How Does a Stop-Limit Order Work?

A stop-limit order, as its name indicates, combines the features of a stop order and a limit order to give an investor the highest level of control in a trade. The order is initiated once a stock hits its "stop price," but it is executed only if the stock maintains a value between that stop price and a limit price. This can be quite an advantageous option for some investors who would like to work within a very narrow price region on a stock. 

Stop Order Only

Sue would like to put a stop limit on Stock X in her portfolio. She will instruct her broker to sell if Stock X drops below $4 per share. This will prevent her from losing too much money if Stock X, or the whole market, crashes. Stock X drops to $4 per share, and her broker initiates the trade. However, it continues to drop, and by the time the trade is executed, the price is only $2 per share. At that price, Sue wishes she had just held onto Stock X in hopes it would regain some value. 

Stop-Limit Order

Sue decides she will not make the same mistake with Stock Y. She initiates a stop-limit order to sell once the price drops to $3 per share, but she puts a limit on the order at $1 per share. The value of Stock Y drops to $3, and the trade is initiated, but the value continues to drop. Stock Y's price hits $0.75 per share, so the limit is in place, and the trade is not executed. The following day, the price climbs to $2 per share, and she sells for a much smaller loss than would have been incurred without the limit. 

Advantages of a Stop-Limit

Stop-limit orders can be initiated on both the buy and sell sides. In the above example, Sue used the model on the sell side. If she initiated a similar stop-limit on the buy side of a security, she could guarantee her broker would buy only once it reached a given price but not initiate the buy order if the stock became too expensive. This control on both the buy and sell sides is what stop-limit users are after. This control is most necessary in a highly volatile market or with a stock that has a low trading volume. In both of these scenarios, the asking price can differ from the market price listed at the time a stop order is initiated.

Disadvantages of a Stop-Limit

The main problem with this model is the cost of the transaction. You will pay for this type of control with your portfolio. The broker has a much more complicated job to do, and the broker will charge you accordingly. Therefore, it is not wise to use a stop-limit where it is unnecessary. Avoid using this model in a market where the price of a stock is not likely to change quickly once a stop order buy or sell has been initiated.

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