How Does a Limit Order Work?

You clip coupons. You eat value meals. You shop at warehouse clubs. You even cut your own hair and wax your own earlobes. Given your penchant for saving money, it doesn't make sense to splurge on stock trading. In certain situations, you should ensure that you get the best price possible when buying or selling a stock. To do this, you instruct your brokerage to place to a limit order on your behalf.

Market Order

To understand limit orders, you must first know what a market order is. When you place a market order to buy or sell a stock, you offer no specifics in relation to price. Your brokerage submits your order on your behalf and accepts the best price available at the time it places the order.

Limit Order

By placing a limit order to buy or sell a stock, you guard against the uncertainty inherent in a market order. When you submit a limit order, you instruct your brokerage to not accept a price for a stock above or below a price you specify. If you are buying a stock, your brokerage will not let the purchase happen for more than your limit price. If you are selling a stock, your brokerage will not let the sale occur for less than your limit price.

Considerations

Limit prices tend to matter most for day traders, when placing large stock orders and in fast-moving markets or in stocks with wide bid-to-ask spreads, that is a significant range between the price a broker will buy your stock from you at and the price he will sell it for. When a few cents in a stock price matters, you should consider a limit order. If you are buying thousands of shares of a stock, for example, a small difference in the price you get can seriously impact future profits. If a stock is volatile, the same holds true; you want to ensure that things did not change so much between the last quote you saw and your placement of the order, that you get a price that is far different from what you were expecting. If you intend to purchase shares in a stock and hold them over the long term, however, the price you pay -- within a couple of cents -- might not be as vital to you.

Hypothetical Example

Imagine buying a stock that trades at $2.50 when you view the quote. Due to low volume in the security, however, the bid/ask spread is wide. If the bid is $2.40 and you sell the stock, you'll get $2.40 per share, not $2.50. If the ask is $2.60 and you buy the stock, you'll pay $2.60, not $2.50. If you place limit order to buy the stock at $2.55, your broker will not execute the order until the ask price drops to $2.55.

About the Author