Stop-limit orders effectively build a limit price requirement atop a normal stop-loss order. Stop-loss orders involve buy trades being triggered as a security's price is rising, or sell trades being triggered as a security is dropping in price.
What Is a Stop-Limit Order?
A stop-limit order combines the features of a stop-loss order and a limit order. Like with a stop-loss order, a stop price is specified higher than the current market price for buy-stops, and below the current market price for sell-stops. If the price of the security hits the stop price, the stop-limit order will then trigger a limit order. At this point the trade will execute as long as it can be filled at the limit order price or better.
As a result, a stop-limit order does not guarantee execution where the stop price is reached. It's possible that the security price gaps through the limit price before the trade can be executed at the limit price or better.
Stop-Loss vs. Stop-Limit Order
Compared to a stop-limit, a stop loss order triggers a market order to buy or sell once the stop price is reached. Since market orders are indiscriminate on price, stop-loss orders almost always result in executed trades once the stop price in reached.
Tip: Stop-limit orders guarantee a minimum price (for sell-stops) or a maximum price (for buy-stops) but it's possible the trade will not execute even if the stop price is reached.
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How Stop-Limit Orders Work
To place a stop-limit order, an investor should:
- Access their brokerage's standard trade order screen.
- Specify the ticker, the number of shares they wish to apply the stop-limit on, and then the direction of the trade.
- Then, in the "order type" field, usually where "market order" and "limit order" appear, they can instead choose "stop."
- Then specify a "stop price". The price in a buy-stop order is set above the current market price, while in a sell-stop order, the price is set below the current market price. This means that at the time the stop order is placed, the trade would have been available at a better price.
At this point the trade order would effectively be stop-loss order. To make the order a stop-limit, the investor will need to also specify a stop-limit price on the trade order screen.
Investors can place stop-limit orders that are day orders, good till canceled (GTC) orders, or set specific expiration dates. Stop-limit orders can remain in place for a long time, and will not execute at all in the below scenarios:
- If the stop price is never reached, the stop-limit trade will never execute (and neither would a stop-loss order)
- If the stop price is reached, but the trade cannot be executed at the limit price or better, the trade will not occur.
Tip: Investors can reduce the chances of their stop-limit price being gapped through by leaving a larger buffer between the stop price and the stop-limit price. A $50 stop price with a $47 limit will have a smaller chance of not executing than a $50 stop price with a $49.50 limit.
Stop-Limit Order Example
Let's assume an investor is long 100 shares of XYZ, and that shares are currently trading for $75. The investor decides they'd like to exit their position if shares of XYZ drop 20% from that level. The investor enters a stop-limit order with a stop price of $60 (20% of $75), and decides to specify a stop-limit price of $58.50.
- If shares of XYZ decline to the stop price of $60, the 100 shares of XYZ will be sold as long as a minimum price of $58.50 can be obtained.
- If the stock price has dropped sharply, and a sell order cannot be executed at $58.50 or higher, the 100 shares of XYZ will remain unsold.
Pros & Cons of Stop-Limit Orders
Pros
- Can limit losses if the price of a security moves against an investor's position.
- Comes with guarantees: These orders allow investors to guarantee a maximum execution price for buys, and a minimum execution price for sells.
- Traders can establish new positions at price levels they believe represent the beginning of a new trend in the same direction, so long as the stop-limit price is not breached.
Cons
- Triggered by short-term price fluctuations: Stop-limit orders (as well as stop-loss orders) can be triggered by short-term price fluctuations, pushing investors out of positions they were hoping to hold onto.
- Do not guarantee execution, even if the security price reaches the stop level. Occasionally, investors may be stuck holding a position that takes on far greater losses than they were comfortable with.
Important: Some investors will use stop-limit orders to establish new positions at price levels they believe represent the beginning of a new trend in the same direction.
Bottom Line
Stop-limit orders are used by investors in an attempt to limit losses. Stop-limits add an extra layer of control atop a normal stop-loss, and will not result in trade execution if the stop-limit price cannot be obtained. Occasionally, however, stop-limit orders could result in the investor continuing to hold a position that has suffered greater losses than they were originally comfortable with.
Analyst’s Disclosure: I/we have no stock, option or similar derivative position in any of the companies mentioned, and no plans to initiate any such positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it. I have no business relationship with any company whose stock is mentioned in this article.
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