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Many exam candidates struggle with the difference between stop and limit orders. However, they are quite different. When an investor enters a limit order to buy or sell, the investor is ready to buy or sell the security. He simply wants to buy or sell it at a specific price—or not at all. And, logically, the price he wants to buy or sell the security at is better than the current bid or ask for the security. If ABC can be purchased for $50.12 now, a buy-limit order would be placed at a better price than that—a lower price. Maybe the investor places an order to buy 300 ABC @$50, limit.
That is a buy-limit at $50 order. Only if the Ask price drops to $50 or lower—and there are 300 shares available at the time—will that purchase order be filled.
Other investors may hold shares of ABC. Those interested in selling, say, 400 shares may also choose to name a price for execution. If the Bid is currently $50.10, maybe one investor decides she is willing to sell 400 shares of ABC if she can get at least $50.25 per share. If so, she enters an order to sell 400 ABC @50.25, limit. Only if the Bid rises to at least $50.25 will that order be executed.
Notice in both cases the price for execution is more important than getting the order filled. If an exam question asks which type of order to use when the investor wants to make sure the order is filled, the answer is a “market order.” Market orders are filled at either the best available Bid (sell orders) or Ask (buy orders) prices.
Stop orders come from a much different perspective than limit orders. Limit orders are placed by investors who want a particular price—or better—and are willing to forego the transaction altogether if that price is unobtainable. Stop orders are used to protect a stock position, especially if a small “paper gain” has already occurred. For example, maybe an exam question says an investor purchased $8,000 of XYZ common stock, which now trades for $10,000…which type of order can protect this “paper gain”?
We are not saying he is ready to sell XYZ common stock. But he has a 25% gain on his hands. Maybe he owns 100 shares of XYZ, now trading at $100 per share. If so, he could place a sell-stop order with an activation price below the current market price. Maybe he places an order to sell 100 XYZ @99.10, stop.
Best case, the stock stays at $100 or rises a few dollars per share. If so, he can cancel that stop order and place a new one, at a higher activation price. But, as long as that sell-stop order is there, just below the current market price, the investor can focus on other things, knowing the next time he checks his account, he will either still hold 100 shares of XYZ—at a favorable market price—or, he will have about $9,910 in cash, as a result of that sell-stop order being triggered and filled.
With a sell-limit order, the investor would simply sell XYZ for a little more than the current market/ask price. With a sell-stop order, he can ride out the position, knowing the worst case is an automatic sale, which often represents a profit. In our example, he bought the stock for $80 a share; therefore, if it is triggered and sold for about $99.10, that represents a pretty good outcome. Even better would be for XYZ common stock to rise to $110, then $120, then…who knows?