For example, say you purchased 1,000 shares of a company at Rs. 50 each, and you want to sell them now because the company’s share price is Rs. 65. You expect a profit of Rs. 15,000. So, you place a market order where the shares will be sold at the current market price. But by the time your order is executed, the company’s share price dips to Rs. 60 per share, giving you a profit of only Rs. 10,000.
To avoid this issue, you can place a limit order instead. Not sure what a limit order in the share market is and how it works? In this article, we’ll take a closer look at this type of stock market order, so you can use it to your advantage.
Understanding Limit Orders in Trading
A limit order is a directive given through your brokerage account, indicating a specific quantity of stocks or securities to be bought or sold at a set (or more favourable) price. This kind of transaction gives you greater control over the prices at which you buy or sell shares and securities in the market. The execution of a limit order depends on market conditions and the bid-ask spread, as the trade will only occur if the specified price is reached or exceeded. Here’s how it works:
- Buy Limit Order: This executes at the specified price or lower. Buy limit orders ensure that you do not pay more than your set price.
- Sell Limit Order: This executes at the specified price or higher. Sell limit orders ensure you receive no less than your set price.
This entire mechanism benefits traders by giving them more control over their profitability. Purchases are more advantageous at lower prices, while sales are more profitable at higher prices. However, it is also important to note that a limit order may not execute in case the market does not reach the specified price.
Limit orders are particularly great for traders who are trying to manage risk while also maintaining control over their trading decisions.
Additional Read : What is a Stop-Limit Order
How Does a Limit Order Work?
In layman’s terms, limit order is an easy way to control the price at which you buy or sell stocks. As discussed, you set a specific price you are comfortable with, and the trade will only happen if the market price matches or improves on it.
Let’s break it down with an example. Say you want to buy 500 shares of a company, but the current price is ₹58 per share. You think the price might drop to ₹50, so you place a buy limit order at ₹50. This means you are telling the market, “I will buy these shares, but only if the price is ₹50 or lower.”
If the market price drops to ₹50 and there are enough sellers, your order will execute. If the price drops even further, let’s say to ₹48; your order will still execute, but at ₹48, which is even better for you. However, if the price never falls to ₹50, your order won’t execute, and no transaction will happen.
The same idea applies to selling. Let’s say you want to sell shares and set a sell limit order at ₹150. The order will only execute if the stock price rises to ₹150 or higher.
The beauty of a limit order lies in its precision. It ensures that trades occur only at desired price points. This protects you from paying too much or selling too low. In a nutshell, limit orders control the price of your trades. Yet again, they do not guarantee execution unless the market hits your price. They are perfect for traders seeking precision over speed.
Things to Know Before Placing a Limit Order
Here are some important things you need to keep in mind before you place a limit order in the share market.
Limit Orders Need to be Used Under the Right Conditions
A limit order is better suited for certain conditions. If the market is extremely volatile, using market orders will result in a great deal of slippage. You can avoid this by using limit orders instead. A limit order may also be suitable if you are not in a hurry, or if you do not have the time to monitor the market round the clock.
It is Important to Set Realistic Limits
The limits you set for your orders need to be realistic. If you place a sell order with an unrealistically high price limit or a buy order with an unrealistically low price limit, that price may never be attained during a given trading session. This means your order may lapse (unless it is a ‘Good Till Trigger’ or GTT order). Even then, it may take several days for the price to reach your desired limits.
Limit Orders Do Not Guarantee Execution
Unlike a market order, which gets filled instantly at the best available price, a limit order will only execute if the market price meets or exceeds your specified price. This means there is no guarantee your order will be fulfilled. If the stock never reaches your limit, the order will remain open and unfilled.
Partial Fulfillment Exists
Limit orders can be partially fulfilled, especially in illiquid stocks or during periods of high volatility. For example, if you are buying 500 shares at ₹200 but only 300 shares are available at that price, only 300 shares will be purchased. This leaves the remaining 200 shares pending until the price returns to your limit or a better price is available.
Market Volatility Has an Impact
Limit orders can be highly affected by the constant market movements. During highly volatile times, the price may bypass your limit order altogether, which can either cause missed opportunities or fill your order at a better price. It is highly important to consider how market fluctuations can impact your trade.
