Back To Basics Limit Order

Question from a student: I'm completely confused by limit orders. What good do they do, especially in relation to risk management? Can I hold an overnight position on a stock bought at $20.00 (ordered, say, thirty seconds before the market closes) and set a stop loss of $19.90 on it, so that if the stock gets a surprise downgrade the following morning, I won't take such a horrendous loss on it? Is this possible, using some type of Good Til Cancelled scenario. I guess what I'm trying to say is: is there any way to competently guess the market in order to limit devastating losses? If not, then why not use market orders exclusively? The risk is the same, and more often than not, market orders are much cheaper. Any help here would be greatly appreciated.

Mike 's Answer: Let's start with a simple definition. Limit orders specify a specific price (or better) and share size. Market orders are executed at the price the market is at - At Time of Execution. Limit orders do not suffer slippage, but run the risk of not being filled. Market orders are almost always filled, but you can get filled "away" from the price you had in mind.

Now, the question you pose ultimately has to do with Stop Loss Limit versus Stop Loss Market orders. In your scenario, you are long and taking it overnight. You had good reasons to do so, but an extraordinary event causes it to gap down several points.

Scenario #1: You bought at $20 and place a Stop Loss Limit of $19.90. The market gaps down to $17. The first trade was well below your SLL of $19.90. You do not get filled, thus, you are now holding a $3 dollar loser. You still have the position and we can work with this, but clearly, this is not the best scenario.

Scenario #2: You bought at $20 and place a Stop Loss Market. The market gaps down to $17. The first trade was at $17. This activates your Market Sell order. You will probably be filled on the next trade at the Inside Bid price ( $16.99, $17 or $17.01). You have been filled, thus, you have taken a $3 dollar loser. You are out of the trade, which is good, but you have suffered a significant draw down. I could be glib and say "Welcome to trading," but let's see what we could do. Again, this is not a good scenario.

Scenario #1 protects you against normal wear and tear of price movement, although $0.10 is fairly tight for an overnight stop. Most traders are trying to maintain at least a 1:3 Risk to Reward ratio. That is to say, if you risk a dime, you expect 30 cents minimum. Overnights are high risk trades, as you cannot control events (assassinations, fraud, terrorism or just a good old earthquake – I live in California) and, therefore, should you take one home, you need to have very high probability that a excellent reward awaits you (high risk better equal high reward). Extraordinary events do catch us. So a Stop Loss Limit actually protects you by giving you the opportunity to "work" the position rather than "eat" the big loser.

In this case, it has gapped down against you. Almost always, there will be "gap filling" pressures. Gap fills take place in the first 45 minutes (sometimes an hour). Thus, instead of canceling your SLL and blowing out the position at Market, watch for the first hour. We are not trying to make a profit here, but rather, to manage and salvage our loss (You are not "hoping" for it to come back, you are calculating a better exit). If the gap fills only 38.2%, sell the whole position. If the Gap fills 50%, sell half of your position, and watch for any weakness. If weakness shows, blow out the balance. If the gap fills 61.8% or higher, then hold on a little longer, because this higher percentage of gap fill shows this stock has some strength. Be prepared to dump the whole thing if there is any indication of weakness.

Again, we are trying to cut your loss, not make a profit on a loser. If you were fortunate to retrace to the 61.8 % fill, you have saved about $2 of the loss. The percentages I mentioned here are Fibonacci Retracement numbers.

So, we are at decision point. First, should you take this stock home overnight? NEVER take home a loser. If you take a 'long ' home, you want it closing on or near the high of the day with increasing volume.

Next, what stop loss to use? First question for every good trader is, "How much am I willing to lose if I am wrong?" Whatever that amount is, multiply it by 3, and then look to see if you can achieve that profit. If not, pass on the trade.

An example of this to consider: You say, "I can afford to lose $0.50/share on this trade". Therefore, you have calculated that you can make $1.50/share in potential profit. Now look at the reality of the situation. You are playing a $20 stock. For it to move $1.50 the next day, it will have to move 7.5% or better. Is this realistic? If it is, then you must realize that you are playing with a fairly volatile stock (probably a Beta of 2 - 2.5). Most stocks move a couple of percent in a day. So, if the stock has been moving only 3 or 4 % in its recent history, you must decide on one or two possibilities. First, a $0.50 stop loss is too large to protect the risk/reward scenario. If the stock only moves 5%, then $1 is the profit target, thus, you should probably reduce your stop loss to only $0.33 (remember 1:3 ratio).

The 2nd thing to consider is the aspect of "extraordinary events" - how do you factor them into your risk profile? Look at the over-all picture. Has the market been clearly trending or is it choppy? Are there good Economic and Market indication to support your decision to hold overnight? If you only expect to make $.25 or $.50 the next day, but could suffer a $2-$3 loser, then why not buy it the next day. Sure, you may lose some profitability to gap ups or release of news, but the game is learning "how not to lose" and Capital Preservation. Remember, better money missed, than money lost!

So, in reality, it does not matter which Stop Loss you use - Limit or Market - but rather the risk/reward scenario, your risk tolerance, the stocks characteristics and the possibility/probability of bad news. A trade plan (which includes a Stop Loss) is absolutely necessary.

However, we all get caught occasionally - That IS trading- but if you follow the "loss management" I proposed above considering Gap fill, you can hold your account together to fight another day.

Last comment. You mention that Market orders are much cheaper than Limit. First, check around with other broker dealers. If you are working with very cheap commissions, then you may be doing yourself a disservice. A $5 market order on a 1000 shares costs about $25 with only a $0.02 slippage. A $15 limit order is $15, as there is no slippage. I have no idea who you are with, what prices you pay, but please consider what we call "load" - which is slippage + commission + fees. You might be surprised what that "cheap" ticket is really costing you. You can check out our partners page to see which broker/dealers also offer tuition rebates – a win/win situation:

Thanks for your question and happy trading