While trading stocks, commodities, bonds, currencies, and cryptocurrencies, you place an order with your broker. In simple terms, an order is an instruction to your broker to trade on your behalf. There are several types of orders that an investor can place. What's a limit order, and how does it differ from a market order or a stop order?
The types of orders an investor can place include:
- Market orders.
- Limit orders.
- Stop orders.
- IOC (immediate or cancel) orders.
- AON (all or none) orders.
- FOK (fill or kill) orders.
- Day orders.
- GTC (good till canceled) orders.
All of these orders serve different purposes. For instance, in AON orders, your trade would get executed only when the desired number of securities are available. They're particularly useful where volumes are low, such as in over-the-counter or penny stock trading.
Limit order definition
In a limit order, you instruct your broker to buy or sell the security at a specified price. The trade can be executed only at that price or better. So, in a buy limit order, the trade would get executed at either your instructed price or lower, and in a sell limit order, the security would be sold at the limit price or higher.
Limit order versus market order
In a market order, you don’t specify any price to your broker—the trade is executed immediately. If you place a buy market order, the trade would get executed at the current ask price. Market orders for selling securities are executed near the current bid price. There's not much difference in bid and ask prices for securities where the volumes are very high. However, the bid-ask spread can be wide for thinly traded securities where liquidity is low.
The basic difference between a limit order and a market order is about certainty. In a market order, you can be certain that the trade will get executed, but this is not the case for a limit order. On the other hand, in limit orders, you can be certain the trade will get executed at a particular price, but in market orders, you don’t have any control over the trade execution price.
Certainty of execution versus certainty of price
Market and limit orders cater to different needs. If execution is important, market orders may be better. However, if price is more important, go for a limit order.
Short-term traders, who prioritize price, tend to prefer limit orders. Meanwhile, long-term investors, to whom execution is more important, prefer market orders—when holding a security for years, small differences in buying price don't make much difference in your total returns.
I talked about setting a stop-loss the other day and got asked what that means.— Ace (@NoTimeZone_) December 13, 2020
A stop-loss is an order placed to buy or sell a specific stock once the stock reaches a certain price.
You can set your stop loss to work in your favor if the stock runs up or if it dips.
Limit orders versus stop orders
In a stop order, the trade is executed at a pre-specified price. Unlike limit orders, they're not seen by the market. When placing a big order, traders may prefer a stop order because a visible limit order for a large volume can impact the stock's price.
A stop order is the opposite of a limit order. Whereas in a stop-loss order you instruct your broker to sell the security if the price falls below a specified level, in a limit order, you direct the broker to sell the security at or above a specified level. The purpose of a stop-loss order is to limit your losses.
To sum up, no order type is good or bad—their suitability ultimately depends on your preferences. You can prioritize execution and place a market order or prioritize price and place a limit order.