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Limit Orders: What They Are, and What Happens When Price Gaps?

<p>insta_photos / Getty Images</p>

insta_photos / Getty Images

Reviewed by Charles Potters

Buy limit orders are instructions from traders to purchase an asset at a specified price or better, but only if the market price reaches that level. When price gaps occur above the market price, buy limit orders may not be executed immediately if the asset’s price jumps to a level beyond the specified limit.

Let’s take a look at why this happens and what you can do to make your buy limit orders more successful.

Key Takeaways

  • When too many buyers have the same idea, a limit order becomes ineffective if the price of the underlying asset jumps above the entry price.
  • A buy stop order is a type of order that transforms into a market order once the stated stop price has been reached.
  • The downside of a buy stop order is that you may end up paying more than you expected if the opening price is higher than you estimated it would be.
  • A buy-stop-limit order triggers an order to buy once the stop price is reached but only at the stated limit price.
  • A buy-stop-limit order protects you from overpaying by setting a minimum and maximum limit price.

Understanding Buy Limit Orders and Price Gaps

You’ve decided to invest your cash in stocks, hoping for a strong return. You’ve conducted your research and feel that you are ready to invest by implementing a limit order. You’ve found a company that, according to news sources, is set to trend. You consider it an excellent investment opportunity.

You determine a limit price based on the closing stock price that day and place what you feel is a reasonable limit order. You’re confident in your decision. Then, you check the stock the next day, only to find that your order was unable to be filled because the stock gapped up sharply in price when the market opened.

The above scenario is a prevalent one and can be frustrating for investors. Many traders, once they’ve identified a potentially profitable setup, will place a limit order after hours so their order will be filled at their desired price or better when the stock market opens. The problem is that many buyers do the same thing and the increased demand can cause the price of the stock to gap higher on the open.

Why Might a Limit Order Not Get Filled?

A buy limit order won’t get filled if the price of the underlying asset jumps above the order’s stated price. This is because the limit price is the maximum amount the investor is willing to pay. In the case of a gap, that price would now be below the market price.

You can minimize the chances of this situation happening again if you understand two types of orders: the buy stop order and the buy-stop-limit order. Each of these two are discussed more in-depth in the next sections.

What Is a Buy Stop Order?

A buy stop order is an order that transforms into a market order once the stated stop price has been reached. To explain how this works, let’s consider a hypothetical example.

Say that the current price of XYZ Company is $12.86 and it looks like it is positioned to go higher. You may wish to place a buy stop order with the stop price set at $13.01. This order would become a market order once the market price traded at or above $13.01. It would then be filled at the next available price. By using a buy stop order, you would eliminate the problem of not getting filled when the price rises above your desired entry price.

Unfortunately, you also run the risk of getting filled at an unwanted level if the price surges drastically higher. For example, if the price of XYZ Company opens the next day at $17, the stop order to buy is triggered at $13.01. You will buy the shares for around $17 instead of around $13 as you had planned.

Limit Order Risk

A limit order gives a trader more control over market entry points than a market order. However, you risk getting a partial fill or no fill at all should the market fail to reach your limit price.

What Is a Buy-Stop-Limit Order?

Using an order known as a buy-stop-limit, you can eliminate the chance of getting a bad fill by specifying the price paid for the asset. A buy-stop-limit order is similar to the buy stop order except that, instead of becoming a market order once the stop price is reached, a limit price is set as the maximum amount the investor is willing to pay.

For example, assume a buy-stop-limit order is placed on XYZ Company with a stop price at $13.01 and a limit price set at $15. If the price jumps to $17, this order will not get filled because you specified you didn’t want to pay more than $15.

  Buy Stop Order Buy-Stop-Limit Order
 Characteristics Becomes a market order when the market reaches the stop price Becomes a limit order when the market reaches the stop price
 Result Order fills at first available price Order fills at specific price or not at all
Control Ensures your trade will fill but not at a price you specify Ensures your trade will fill only if market reaches limit price or better
 Risk Order may be filled at a higher than anticipated price No guarantee that your order will be filled
Benefit Provides some upside protection by triggering order to buy Provides upside protection by limiting price at which order can be filled 
When to Use Use if you must get in the market, desire some upside protection, and can accept a higher than expected price Use if you want to buy at a specific price and can accept a partial fill or no fill at all if price isn’t met

Why Is My Limit Order Not Being Filled?

Bear in mind that, for a buy limit order, you’ve set the highest price at which you want to buy shares. Thus, your order fills only if the market trades at that price or better. If the market is trading above your limit price, there’s no guarantee your order will be executed.

What Happens If You Place a Limit Order Above the Market Price?

A buy limit order only executes when the market price of the stock is at or below the order’s limit price. So, generally speaking, if you place a buy limit order with a price that’s above the market price, the order will execute (perhaps at a better price).

However, this won’t be so if the market price gaps. Say, you place a buy limit order with a price that’s above Monday’s closing market price for a stock. You’re planning to buy the stock the following day at no more than your limit price as the market trends upward. At the opening on Tuesday morning, the stock price unexpectedly gaps up sharply, completely bypassing your limit price. In such a case, your order will fail to fill.

What Is the Difference Between a Buy Stop Order and a Buy-Stop-Limit Order?

A buy stop order becomes a market order when the market reaches the stop price. A buy-stop-limit order becomes a limit order when the market reaches the stop price. A limit order is filled only if the market then reaches the limit price. There’s no guarantee that it will be filled.

The Bottom Line

Entering the market at a specific price can be a difficult move to time. It may result in missing opportunities or getting in at the wrong point, based on your research.

Utilizing the buy stop order and the buy-stop-limit order can help you buy your stock at prices you see value at. Once you are comfortable with these order types, you can increase the likelihood of your orders getting filled when and how you want them to be.

Read the original article on Investopedia.