For many beginning stock traders, understanding how a limit order can be confusing. While the formal definition states that it is an “order that is to be executed at a specified price or better “, it can seem a little vague. In the next few paragraphs I will give an example using an every day object you would be purchasing in the market place. To gain a better understanding of what a limit order is, and how it actually works to you benefit. We will facilitate the “buying a used car” as an example. Bear with me a moment and let the information sink in.
Buy Limit Order
When buying a used car we want to buy it at the best price available. Since we are buying a used car, we also know that we want to get the cheapest price. So the cheapest price would be considered our “limit”. Say that we want to buy a used honda accord, and we look at the blue book value, shop around, and determined that used honda accords are priced between $8000-$10,000 dollars. Now we have determined what the “market price” of a used honda is. Again, we want the cheapest price, and realistically set our “buy limit order” at $8000. In conclusion, our set limit order would be $8000. Of course, should a better deal come around, say for example a honda accord selling for $7500. Again, a buy limit order is to be executed at your specified price or lower. In another scenario, we don’t want to be too greedy, or we don’t want to wait too long to get a deal. So, let’s say we set a buy limit order at $8500 to get that Honda. Our “limit price” is $8500, therefore we will purchase any car at $8500 or below.
Sell Limit Order
To explain a sell limit order, we will also facilitate the used car in this example. We have a used Honda Accord, and since we are selling it, we want to sell it at the highest price available. We have looked at various sources and determined that used Honda Accords sell between $8000-$10000. We obviously want the best price to sell, and that would be $10,000 dollars. Therefore, we set our “sell limit price” at $10,000. So anytime there is a buyer that is willing to spend $10,000 dollars we would execute a sale at that price or better. Because a sell limit order get us the best price, if somebody were willing to buy our used car at $12,000 we would also sell because, a sell limit get us our specified price or higher.
Application of Limit orders In the Stock Market
With a better understanding of how limit orders work conceptually, we can now use this knowledge to apply it to buying or selling a stock using a limit order.
Let’s say we want to buy some XYZ stock, and we check today’s quotes and charts and determine that XYZ has been trading between $25 – $27. If we were buying, we want to get the best and lowest price available. So we would set our limit order at $25. If we were selling Apple stock we want to get the best price, in this case the highest price for our sale. So we would set a sell limit order at $27.
Keep in mind that the example above is just an example and setting a buy limit order at the exact bottom, and setting a sell limit order at the exact highest price is NOT REALISTIC. With the volatility and speed that the market moves, your order may or may not get executed. So, when setting a buy limit order I might want to pick $25.50 to get a better execution. Likewise when setting a sell limit order, in this case I would set my sell limit price at $25.5o..