What is a Stop-Limit Order?
A stop-limit order is an order type that combines the features of a stop and a limit order with the idea to reduce slippage risk.
To successfully execute this order type, two price points must be determined: a stop price and a limit price. The stop price will trigger the order into a limit order and will only be executed at the limit price or better.
How stop-limit orders work
Let’s assume you want to buy XYZ stock which is currently trading at $21. The price of the stock is expected to rise to $28 but you don’t want to pay more than $28.
When you place a buy stop limit order when purchasing XYZ stock at $28, the order will only become active if the price moves higher than $28. If it becomes active, the order will only be executed at $28 or better.
Assuming you want to sell the XYZ stock if it trades to $19. At the moment, it is currently trading at $23. Your goal is simple, to limit your loss. Since you don’t want to suffer slippage, placing a sell stop limit order to sell the XYZ stock at $19, the order will only become active when the stock’s price goes down past $19.
When it becomes active, it will be executed at $19 or at a much better price. This is the sell stop limit order.
Primary advantages of stop-limit order
The goal of a stop limit order is to provide the trader with control over how and when an order will be filled. Furthermore, it can help you overcome major drawbacks that are common with a stop order.
What does this mean? The stop limit order can help you to lower the risks and effects of slippage. Slippage refers to the situation where prices move quickly in fast moving and volatile markets. This results in the trade being executed at a poor price.
Drawbacks
One thing investors are not guaranteed is the probability that the trade will not be executed especially if the asset does not attain the stop price within the determined period. This means it is not 100% reliable.
Another thing you need to note is that stop limit orders may not work when it comes to dividend stocks.
Final Thoughts
A stop limit order is very useful. Not only does it help you to lower the effects of slippage but it helps to improve profitability. One problem exists; the percentage of orders to be executed will lower.
Always document reasons why you engaged in a stop limit order especially in your trading strategies. It will be beneficial towards decision making in the future.