What is a Stop-Limit Order?
A stop-limit order is a trade that triggers a limit order once a specified stop price has been reached or broken through. A stop-limit order is a two-part trade that consists of two prices, those of course being the stop price and the limit price. The stop price is the start of the specified price for the trade and the limit price is the price outside the target price for the trade. Once an asset hits a stop price, the limit order is triggered. This type of trade is generally used to mitigate risk as it gives the trader a specific timeframe and total control over when the trade is executed.
How Does a Stop Limit Order Work
Once the trader has set a stop price and a limit price, they can now wait out the performance of their chosen asset to see if the order will be fulfilled. Once the stop price is hit, the stop-limit order turns into a limit order with the option to buy or sell at the limit price. The reasoning behind combining a stop order with a limit order is to curtail exposure to undesirable positions. If you were to place just a stop order, your order would be executed at any price at or above your stop price.
So, the price could shoot up to way above your stop price and thus leave you exposed to a potential market correction downward. Placing a limit order in concurrence with a stop order protects you against this because if the price of an asset goes above your limit order price the trade will not be executed. However, with every type of trading maneuver there is also inherent risk and/or a downside. The downside when trying to execute a stop-limit order is if the stop price is never hit, you won’t have the option to buy or sell your limit order.
Example of a Stop Limit Order
For example, let’s assume that crude oil is trading at $38/barrel and the trader wants to buy a contract because he or she believes there is some upward momentum down the pipeline. The investor would place a stop price at $43/barrel and a limit price at $48 a barrel. If the price of crude oil moves above that $43/barrel stop price, the order is now active and turns into a limit order. The trader can then execute their limit order, provided the price of oil hasn’t surpassed their limit price of $48. If for some reason the price leaps over your limit price, the trade cannot be executed.
How Does a Stop-Limit Order Differ From Other Stop Orders?
The two main types of orders that often get confused with stop limit orders are stop orders and stop loss orders. A stop order is similar to a stop-limit order except it does not give the trader the option to purchase a limit order. A stop-loss order is executed in order to mitigate loss.
Stop Order
The main purpose of a stop order is that it allows traders to capitalize and take profit on price swings. A stop order is often used when trading the currency markets because a small swing in the price of a currency can create a large potential for profit. As mentioned above, the main difference between a stop order and a stop-limit order is that a stop order does not give the trader the option to purchase a limit order. Instead, the trader identifies a stop point and when the asset reaches that specified point a market order is executed. Stop orders are also commonly used in a stop-loss strategy.
Stop-Loss
A stop-loss strategy is exactly what it sounds like. A trader enters a position, but subsequently places an order to exit that position at a specific loss point. So, let’s say crude oil is trading at $40/barrel, a trader could put in a stop order at $35 to try and curtail their potential losses. If the price of oil dropped to $35, the stop order would be executed, and the position would be sold off. In fact, if a trader wished to, they could place a stop-loss and a limit order at the same time to try and make some sort of profit.
To piggyback off that, there are two types of orders that can be executed in a stop-loss strategy. The first is a sell-stop and this is used to protect long positions. A sell-stop occurs when a trader has purchased an asset, the asset has gone up, and the trader wants to lock in a certain profit. The trader would place a sell-stop at a specified price and if the asset drops to that price it would be sold off.
The second order is a buy-stop order. In theory, a buy-stop order is the same as a sell-stop except it is used to protect short positions. A buy-stop order would be above the current market price of the asset and if that price is reached, the order will be triggered.
Advantages and Disadvantages of a Stop Limit Order
As mentioned previously, the primary advantage to a stop-limit order is that it allows the trader control over the price at which they buy or sell an asset. It has the benefits of a stop order without all the drawbacks like slippage. A stop-limit order allows you to buy an asset at a price that is deemed to have good value, it protects you against overpaying.
However, the downside to a stop-limit order is there is a chance the order is not executed. Because you are relying on an asset hitting whatever stop price you set. If the asset never hits the stop price, there is no chance for the order to be filled. This could potentially lead to a trader missing out on a trade he/she would have liked to execute. As with all trading strategies, we recommend doing proper research and practice before trying to execute a stop-limit order. Our knowledgeable and experienced RJO Futures Brokers are a great resource and we highly recommend reaching out to one of them if you have any questions or would like more information on stop-limit orders or any other facet of futures trading.