The sell stop limit order is executed at/above the limit price while the buy stop limit order is executed at/below the stipulated limit price.

In this post we want to go deep into stop limit orders.

How does a stop limit order works?

Traders use stop limit orders as a control in their trades. To do so, one sets two prices: the limit price and the stop price. The stop price is the price point at which the stop limit order will be executed. On the other hand, the limit price is the maximum/minimum price that the stock will be sold or purchased.

Buy limit order

For the buy stop limit order, a limit order will be executed once the stock reaches the stop price. Subsequently, the stock will be purchased at/below the set limit price. This type of limit order is common among traders who intend to short sell shares.

Sell stop limit

On the other hand, a sell stop limit order is helpful when the trader’s intention is to protect the gains or limit the losses on the owned stocks. Once the share price reaches the stipulated stop price, the broker will execute the limit order. As such, the share will be sold at/above the set limit price.

Example of a Stop Limit Orders

Consider the following scenario; a trader purchases the shares of company X at the price of $10 per share. He uses $2,000 hence ends up with 200 shares.

The market is expecting certain news that is likely to affect the company negatively. However, the trader has a situation that he has to attend to thus making it difficult for him to monitor his trade.

In such a scenario, a stop limit order will be a suitable risk management strategy. So let’s assume that the trader places a stop limit order at a stop price of $7 and a limit price of $5.

True to the market’s expectations, the price of the company’s stock falls to $7 hence triggering the set limit order. As more traders sell off their shares, the price drops further. The limit order is executed at $8. The trade in question is now worth $1,600.

By the time the trader gets back to his trade, the price has reached $4. If he had not placed the stop limit order, his trade would now be worth $800 – a loss of $1,200 from the initial amount.

Stop limit order strategies

Volatility

Consider the volatility of the stock when determining your limit price: if the stock is more volatile, you should have a wider limit. In a volatile market, a small limit is likely to result in low gains while an extremely wide limit may cause hefty losses.

Analyze Charts

Analyze stock charts: It is advisable to place your stop limit order around the levels where other traders are expected to buy or sell their assets. This is because such levels often indicate prior swing lows/highs or support/resistance levels.

Liquidity is likely to increase as the price nears these levels. A horizontal line on the stock chart is one of the tools that can help you identify these points.

Liquidity and Trading Volume

Analyze the stock’s liquidity and trading volume: The trading volume will help you determine whether you need the stop limit order and at what point you should place it.

Besides, a stock with high liquidity may not require such an order. If the shares are highly illiquid, consider lowering the size of your position as a risk management approach.

Potential risks of stop limit orders

Limit order not filled

The stop limit order may not be filled. Consider a scenario where a trader places an order at the stop price of $20 and a limit price of $18. The stock goes below the $20 mark, triggering the stop. However, the market does not have buyers willing to purchase the shares thus pushing the price down to $17.

In such a scenario, you will be trading at a price that is lower than your set limit price but will still be holding a losing position.

Partial fill

You may end up with a partial fill: using the scenario created in the previous point, lack of liquidity may result in a trader only selling a portion of his position after the stop has been triggered.

This will occur if you sell part of the shares at the stop price, but then the price quickly falls below your limit level. In such a case, you may incur hefty losses.

Paying higher commission

You can end up paying a higher commission: depending on the commission placed by your broker, your fees will be higher if there is no liquidity and the stop limit order ends up being filled in several parts.

If you chose a market execution order, you would only pay the commission once.

Stop loss v. stop limit order

Both the stop loss and stop limit order are used as a risk management strategy in trading. While they are both utilized in reducing losses, they have a subtle difference.

A stop loss is not influenced by changes in the stock price. The stop loss will convert into a market order as soon as the price hits the set price. If you purchase a company’s share and its value begins to fall, the stop loss will be executed as soon as the stock price reaches the stipulated point.

On the other hand, the stop limit order has a bit of predictability. When the stock hits the set stop loss, it triggers a limit order as opposed to a market order.

With the limit order, the broker will sell or purchase the stock at the stated price or at a better one. With the stop limit order, the broker will sell the share at/above the stipulated price and buy it at/below the set price.

Final thoughts

Most brokers avail the option of a stop limit order. It is an effective risk management approach in trading. However, just like any other trading strategy, it has certain potential risks. As such, it is crucial to conduct detailed research to determine whether you need to place such an order and at what point.

External Useful Resources

  • Mastering the Order Types: Stop-Limit Orders – Schwab
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