Financial Jargon Busting What is a stop-limit order?

If you have recently entered the world of trading or investing, you might have heard of the term stop-limit order. But understanding order types can be complicated, so let’s break it down for you.

What is an order?

In the world of investing, an order refers to instructions an investor gives, usually to a broker, of their intent to buy or sell a financial instrument like stocks, bonds, commodities and foreign exchange at a specified price. As the name suggests, a stop-limit order combines elements of two other commonly used orders – the stop order and the limit order.

Basically, by placing a stop-limit order, an investor wants to have more control of the price when buying and selling the asset.¹ However, there is no guarantee the transaction will even occur. Simply put, a stop-limit order is an instruction to the broker of the maximum price the investor is willing to pay – or the minimum price that they are willing to accept – once this order is triggered.

To better understand stop-limit orders, it might be helpful to understand its respective components.

What is a limit order?

A limit order is an instruction to buy or sell an asset, such as a stock, at a specified price – or better. However, a limit order is not guaranteed – it can only be filled if the limit price is currently available in the market. Buy-limit orders are placed below the current market price, while sell-limit orders are placed above it.

For example, say the bid/ask spread (i.e., the difference between the maximum price buyers are willing to pay and the minimum price sellers are willing to accept) of ABC stock is $50/$50.50. This means that one can buy a share at $50.50 or sell at $50. If an investor wants to buy 100 shares of this stock at $49, then they can place a buy limit order at $49. If the price reaches $49, then this order will be triggered.

The key point here is that the investor is guaranteed a buying price of $49 if the order is executed. However, the execution is ultimately not guaranteed, as the price may never reach that level. Stock availability is another factor that may affect execution, though, but most brokers will ensure that the fill does happen.

What is a stop order?

A stop order is a similar instruction to buy or sell a stock once the price of the stock has reached a specified price (i.e., the stop price). Unlike limit orders, the specified price is not guaranteed. When the stop price is reached, a stop order will then become a market order. Therefore, it is now subject to market forces that might cause it to be filled at a different price that is usually less favorable to the trader.

Typically, stop orders are placed to close out existing trades, but they can also be used to initiate new positions. Either way, sell-stop orders are placed below the current market price, while buy-stop orders are placed above.

For example, using the ABC scenario outlined above, an investor seeking to initiate a new sell position at $49.50 would place their sell-stop order at this price (below the current market price of $50). If this price level is reached, then this order is treated as a market order and filled at the best available price, which may or may not be $49.50. Again, execution is dependent on the price reaching this level, but the price is not guaranteed even if the order is activated.

Placing a stop-limit order

A stop-limit order will initiate a limit order to buy or sell a stock when a specific stop price has been met.

Again, using the above scenario with ABC, an investor looking to sell 100 shares of ABC at $49.50 places a stop-limit order at that price. In doing so, the investor is sending the following instruction to the broker: “I want to sell 100 shares of ABC stock, and the minimum price that I am willing to accept, once this order is triggered, is $49.50.”

The stop and limit components can be different. For example, the investor might place the stop at $49.50 and the limit at $49, meaning that they want to sell once ABC trades at $49.50 but are willing to accept a price as low as $49.

Stop-limit order risk

The main drawback to using a stop-limit order is the dependence on limit price. Any market movement that skips – or gaps – the limit price would result in the order not being executed.

Using the ABC stock scenario, an investor buys 100 shares at $50.50 and places a sell-stop limit, with the stop price at $49.50 (stop) and the limit price at $49 (limit) to close out this position and take a loss of $100 to a maximum of $150. An unforeseen event causes the price of ABC stock to plummet, gapping over the stop-limit price, to trade at $48.

The stop-limit order did not execute because the investor specified $49 as the minimum price that they would accept to sell their shares. The investor is now faced with an unrealized loss of $250. So while this order has been triggered, it will not execute unless the price rebounds to $49. However, without a potential rebound, the investor runs the risk of losing more money if ABC continues its downward spiral.

When used prudently, stop orders can be a robust part of a sophisticated investment strategy. To learn more about how to incorporate stop orders into your own strategy, speak with a J.P. Morgan advisor today.