What is a limit order?

A limit order is a tactic to that you can use to minimize your risk when purchasing stock. You may buy or sell stock with several different options. This article will explain the basics on how to purchase stock and why you may want to use a limit order when you purchase stock.

You have three basic options to trade stocks: buys, sells and short sales with a couple variations of those.

Buy

A buy is an order to purchase a specified number of shares. If you place a `market order' then your stock broker will execute the purchase immediately at the going price on the market. This transaction will usually take only a few seconds depending if you go on line or if you are talking directly with your broker.

Buy Limit or Limit Order

A buy limit order is useful for preventing you from overpaying for a fast-moving stock. For instance, if you want to purchase XYZ and the last time you looked the stock was trading at $25 per share then you could place a maximum limit on the amount you are willing to pay. If you limit the order at $27, then your stock broker will only execute the purchase if he can find a seller that is willing to sell the shares below $27.

Usually a limit order will have an expiration date. This prevents the order from being valid for too long and executing when you don't want it to. For example, if your limit order is valid for six months, the company could have some terrible news and declare bankruptcy. If you limit order is still valid, you may end up purchasing some stock when the price comes down when the stock market hears the bankruptcy news.

Sell

A sell is an order to sell shares that you own, either at the current market price, or at a specified minimum price. If you sell at market price, then your broker can execute immediately by getting the best price possible right now. The transaction will usually only take seconds. As with buy limit orders, a sell limit order will only be executed if a buyer wants to pay your specified price.

Sell Stop

A sell stop is an order to sell a stock if it drops below a specified price. This is a tactic you can use to minimize your losses. If you purchase a stock at $25, you can put a sell stop at $20 so that if the price drops to that point, your broker will automatically sell in order to limit your losses. However, the stop limit won't guarantee you will get that price. For example, if bad news hit the company during the night when the exchange is closed, the stock might open the following morning at $18. Your sell stop limit would be triggered so your stock would sell, but you would only get $18 per share.

Short Sale

A short sale is an order to sell a stock that you don't own. Short-selling involves borrowing shares from your broker and selling those borrowed shares in the hope that the price will drop. You will be able to replace the borrowed shares by buying them at the lower price. Selling short requires that you have a margin (credit) account with your broker. This tactic can be very risky because you can lose more money than you have put into the market. Only the sophisticated investor should be using this tactic.

You can now see the different types of ways you can purchase stock. The limit order should be used to minimize your risk when placing a purchase order. When you have a fast moving stock the limit order can be very useful.

In summary, purchasing stocks using a limit order reduces your risk. Your broker will only execute your order if the market price meets the price you set. However, you are not guaranteed that all transactions will be executed.