One of the key trade execution tools that you’ll have available to you when you trade stocks is the limit order. It’s also one of the most versatile, and you can use it to maximize profits as well as minimize losses.
A stock limit order can be used to open a position, increasing your exposure to the market, or cut or close a position, decreasing your exposure to the market. It can be placed at any time, and will help your trading to remain disciplined and on target to be profitable.
Many traders have a price target to which they believe the stock will rise when they buy stock to open a long position, and place a sell limit order at or near this target. Often, this limit order is placed at the time the long position is opened. This means that they will sell the stock when it reaches the price of their sell limit, and bank the profit. They don’t even need to be sitting in front of their computer to do so.
Let’s assume that you bought 1,000 shares of ABC stock at $50, and expect the shares to trade up to a price of $52. At $52, you’d make a nice profit of $2,000. By placing a limit to sell 1000 shares at $52, your stock will be sold at $52 or better when the price moves up and through that level.
The risk you take with a sell limit is that the stock price keeps on moving better. If you’ve sold at $52, you won’t profit should the share price move up to $53. But then again, no one ever went bust taking a profit.
But what if the stock price falls? You’ve bought stock expecting it to go better, but something happens that causes the shares to reverse. Perhaps bad economic figures are released, and the whole market is falling away, or maybe ABC announces its own bad quarterly results. Well, in this instance you might rush to place a sell order to cut your losses as soon as possible. But if the market is moving fast, you might miss the price. Losses can rack up quickly when this happens. Using a stop limit will ensure your stock is sold and reduce potential losses.
Here’s how it works:
In the above example, where you’ve bought 1,000 shares of ABC at $50, the company announces earnings well below estimates. The market in ABC stock immediately sells off, and the stock falls 10% to $45. You’ve lost $5,000. If you had placed a sell stop limit order at $49, then your stock would have been sold at $49, reducing the loss to $1,000.
So, as protection against an unexpected fall in the share price, when you initiate your long position you might also place a sell stop limit at a price below the market price. This will limit your losses should the market turn sour.
You could, of course, place a simultaneous sell limit and sell stop limit when opening that initial position. This will ensure you put that profit in your pocket should the stock move up, and keep your losses to a minimum if the stock moves down.
But what if the stock becomes very volatile, and moves first one way and then the other? You might find yourself short of stock at the wrong price, having executed both limits. To stop this from happening, you set the limits to cancel automatically if the other limit order has been executed.
Limit orders are also great for trading stocks that are range bound, and range traders use them all the time.
Let’s say that you’ve been watching ABC for some while now, and every time they get down to $50 the trend reverses and they move back up. A similar thing happens when they get to $52: sellers seem to appear and they start to ease back toward $50. The stock appears to be stuck in a rut, and is range bound.
By placing a buy limit at or just above $50, you’ll buy stock at the bottom of this trading pattern, and by placing a sell limit at or just below $52 you’ll sell stock at the top of the trading pattern. This takes away the need for continual concentration, and allows you to increase your trading volumes, perhaps also trading in more stocks than if you were manually inputting orders each time you execute a buy or a sell.
If your trading system allows you to, you could set it so that your buy and sell limit orders are automatically refreshed should the opposite limit order be executed. But be warned: ranges get broken, so you would be wise to consider placing a sell stop limit (to cover your long position on an unexpected fall through your buying price) and a buy stop limit(to cover your short position on an unexpected rise through your selling price) to protect yourself from losses caused by wild price movements.
Whatever method of trading you employ, whether it be range trading, position trading, gap trading, swing trading or market making, you’ll find limit orders to be one of your best friends. They allow your trading system to concentrate for you, and help you to be disciplined in your trading decisions. In turn this means that you become more relaxed, make better trading choices and this increases confidence. And a confident trader makes more money.
Try using limit orders on your trade simulator, practicing with the different types and integrating them into your trading strategies. Learn to manage them throughout the day, reviewing them at the close of business and updating when necessary. When you become an expert with limit orders, you’ll see your profits really take off.