When purchasing or selling a security it is not uncommon to place an order and then find that the price has changed before your order is fulfilled, sometimes the price changes substantially. A limit order is an investment strategy designed to limit an investor’s exposure to this price fluctuation risk.
For example, an investor may want to get in on a hot stock and so, at $25 a share, places an order to buy. The order may take a little while to go through and by the time the investor’s order to purchase 100 shares is complete the share price could increase. What he was expecting to pay $2,500 on could now be $5,000. A limit order could have prevented this.
A limit order can be used to both buy and sell. A limit order specifies the price at which an investor wishes to do business.
Buy!
With a limit order to purchase the investor in our example could have specified to but the securities up to $30. If the price exceeds $30 the buy order will not be placed. This would have limited his exposure and prevented him from buying so high.
A limit order like this could also prevent the investor from a sudden swing in prices, if that same security shot up to $50 where he purchased the security then dropped to $15 a share he would suffer substantial losses. A limit order limits the potential damage that a volatile security could cause.
Sell!
A limit order to sell instructs the broker to sell a security once a certain price has been hit. This can work both ways with instruction to sell once the price drops or rises to a certain value.
This limits the potential loss for an investor. It also allows the investor to escape any emotional attachment or reaction to the securities performance.
In the example above the security dropped to $15 a share. With a limit order at say, $40, the securities would have been sold and the investor would have limited his losses. The opposite is also true, with a volatile security if it rose from the $50 to $75, and there was a limit order to sell at $75, the investor will have sold before the price could drop.
Limit orders are particularly effective with securities that are volatile and the share price fluctuates greatly, but they can be used with any security. When an investor needs a little more security than a simple buy or sell order can provide a limit order offers a great alternative.
Limit orders are an effective tool in any investor’s portfolio. Learn how to use them and use them to your advantage!