Graham Jarvis
Profile
Freelance Business Journalist
Publish date
20/03/24

Understanding Limit Orders: A Comprehensive Guide to Precision Trading

 

The limit order definition says they are sometimes referred as pending orders. Limit orders permit traders to purchase and sell securities or sticks at a specific future entry and exit price. They are part of a precision trading strategy, where limit orders are deployed to execute trades based on specific pre-defined conditions. The goal of both precision trading and limit orders is to maximise profits while minimising risks. With limit orders traders can establish the specific conditions for their trades to ensure that they meet with their criteria.

Price for buying and exiting trades is but one condition that traders often set. By setting a limit order, brokers or traders can ensure that they get the price they want for their trades. The practice is increasingly being enhance by the use of artificial intelligence and machine learning platforms, which analyse the market and recommend when to buy and sell certain trades. Traders use these platforms to execute and automate trades when they reach the pre-defined levels. If the conditions for trading aren’t met, then an order will be fulfilled if says the price is not met. So, in effect, a limit order sets the maximum and minimum price traders are willing to buy and sell.


For example, let’s examine how limit orders work: if a trader wished to buy a stock at £10 per share, a limit order could be set for this amount. Subsequently, the trader would not any more than this amount for it. Yet it may be possible to buy that stock for less than the specified limit order of £10 per share. So, it’s possible to increase the profitability of a trade with a limit order, while preventing too much risk and financial loss, which could occur beyond the set trading limit. 

Benjamin Curry, Retirement and Investing Editor of Forbes Advisor, warns in his article ‘Limit Order Vs Market Order’: “Not all stock trades are created equal—pick the wrong moment to buy or sell and it could cost you big. That’s because stock prices fluctuate quickly, making it vital for new investors to understand the difference between two of the main order types: limit order vs market order.”

How limit orders compare with market orders

Then there are market orders, which every trader also need to consider. With a market order, traders only don’t enter a price. Instead, they just submit the quantity of stocks or securities to be bought. Rather than setting the price limits in the way that occurs with limit orders, the order is executed when the best available price is reached. 

So, if a trader were to place a market order to buy 200 stocks of company ABC, and if the price is £45 at the time and 200 stocks are available for this figure, the trade would be completed at £45 per stock. Orders can also be placed when the stock exchange is closed. When the market opens, the trade is completed by being sent to the market. The downside of this practice is that the price of the trade when the trader placed order will be different the next day. 

So, if a positive annual report details how well a publicly traded company is doing, or the announcement of government incentives that might have a positive impact on sales or the finances of a company, the stock may resume trading the next morning at £50 per share rather than at £45 per share. With a market order the trader might then buy, say, £6,000 of the stock when the market opens the next morning. However, the market order can still be removed. 

It’s also important to remember that market orders do not guarantee a price, but they do guarantee the order's immediate execution. Individual investors often like market orders because they want to buy or sell stocks without delay. They are nevertheless guaranteed that the trade will be ‘filled’ – completed by being executive as soon as it is possible. Yet the investors may not know the exact price at which it will be fulfilled. Nevertheless, market orders on stocks that trade over thousands of shares per day will likely be conducted close to the bid or asking prices.

The role of artificial intelligence

Like with limit orders, artificial intelligence and machine learning are being increasingly used with market orders. With AI-powered systems traders and investors can benefit from real-time monitoring and analysis; automated risk assessments by providing risk scores against a potential trade; trade execution optimisation by dynamically adjusting the order parameters in terms of their size, timing and routing to attain the best possible buy or sell price; settlement validation by automating the validation process of trade settlements; and fraud detection and prevention by monitoring activities such as spoofing, layering, and insider trading.  

AI is also increasingly being deployed for regulatory compliance monitoring, predictive analysis to predict potentially disruptive issues such as settlement issues and market disruptions. This permits financial institutions to take and enforce preventive measures before any issue has any significantly negative impact. Amongst other benefits, AI can analyse vaster amounts of data than a human trader can do to identify trends, correlations, and market dynamics. These may influence trades and settlements, and so it helps to make more informed trading decisions. 

Artificial intelligence and machine learning can therefore improve the performance of both limit orders and market orders. Machine learning can enable data – including historical data - to be used to make more accurate trade buying and selling decisions, while minimising associated risk.

When are market orders best?

James Royal, PH.D. writes for Bankrate, ‘Market order vs. limit order: How they differ and which type is best to use,’ writes that a market order is best used when an investor or a trader just wants to get the trade completed immediately, no matter what the price is. It’ suitable when you are trading the stock of a large corporation. This is because the stocks of large companies tend to be quite liquid. The price of the bid and ask prices are often only a couple of pennies apart. This means that it might be possible to get a quote for stocks at the last traded price, or even better. This very much depends on the market at any given moment. 

Market orders can also be good for those wishing to trade relatively few shares. In his article, which also appears on AOL.com, he says: “If you’re buying or selling a relatively small number of shares (think a couple hundred or less), especially on a larger stock, you’re less likely to move the price than if you need to transact on thousands of shares.”

Like limit orders do, market orders have their disadvantages. As highlight above, there is no guarantee that a trader or investor will obtain the price at which they wished to buy or sell. It may even be totally different to the current market price. Royal says this is especially true for “thinly traded stocks or smaller stocks.” He therefore warns about the ‘wild pricing’ of market orders.

Advantages and disadvantages of using limit orders

To avoid uncontrolled wild pricing, traders and investors can use limit orders – particularly when they want to buy or sell at a specific price. This will ensure that the trade doesn’t transact unless they get what they want at the price set, or even better. However, this may mean that the trader or the investor may need to wait longer than they would with a market order to ensure that the price is achieved or improved upon. Only then will the trade be executed. 

