Terms Beginning With 'l'

Limit order

  • January 17, 2020
  • Team Kalkine

What is an Order

In the financial markets, there is a highly organized and systemic mechanism of trading which leads to a seamless transaction of securities worth billions of dollars every day. Order placement is one such part of this mechanism.

 

An order is simply a willingness of a buyer or a seller to buy or sell a specific quantity of a security at the desired price at any point of time. This willingness is put forth in an exchange in the form of confirmation is called an order.

 

2 Types of order

To execute a transaction on a stock exchange, there are primarily two types of orders, either one of which needs to be placed to buy or sell the desired security. Both of these orders can be used to execute a transaction but the main difference between the usage of two lies in the desired prices at which the buyer or seller wants to buy or sell with respect to the current market price (CMP) of that security. These two order types are

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We will be discussing the Limit order here.

Limit Order

The price is ever moving, and the securities frequently become overpriced and underpriced or sometimes the movement of price is way too erratic, especially around any major announcement by the company. Many times, the buyers and sellers are willing to transact at their own desired prices which is different from the current price. A limit order does this job.

A limit order is an order in which the buyer or the seller defines a better price at which he/she is willing to transact. The order will only get triggered when the current market price comes to the desired price. These prices are lower than CMP in the case of a buy order and higher than CMP in case of a sell order as a lower price to buy, and higher price to sell is always preferred.

While dealing in securities using the limit orders, an investor or a trader can guarantee to transact at a better price if the order gets triggered. Limit orders are beneficial when the investor/trader is not watching the prices movements through the day as these orders get placed and sit in the exchange till, they get filled, or the market closes.

A Limit Order does not come with a guarantee to be filled. There is no assurance that the CMP would reach the limit order price. Limit Order stands to cancel and is not filled if CMP doesn’t reach to the order qualification and the market ends the day’s session.

Limit Orders during Gap up/Gap down

Another great advantage of Limit order is witnessed during gap ups and gap downs while placing an after market order (AMO), which is placing a limit or a market order after the closing of the trading session for the next day. If the market opens with a gap and surpasses the limit price, then the buyer or the seller may even get a better price than the desired one.

To put it simply, If CMP is $110 and buy limit order is placed at $105 for the next day (AMO), if the market opens gap down at $ 101, then the buy order would get trigger at $101.

Similarly, for a seller, If CMP is $110 and sell limit order is placed at $113 for the next day (AMO), if the market opens gap up at $ 115, then the sell order would get trigger at $115. Although in both instances, order fill is not guaranteed.

A practical example of using a limit order

Suppose there is an investor B who is willing to buy XYZ stock at $50, but the CMP is $55. He has two options, either to buy immediately at CMP (which is not his desired price) or to place a limit order and wait for the stock to come to his desired price.

 

After placing a buy limit order at $50 either of the two instances would happen.

Case 1 – CMP didn’t come at the Limit price

Throughout the trading session if sellers are not willing to sell at $50, then the CMP would not reach the limit price, and the order will not be triggered. In this case, the order shall stand cancelled, and the buyer will have to keep trying to get XYZ at $50 every day till the order gets filled, for which there is no guarantee.

Case 2- CMP reaches the limit price

Sometime throughout the day, the CMP comes to the limit price, but again there are some other aspects which may hinder the order fill, primarily related to the quantity.

Suppose, even if CMP comes to $50, all the orders which have been placed before B would first get triggered and filled, and maybe by the time B’s order gets triggered all the supply gets absorbed, and no more sellers were left to sell at $50. In that case, the market will rise again, and B’s order will either not get filled fully or may be partially filled (whatever the case may be).

The same scenario pans out in the case of a limit sell order in the opposite direction.

The drawback of using a limit order

Although a better price is guaranteed if filled, whether the order would be filled or not is always uncertain. This may also lead to loss of opportunity in case the order doesn’t get filled, and the stocks move in the chosen direction.

Using above example, If the price of XYZ didn’t come to $50 and within a few days the price starts to rise and eventually touches $65, in that case, the opportunity to make $10 profit, had it been bought at CMP of $55 is also been missed.

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