What is a Stop Limit and Why Should I Care?

Knowing what a stop limit is, is very important for investors. A stop-limit combines both a stop order and a limit order. Still confused? Don’t worry, we’ll break down the terms for you. It’s important to understand, however, that these tools are essential for investors who cannot watch their portfolio closely every day. If you have a retirement portfolio, but spend most of your day working or otherwise occupied, having a stop-limit order, or limits, or stops, placed on your stock holdings could help protect you from losses and even secure profits.

What is a Stop Order?

Many online brokers allow you to automate your trading portfolio. In other words, you can use automated commands to execute trades. With a stop order, you can “command” your portfolio to conduct a trade, either buying or selling, when prices pass a certain point.

Let’s say you’re going on vacation, somewhere remote even, where you won’t be able to access the Internet, like the Amazon jungle. You have a big investment in General Motors, and while you’re confident that stock prices will climb in the future, you’re also worried about the most recent rumors of a scandal. Not worried enough to sell, but worried enough to worry.

Since you won’t be able to monitor your portfolio, you can put a stop order on the stocks. Stocks are currently selling for $30 dollars, let’s say, so you place a stop order to sell the stocks automatically if prices drop to $25 dollars. If a scandal breaks out and stock prices drop, your stocks will automatically be sold.

By the way, stop orders that are set to stop losses are called stop-loss orders. You should know, however, that stop orders can be set up for both buying and selling.

For example, let’s say you’re going on vacation, and you really like Apple stocks, which are selling for $110 dollars. This seems to high, but if stock prices drop to $100, you’d like to buy. So you set a stop order for Apple at $100 dollars. If prices drop below that point, your broker will automatically buy.

What is a Limit Order?

There is a limitation to stop orders. Once the price threshold is reached, the order is converted to a market order. In other words, the trade will be executed, no matter what.

With a limit order, the trade will only be executed above a certain thresh hold. This may seem like a minor nuance, but it’s actually a very important one. Let’s say you have some Google shares in your portfolio, and you’re preparing to take your trip to the Amazon. In this case, let’s assume that you like Google, but if stock prices hit $750, you’d like to sell.

Let’s say you set a stop order to sell at $750. While you’re on vacation, Google announces a breakthrough technology and stock prices jump to $750, so your broker begins to execute your trade. At the same time, however, news of a huge scandal leaks and stock prices suddenly plummet to $650. Problem is, your broker automatically executes your trade and you only get $650 per share!

In order to avoid this, you can use a limit order which will stipulate that share prices must be above $750 for the trade to be executed. With a stop order, the trade is placed no matter what, with a limit order, you get a guaranteed price.

Since limit orders are harder to fill, there is also a commission on them, which makes them more expensive than normal trades. This is because non-market orders are usually more expensive to fill. With stop orders, many brokers will conduct the trades for free or at a very low cost, making them more affordable but also a bit riskier.

So What Is A Stop Limit Order?

Now, we’ll combine the two terms to answer the question of “what is a stop limit order?”. When you put a stop limit on a quote, you are adding precision by combining both a stop, and a limit. Once the stop price is reached, a trade will be put in motion, but only if stock prices are favorable according to the limit order.

Let’s say you’ve heard rumors that Google might unveil a truly amazing technology in the next few weeks. Nothing is confirmed and shares are currently trading at $750. So you set a stop limit order for $770 with a limit of $780. This means that the trade will only be executed if prices reach $770, but stay below $780. This way, you can catch upside if prices start to climb (which probably means Google unveiled an awesome new piece of tech), but the trade won’t execute if markets overheat.

You can even set a trailing stop limit based on percentages in order to sell off your stocks. Let’s say you’re worried about a market collapse, so you set a 10 percent trailing stop limit on all of your stocks. If prices drop by 10 percent, your stocks will be sold off, thus protecting your investment.

All of these different automated tools are very important. As an investor you need to know how to use them to both protect and increase your financial wealth.