What is a stop-limit order?

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ok_5513
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Trading
22 June 2023
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In the world of finance and trading in financial markets, a stop-limit order is an indispensable tool for a successful trading strategy.

Most beginners associate a stop-limit order with the word stop. If you compare a stop order and a stop limit order, it seems to be the same thing, but that's not quite true. A stop-limit order can be used to place a stop order, but that's not all the features it gives us. A stop-limit order offers more control and the ability to customize it. 

But what is it? How and when should it be used? Let's find out.

What is a limit stop order?

What is a limit stop order?
A limit stop order is a combination of two different types of orders, which includes elements of a stop order and a limit order.

In short, a stop order is a type of order that involves buying or selling a currency pair (or other asset) when its price reaches a specified level, known as the stop price. It is similar to the navigation system in your car: when you reach a certain point, it gives you a signal.

A limit order, on the other hand, is a type of order that is designed to buy or sell an asset at a price that is either better than or equal to the current market price. It is like telling your real estate agent that you are willing to buy a house, but only at a certain price.

Thus, a limit stop order is a combined tool that starts acting like a stop order when the stop price is reached and then turns into a limit order.

How does a limit stop order work?

limit stop order

Now that we understand what a stop order and a limit order are, let's combine them and find out how a limit stop order works.

A limit stop order begins as a stop order. You set a stop price, which represents the activation price. Once the market price reaches or exceeds this stop price, your stop order becomes a limit order.

In this state, your order will only be executed at the price you set as your limit price or the best price. If the market moves too fast and your limit price cannot be executed, your order will remain in the system until the necessary price to execute it is reached.

Thus, a limit stop order gives you more control over the strike price. Instead of just placing a stop order and hoping for the best, a limit stop order allows you to set the exact value at which you want to buy or sell a security.

In simple words, a limit stop order works as follows:

  1. You set the stop price.
  2. You set the price of the limit order.
  3. When the market reaches this stop price, your stop order turns into a limit order.

This limit order will then be executed at your limit price or better.

This operating mechanism makes a limit stop order especially useful in high volatility situations where prices can change rapidly and conventional stop orders can lead to unwanted trades.

Understanding how a limit stop order works is a key element of a successful trading strategy. It can give you more control and flexibility in your trading decisions, help you manage risk and protect your potential profits.

  • Stop is the activation price of the limit stop order.
  • Price is the price of a limit order.
  • Amount is the amount of the asset you want to buy/sell.
How does a limit stop order work?

When to use stop-limit orders

Stop-limit orders are definitely useful in some situations. Particularly if you anticipate that a trading pair might rise or fall to a certain level, but then change its direction. Or perhaps you just want to make sure that you will only be able to buy or sell an asset when a specific price is reached.

It is important to understand that a stop-limit order may fail to execute if the price of the asset does not reach the limit price after reaching the stop price.

When to use stop-limit orders

Advantages of using a limit stop order

  1. Protecting against volatility: A stop-limit order helps protect your assets from significant price fluctuations. This is especially useful in volatile markets where prices can change dramatically.
  2. Flexibility and Control: This type of order gives the trader more control over the terms of the trade. You can determine at what price you want to buy or sell an asset and the order will only be executed if the market reaches those levels.
  3. Automated trading: Such orders allow you to set the terms of the deal in advance, which makes the trading process less time-consuming and reduces the chance of missing important market moments.

Disadvantages of using a limit stop order

Despite the many advantages, a stop-limit order is not without disadvantages:

  1. Risk of Failure: Unlike regular stop orders, stop limit orders do not guarantee execution. If the price of the asset does not reach the specified limit price after activating the stop price, the trade will not be executed.
  2. Difficulty: For beginners, it can be difficult to understand how stop-limit orders work and to use them correctly.
  3. Potential Losses: If the market moves in the opposite direction than expected and the price of the asset does not reach the limit price, the trader may lose the opportunity to buy the asset at a lower price or sell it at a higher price.

Strategies of placing limit stop orders

Now that we've gotten into the details of how stop-limit orders work, let's look at some strategies that can help you use them effectively in trading: 

  1. Set realistic prices: Make sure your stop and limit prices are achievable in the current market. The market must be able to reach these prices for your order to be executed.
  2. Understand the market: Examine the market dynamics and determine how likely the price is to reach the levels you have set. Try to understand how your asset behaves in different market conditions.
  3. Risk Management: It is important that your stop-limit orders are consistent with your overall risk management strategy. Set orders so as to minimize losses and protect your investments.

Adapting to changes in the market: The world of finance is constantly changing, and your trading strategy needs to be flexible as well. Don't be afraid to adjust your stop-limit orders in response to changing market conditions.

Conclusion

In conclusion, I would like to say that stop-limit orders are a powerful tool in a trader's hands. They not only provide some level of automation and control over your trades, but also allow you to manage risks and maximize profits. Nevertheless, they are not without their drawbacks, and require careful application and a thorough understanding of the market.

Remember, there is no room for haste on the road to trading success. Careful study and understanding of tools, such as stop-limit orders, is an essential part of the process. Take the time to prepare, keep learning, and try to always stay one step ahead of the market. Good luck with your investments!

If you want to learn more about cryptocurrencies and get skills, experience and tools that you can immediately apply in the cryptocurrency market - sign up for trading courses at the CRYPTOLOGY trading school.

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