Talking about thinly trade stocks – those with low trading volumes, Royal explains they can bounce around from one trade to the next. By setting a price with a limit order, it’s possible to minimise trading costs. He says this might save 1% or more of a trader’s or an investor's total investment, which he considers to be significant. Such a saving could be reinvested elsewhere. 

Limit orders are useful when someone is wanting to sell a high number of shares because even a slight change in price can lead to a significant profit or a loss. “A limit order will not shift the market the way a market order might,” explains Royal. 

Bejamin Curry adds: “[Limit orders] can be set for future trades. You don’t have to use limit orders just for a trade today. By setting a limit order beyond the market price, you create automated instructions for an order to execute whenever a target price occurs in the future.”

Disadvantages of limit orders

The main disadvantages of limit orders are that they often require more patience for transaction – whether buying or selling – to be completed. The price set for either activity may not be achieved immediately. In fact, this means that there is no guarantee that the trade will even occur. For example, there may not even be enough supply or demand to complete an order. So, there is still some risk despite the setting of the trading conditions. Yet this may change in a trader’s, broker’s, or investor’s favour over the due course of time. 

A bit like leaving a suit that’s been taken to a dry cleaner and then forgotten, limit orders may be similarly completed – just like the suit would still be cleaned. Limits orders can be placed for up to three months in the future, meaning that a busy person could just forget about them to find that trades have been executed. This could lead to an unexpected trade. However, the trade would still be completed at the order price, but the trade may no longer have been wanted. 

Limit orders may also be placed by traders at a currently quoted price because they don’t want to move the stock price. This allows them to adjust the stock price in either direction – up or down – to enable the execution of the trade more or less quickly. Royal says this can lead to the same effect as a market order. However, it prevents execution at a wild price. 

Royal therefore remarks: “Your choice of market order or limit order depends on the specific circumstances of the trade, but if you’re worried about not getting a certain price, you can always use a limit order. You’ll ensure that the transaction won’t occur unless you get your price, even if it takes longer to execute.”

Curry adds that limit orders can lead to partial orders. He says they are dynamic in that they can only execute when the pricing conditions are met. “This means if you’re trying to sell 100 shares at a minimum price of $50, only part of your shares may be sold if the price dips below $50 mid-order,” he explains before advising that this can be avoided by inserting restrictions on the limit order. This may be an ‘all or none’ parameter, or a ‘fill or kill’ one, but they could also be detrimental to the trade – creating the likelihood that it won’t happen at all. 

He also warns that limit orders may also to extra fees. “If your order can’t all be executed at once, you may wind up paying trading fees each time part of it is filled. That’s part of why it’s important to find brokerages with low or no trading fees,” he explains.

Types of limit orders

Limit orders consist of four types, which define limit order strategies:

  • The ‘Buy Limit’ sets the conditions at which a security or a stock is bought, or below that price as suggested above.
  • The ‘Sell Limit’ establishes at which level a security or a stock may be sold. This often permits them to be sold above any pre-defined limit as a higher price of a stock or securities sale would maximise profit.
  • The ‘Buy Stop’ Limit – an order to buy a security at a price above the current market bid.
  • The ‘Sell Stop’ Limit is an order to sell a security at a price below the current market demand.

Practical tips for using limit orders effectively in different trading scenarios

The key advice to traders is to ensure they set their limit orders on the correct side of the market. If they fail to do so, they may not improve the price at which a trader buys or sells securities or stocks. For this reason, buy stop order limits are placed above the market value, and sell stop orders tend to be placed below it. Orders are converted into a market or limit order once the stop order level has been attained. 

With regard to limit order strategies, Vanguard adds further advice on its website. Speaking about volatile markets, it advises traders and investors to invest carefully: “Traders may not be able to quickly match buyers and sellers to execute your order. he use of options, an advanced strategy that entails a high degree of risk, is available to experienced investors.” It counsels that the price relating to a buy limit order should therefore be set at or below the current market price, and for a sell limit order the price should be similarly set “at or above the current market price.”

It also offers some examples of buy limit, sell limit, stop, and stop-limit orders. With regard to a buy limit order, it offers the following example: “You want to purchase XYZ stock, which is trading at $15 a share. You'll buy if it drops to $13, so you place a buy limit order with a limit price of $13. The order will only execute at or below your $13 limit.”

As for a sell limit order, Vanguard says: “You own a stock that's trading at $12 a share. You'll sell if the price rises to $13, so you place a sell limit order with a limit price of $13. The order will only execute at or above your $13 limit.”

It then warns that stop order and stop-loss can often be found being used interchangeably. Yet there is no such as things as a stop-loss order. That’s because there is no protection from losses as a result of poor execution. To minimise risk, the company advises placing a limit price on a stop order to reduce and manage the risks with this order type. 

With a stop-limit order, Vanguard recommends setting set the stop price at or below the current market price and set your limit price below, not equal to, your stop price. For example, if a trader or an investor buys stock that’s trading at $25.25 once it starts to show an upward trend. Speaking about buy stop-limits, Vanguard says, “you don't want to overpay, so you put in a stop-limit order to buy with a stop price of $27.20 and a limit of $29.50.” the company adds that if the stock trades at the $27.20 stop price or higher, then the order activates and turns into a limit order that won't be filled for more than your $29.50 limit price.

Vanguard illustrates another scenario with a sell stop-limit order: An investor owns a stock that’s trading at $18.50 a share. A sale will be completed if the price falls to $15.20, but it won’t sell for less than $14.10. So, a sell stop-limit order is set at the stop price of $15.20 and a limit price of $14.10. The stop order is activated when the stock drops to $15.20 or lower; the order will only execute at or above your $14.10 limit price. In essence, this is how limit order should work. Investors and traders still need to due their due diligence to get their limit order strategies right.

International payments made simple
Find out more