When getting started in the world of trading and investing, one of the first things to learn is the variety of order types available at your disposal. These orders determine how and when you enter and exit the market. Order types are the same across different markets and can be used whether you are trading stocks, forex, or futures. Mastering them will allow you to enter and exit the market with greater flexibility, enhance your trading strategies, and better manage your risk. Let’s dive in and learn about the three fundamental order types: market orders, limit orders and stop loss orders.
What is a Market Order?
A market order is an order to buy or sell at the best current market price. Execution of the order is guaranteed but you are not guaranteed any specific price. This order type is used when you want to enter or exit the market quickly.
Buy market order example: You have been watching shares of Tesco (TSCO) and waiting for the right moment to buy. After a poor earnings release, the price falls to a level that you have determined as a good entry point. You want to buy quickly as you feel that the price may rebound, so you enter a buy market order for 100 shares and get a fast execution of your order.
Sell market order example: Imagine that you bought 50 shares of Prudential (PRU) at £900. That same day the shares went up to £922. You want to exit the market fast and be sure that you capture a profit. When you enter your order the market is trading at £922, but your sell market order is executed at £921.70, because the market was moving lower at the time you entered it. By entering the sell market order you were able to exit your trade immediately and capture a profit, although you did not have a guarantee of the exact price you would receive.
What is a Limit Order?
The definition of a limit order is an order to buy or sell a stock or other financial instrument at a set price or better. In the case of a buy limit order, the order can only be executed only at the limit price or a lower one. When using sell limit orders, the order can only be executed at the limit price or a higher one. Limit orders give a trader greater control over the prices they will receive when an order is executed. Depending on how the market moves, a limit order may or may not get executed. However, the trader can rest assured that if the order does get filled (executed) it will be at the set price or an even better one. (Better for a sell order would mean a higher price, while better for a buy order would be a lower price.)
Sell limit order example: Imagine you bought 100 shares of Barclays (BARC) at the price of £155. A few weeks later the price went up to £170. You decide you would like to lock in a profit of exactly £20 per share so you enter a sell limit order for 100 shares at your target price of £175. This means that if the price of Barclays goes to £175 and your order is executed you will have captured the £20 in profit for 100 shares, which would be equivalent to £2,000.
Market Order vs. Limit Order Pros and Cons
Market orders have the advantage that you can enter the market fast, but have the disadvantage that you cannot control the exact price you will receive. When the market is volatile, such as during the release of major economic news, you may experience what is called slippage. Slippage describes the variation between the expected price of a trade and actual price at which the trade is executed. Market orders are popular among day traders who are typically in and out of the market many times during the day and need to react quickly to changing price conditions.
Meanwhile, limit orders are free from the problem of slippage but lack the guarantee that they will be executed. Limit orders are useful for traders who are not under pressure to get an order executed fast and can wait for the market to come to the exact price level that they desire.
What is a Stop Loss Order?
A stop loss order (also known as simply a stop order) is an order to buy or sell a stock at the market price when a stock reaches a specified price. If the stock reaches the stop price, the order becomes a market order and is filled at the next available market price. Buy stop orders are placed above the current price and sell stop orders are placed below the current market price.
Stop loss order example: Imagine you bought 200 shares of BP (BP) at £400. You are very bullish on BP based on your research and expect the stock to reach £800 per share. However, you want to limit your risk to the downside and decide that if BP falls, you want to cut your losses at roughly the price of £380. To do this, you enter a sell stop order at the price of £380. Imagine some negative news came out about BP and the price begins to fall and reaches £380. Your sell stop order is triggered and becomes a market order. Because the market is moving downward quickly, your order is executed at £379.20. You are satisfied because you managed to effectively limit your risk, even though your order was not executed at exactly £380.
Limit Order vs. Stop Order
A limit order restricts your buy or sell order to a specific price or better. A limit order could be used to enter the market at a buy price below where the market is trading or a sell price above where the market is trading. A sell limit order could be used to exit a long (buy) position at a profit. A buy limit order could be used to exit a short (sell) position at a profit. (See also: How To Short a Stock).
While a limit order is restricted to a set price, a stop order activates a market order when the stop price has been reached. A stop order is most often used as a means of managing risk. In the case of a long (buy) position, a sell stop order can be placed below the market to limit risk. In the case of a short (sell) position, a buy stop order can be placed above the market to limit risk.
Sometimes stop orders are used to enter the market rather than as a means of risk management. For example, a trader might be especially bullish if a stock is able to reach a certain level above where the market is trading. In this instance, he may set a buy stop order above the market to enter a trade, with the expectation that the price will continue to trend higher once that price has been reached.
What is a Stop Limit Order?
A stop-limit order is a conditional order that combines the features of a stop order and a limit order. Once the specified stop price is hit, the stop-limit order becomes a limit order that will be executed at a specified price or better.
Stop limit order example: Imagine that you bought 500 shares of Sainsbury’s (SBRY) at £224. You are bullish and expect the price to rise to at least £250. However, you want to limit your risk and decide to set a stop limit order at £220. You use a stop limit because you want to be sure of receiving the price of £220 in the event that the price falls and are willing to risk that your order might not get executed. You want the control over the exact price where the order will be filled and are willing to give up the guarantee that it will be filled.
Stop Order vs. Stop Limit Order
A stop order typically ensures the execution of your order but it does not guarantee the price. Since there is no guarantee over the price you will receive, you may end up with a larger than expected loss. When using a stop order, the priority is to exit the trade and the price received is less important to the trader.
Meanwhile, a stop limit order typically guarantees that you will receive the price you set, but it does not guarantee that your trade will be executed. As a result, you risk not exiting your trade and suffering a greater loss on the position you continue to hold. A stop limit eliminates the risk of slippage that may occur with a standard stop order, but the trader remains exposed to the risk that their order may not be executed, even if the price is reached. Neither stop orders nor stop limit orders are foolproof in protecting traders in the event of a gap in prices during regular market hours or overnight.
When choosing between a stop order and a stop limit order you must choose whether you prioritise a guaranteed execution or a guaranteed price. Stop loss orders guarantee execution, while stop limit orders guarantee a specific price.