Stop-limit orders are used as a strategy for controlling risk when trading financial assets such as stocks, bonds, commodities, and foreign exchange. The focus here will be on stocks, since they are the most understandable and accessible asset.
Most investors are familiar with a simple market order—you call your broker and say, “I want to buy some Tesla shares” or “I want to sell my Tesla shares.” There are no conditions on a market order. To the broker it means: Act quickly, whatever the going price.
A stop, or a limit, puts conditions on the order. A stop order tells the broker to wait until the stock reaches $XX per share before proceeding. A limit order tells the broker: Proceed, but don’t go beyond $YY per share.
The difference between these two conditions is important and helps explain why a stop-limit, which combines both, offers investors more control over trading prices.
How do stop-limit orders work?
In the case of a stop-loss order with a stop price of $XX per share, this doesn’t mean the investor necessarily will get $XX per share. It simply means that once the price drops to $XX, the broker must begin selling—even if the market price continues to fall below $XX. Setting a limit price acts as a brake on the stop-loss order, controlling the amount of loss.
Consider how the stop-limit order could work in a volatile market. Let’s stick with Tesla as our example. An investor named Jane recently bought Tesla at $650 a share. She is aware of Tesla’s price swings—trading as high as $900 in the past year, and as low as $270. On some days, Tesla has swung as much as $100.
Jane is a little apprehensive about Tesla’s coming quarterly report—earnings and sales could exceed expectations and boost Tesla’s stock price, while a disappointing report could send the shares skidding. For now she’s more concerned about downside risk, so she places a sell stop-limit order with her broker, calling for a stop price of $625 and a limit price of $600.
In other words, she’s telling the broker: If the market price of Tesla falls to $625 a share after the report, start selling, but don’t sell below $600.
The limit-price constraint is important because otherwise, a simple stop-loss order would allow the broker to sell below $600 if the market price kept dropping. Jane wants to use the limit to keep her worst-case loss to $50 a share on Tesla.
In case the opposite happens—Tesla’s earnings report is strong, and she may want to buy more Tesla shares—Jane simultaneously gives her broker a buy stop-limit order. She sets a stop price of $660 and a limit of $680.
Translation: If shares rise after the earnings report, start buying at $660, but don’t pay more than $680.
Jane could also use a buy stop-limit as a first-time purchaser of shares.
Why traders use stop-limit orders
Buy stop-limits are frequently used by short sellers—investors who profit when shares decline— as a way to protect gains or stem losses from this risky and expensive strategy.
Here is how it would work, using a different scenario. Jane doesn’t own Tesla, the shares are trading currently at $900, and she thinks that price is too high. She believes investors are too optimistic about Tesla’s earnings and notes that some recently tweeted comments by Chief Executive Officer Elon Musk raised doubts about Tesla’s ability to maintain its rate of sales growth.
She asks her broker to lend her 100 shares of Tesla, so that she can sell them in the market at $900, believing Tesla will drop to $750 in a month, at which time she’d buy 100 shares at the market price and return them to the broker.
A week later, Tesla has indeed fallen to $750 per share. Jane now gives the broker a buy stop-limit order, with a stop price of $755, and a limit price of $775.
Jane is saying: If the market price rises above $755, start buying, but don’t pay more than $775. The limit price would allow Jane a basic gain of $125 per share on the short sale, based on how much she got by selling the shares ($900) and how much she paid to repurchase them ($775).
Jane’s risk as a short seller is that Tesla’s price instead could climb back quickly, shrinking her gain from the short sale—or even exposing her to a loss if Tesla rises higher than $900. Furthermore, short selling requires an investor to pledge a lot of upfront money to the broker, in the form of a margin account. Typically, this amounts to 1.5 times the proceeds of the short sale. In Jane’s case, that would be:
(100 shares x $900 x 1.5) = $135,000
The drawbacks of using stop-limits
While potential benefits of using stop-limits are demonstrated from the model scenarios above, less obvious are the drawbacks and the limitations of this strategy. Let’s look at some of them, sticking with Tesla and our investor, Jane.
The sell stop-limit order was given to the broker, but nothing happened. Why? Because if Tesla’s market price dropped below $600, the broker didn’t sell. In the securities business, this is called no execution. The broker couldn’t sell below $600 without further instruction from Jane to accept a lower price.
Jane told the broker to sell 100 shares for no less than $600 each, but only 50 shares were sold. Why? Probably because the share price was falling quickly, and the broker could only sell 50 shares before the market price fell below $600. This is called a partial fill of the investor’s order.
On the day Jane placed her order, Tesla opened for trading at $625 per share. The broker is reasonably confident he can get that price. By the time the order is executed, though, Tesla has slipped $5, to $620. This difference between expected price and executed price is known as slippage.
Some slippage is common among actively traded stocks because market prices are often fluctuating.
The investor calls the broker at 4:30 p.m. Monday in New York with the stop-limit order to sell Tesla. The next morning at 9, the investor goes online to check his account. There’s no activity regarding his Tesla shares. He asks the broker, who explains: Stop orders and limit orders may be given 24/7 by investors, but can only be executed by brokers during regular US market hours, or between 9:30 a.m. and 4 p.m. Eastern Standard Time, Monday to Friday.
3 Things to consider before using a stop-limit strategy
1. Time frame
How long does the investor want an order to be in effect? A single trading day? Several days? Weeks, months? If it was a one-day order, he needs to decide whether to extend the order time or enter a new order, to maintain his boundaries on buying or selling.
2. Price volatility
Does the stock experience large swings in short periods, even in a single day? If so, an investor might regret a stop-limit order. For example, if Tesla drops to $625 as trading opens, the broker begins selling per Jane’s order, and he gets $615 for her. By the afternoon, Tesla is rebounding, and closes at $660—above Jane’s original purchase price of $650. If she had waited a while, without a stop-limit, she might have sold at a profit instead of a loss.
3. Trends and patterns
Technical analysis, the study of trends and patterns in market prices, is important when setting appropriate stops and limits. If Tesla’s range of high and low trading prices were $700 and $600, for example, any stop-limit should be guided by that range.
The investor should also consider the company’s financial condition. For example, if a company starts to experience significant accounting problems and its outlook is uncertain, the stock’s price decline could be deep and lasting. A stop-limit order with the constraining limit price might cause the investor to hold onto the shares too long. A simple stop-loss order would allow the broker to sell faster, and the investor could cut his losses and move on.
The bottom line
The stop-limit strategy is not particularly useful for active traders, who have their eye on the market constantly and are making quick buying and selling decisions, often for small price movements. Stop-limits are more appropriate for the investor, or the investor’s wealth manager, when setting sensible boundaries for trading decisions that don’t require constantly tracking the market.
A strategy that takes into account more than one triggering price, called a trailing stop or trailing stop-limit, also could be used by an investor who can’t conduct around-the-clock surveillance.
For example, our investor, Jane, who bought Tesla at $650, could set an order to sell at 5% below the current market price, with a limit of 7%. If Tesla should decline from $650, the trailing stop would trigger at $617.50, with a downside limit of $604.50. If Tesla should rise, say to $700, then begin to decline, the trailing stop would trigger at $665, with a limit of $651.