Pay Attention to the Order Duration
Limit orders will not always expire at the end of the trading day. You can choose between a Day Order (which expires at the close of the trading session), or a Good Till Cancelled (GTC) order (which remains active until it’s executed or you cancel it). Make sure to choose the right duration based on your strategy and market outlook.
Transaction Costs Can Add Up Quickly
Depending on your broker and the type of order, limit orders might incur higher transaction fees. For frequent traders, these added costs can accumulate quickly. Hence, it is important to consider them in your overall strategy.
Limit Orders vs. Market Orders
Limit orders and market orders are two of the most commonly used types of trades. Each of these serves a different purpose and offers distinct advantages.
Limit Orders
A limit order allows you to set a specific price at which you are willing to buy or sell a stock. It gives you more control over the price. In simplr terms, limit orders ensure that you don’t overpay or undersell. However, there is no guarantee that the order will be executed unless the market reaches your specified price.
Let’s say you want to buy shares of Company X, which is trading at ₹1000. However, you are only willing to buy at ₹980 or lower. You place a buy limit order at ₹980. If the price drops to ₹980 or lower, your order will be executed. If the price doesn’t reach your limit, your order won’t be filled.
Market Orders
A market order, on the other hand, is an instruction to buy or sell a stock immediately at the best available price. While it does ensure quick execution, the price you get may not be as favourable (especially in volatile markets). Market orders are ideal for traders who prioritise speed over price precision.
Here, you are willing to buy shares of Company X right now, irrespective of the price. You place a market order. The order will be filled immediately at the best available price, which could be ₹1000 or even slightly higher (depending on market conditions).
Advantages of Limit Orders
Limit orders offer several advantages for traders looking to maintain control over their trades. Besides giving you control over your risk management and trading strategy, some others include:
- Protecting from Market Fluctuations: First and foremost, they allow you to set a specific price, thereby ensuring you don’t end up paying more or selling for less than you intended. This helps protect you from sudden market fluctuations.
- Flexibility: Limit orders also provide flexibility. This is because they can be set for different durations, right from a single day to an extended period.
- No Need of Constant Monitoring: Additionally, they also help in reducing the emotional aspect of decision-making. This is because your trades are executed automatically when your target price is met, thereby removing the need for constant monitoring.
Disadvantages of Limit Orders
While limit orders offer control, they come with certain drawbacks. Some include:
- No Guaranteed Execution: If the market price never reaches your limit price, your order may remain unfulfilled. This can result in missed opportunities, especially in a market that is moving at a rapid rate.
- Chances of Partial Execution: Additionally, limit orders can be partially filled, meaning only part of your order is executed if there aren’t enough shares available at your specified price. This can leave you with an incomplete position.
- Requires Patience: Limit orders may require more patience, as they can remain open for extended periods. This might not suit traders seeking immediate results.
Practical Use Cases in the Broking Industry
Limit orders are widely used in the broking industry for various reasons. In fact, it allows traders to adjust their strategies. Some of the practical use cases of limit orders in the broking industry involve:
- Price Control: Investors set limit orders to buy stocks only when the price drops to a level they’re comfortable with or to sell when the price rises to their target. This is especially useful in volatile markets, where prices can change in the blink of an eye.
- Portfolio Rebalancing: Here, traders use limit orders to buy or sell assets gradually at specific prices without impacting the overall market.
- Risk Management: This is yet another key use, as traders can place stop-limit orders to reduce the potential losses by automatically selling a stock if its price falls below a certain threshold.
- No Emotional Trading: In addition, limit orders help reduce emotional trading by automating decisions based on preset targets. Thid system ensures disciplined and systematic trades.
Conclusion
This sums up what a limit order in the share market is and how it works. You can use this kind of order to your advantage if you want to ensure that you do not miss out on a lucrative trading opportunity. To get started with stock market trading and use limit orders to make custom trades, open a demat and trading account with Bajaj Broking today via a simple 3-step process, and experience the advantage offered by Bajaj Broking.
