Limit Orders: Explained
Order types are an edge that trades use in the market. A limit order guarantee trade execution at predetermined prices. This mitigates risk for sophisticated traders.
What Is A Limit Order?
A limit order is an order set by investors. Execution only takes place if the price trades at or through the price set by the market participant. Also, fills rarely occur if price only trades at the limit price. Fills are only guaranteed if prices trades through the set limit.
Additionally, investors set time limits on these orders. Some limit orders terminate immediately unless filled- these are called “immediate or cancel” (IOC). Another name for this order type is “fill or kill” (FOK). Day traders or complex hedge funds use these orders. Other time limits are “good till cancelled” (GTC), meaning these limit orders exist as long as the investor does not cancel the order.
Limit Order Examples
Limit orders are passive orders, meaning they sit idle until price reaches the limit. Conversely, market orders execute immediately at the best available price in the market. For example, an investor that is long a stock and looking to sell at a specific price that shows a profit, he places a limit order to sell his position at the desired price. This way he sells his stock without watching the market tick by tick.
Additionally, sophisticated investors use this order to enter the market at predetermined prices. If an investor believes that fair value for a stock is $20 and he is only willing to buy at that price, he enters a limit order for $20. The order activates when the stock trades for $20 or less, or until the investor cancels the order.
Finally, limit orders are a superb risk management tool. Investors control the price of their entries and exits. However, they risk executions, meaning they may miss an entry or exit depending on where the market trades.