Every trader in any financial market aims to execute a transaction to buy or sell an asset at a specific price of interest. Typically, this price is determined by a trading system with fairly rigid rules. However, not all market entry methods definitively solve this task. The preferred option is commonly known as a limit order.
In this article you will learn:
- Limit orders play a pivotal role in trading, facilitating precise market entry and profit locking for traders.
- Understanding the types and execution of limit orders is essential for effective risk management and strategy implementation in trading.
- Usng limit orders offers traders significant advantages, including precise execution according to trading system criteria and reduced need for constant market monitoring, particularly beneficial for novice traders.
What are limit orders and how do they work?
A limit order is a trader’s instruction to a broker to execute a transaction to buy/sell a specified volume of an asset when the quotes reach a certain level (execution price). Such an order must specify two parameters:
- The price at which the trader wants to execute the buy/sell transaction. It must be better than the current market price and differ from it by at least the minimum allowable number of price steps (points) according to the trading platform’s rules.
- The planned transaction volume.
Thus, a limit order opens a trade in the direction of price movement only when it reaches the specified level (limit). Its main advantage lies in entering the market only at the specified price or better. This is the key difference between a limit order and Market or Stop order. The latter two are executed at the current (Market) or declared (Stop) price or worse.
All limit orders are reflected in the order book (Level 2 on American stock exchanges). The price at which sell orders are placed is called Ask, while the price of buy orders is Bid. In traditional order book displays, the former is located in the upper half and the latter in the lower half.
Types of Limit Orders and Their Execution
In stock trading, two types of limit orders are commonly used:
- Sell Limit. Placed above the current price, it triggers by opening a sell (short) position when rising quotes reach the specified level.
- Buy Limit. Positioned below the current market price, it executes when prices fall to the specified level, opening a long position (buy transaction).
Crucially, the execution of a limit order is not guaranteed. If the price does not reach the specified level, the order will not be executed and will remain in the order book. It is only canceled manually by the trader.
Execution of a Limit order is only possible when there is a matching market order, and the order may be partially filled.
Here’s an example.
A trader decides to sell 10 lots of company XXX shares at $100 each. The current order book shows the best bid at $90 and asks:
- $95 for 5 lots
- $98 for 3 lots
- $100 for 2 lots
The trader places a limit order for 10 lots at $100. Now, the order book’s upper half shows:
- $95 for 5 lots
- $98 for 3 lots
- $100 for 12 lots
Another market participant places a market order to buy 12 lots of shares. This order is executed at the best available prices. Consequently, the buyer gets 5 lots at $95, 3 lots at $98, and the remaining 4 lots are distributed between the existing orders at $100.
If the buyer has placed a Market order for:
- 20 lots. The trader’s limit order would have been fully executed.
- 10 lots. The trader’s limit order would not have been executed due to the order’s priority.
In this scenario, the trader executes a sale of 2 lots of shares and maintains the best ask for the remaining 10 lots. When the next market order to buy shares appears, the trader’s order will be executed first.
Order execution prioritization is handled by market makers, considering the time of placement and order volumes. They aim to execute the maximum number of orders in full volume.
Using Limit Orders in Trading
Limit orders in trading are used for:
- Market entry: buying or selling assets at a specified price or better. This use case has been discussed earlier.
- Profits locking for open positions. In this case, a deferred limit order has its own name – TakeProfit. The rules for its placement and execution are no different from placing a regular limit order. The only thing to remember is that the order volume must match the volume of the open position.
It should not be forgotten that a limit order can be executed partially, so there is a possibility of locking profits not for the entire volume of the open position.
Additionally, a limit order is part of some types of combined deferred orders available on various platforms and terminals, such as Stop-Limit.
Moreover, some traders successfully utilize the rules for executing limit orders by splitting one order with a significant volume into several smaller ones. This allows:
- Not creating significant barriers to the movement of quotes, thereby encouraging the emergence of additional support or resistance levels.
- Providing prompt asset maneuvering on rebounds by placing subsequent orders at a better price.
- Entering the market as quickly as possible.
- Executing a transaction in full volume at a price (through averaging) often better than a large order would be executed in full volume.
Moreover, the limit order provides the trader with two more crucial advantages:
- Allows precisely fulfilling the conditions of the trading system used since it is executed exactly at the specified price or better.
- Eliminates the need to constantly monitor the market situation. After the order is sent, it is placed on the exchange servers and, under favorable circumstances (movement of quotes in the desired direction to the required level), will be executed without the trader’s involvement.
For beginners in stock trading, it is recommended to use deferred limit orders. This ensures the accuracy of order execution and eliminates unforeseen losses due to slippage and entering trades at prices worse than specified (current).