What is a limit order?

An order placed in advance to buy or sell shares is known as a limit order. It allows you to specify the price you feel comfortable paying or receiving for the shares purchased or sold in the trade. However, if the share price never reaches your specified price, then the order won't execute.

A limit order provides certainty around the price you will pay for a trade.

If you are executing a buy order, then the transaction will only proceed if the share price is at or below your limit price, guaranteeing that you will pay no more than you are comfortable with for the shares.

If you are placing a sell order, the trade will only proceed if the share price is at or above your limit price, guaranteeing that you receive no less than you expect from the transaction. 

How does a limit order work?

Let's illustrate how a limit order works with two examples.

When buying …

Let's say you want to buy shares in an ASX growth company like WiseTech Global Ltd (ASX: WTC), but you reckon its current share price values the company too highly. Based on your research and analysis, you think a fair price for WiseTech shares is more like $40.

You can place a limit order to buy 100 WiseTech shares at $40 a share, which will execute only if the WiseTech share price drops to $40 or less. That way, you know the most you'll have to pay for 100 WiseTech shares is $4,000 (plus fees and brokerage).

Or selling

On the other hand, let's say you already own 100 WiseTech shares and want to sell them for what you perceive to be a fair price. You have faith in the company's business model and think its stock is currently undervalued, but its price might soon increase.

You can place a limit order to sell your 100 WiseTech shares if the share price increases to $50 a share — which you think is a fairer price based on your understanding of the company. This provides the certainty that you will receive no less than $5,000 (before fees) as long as the order executes.

It is important to remember that, in both cases, the trade will not execute if the share price never reaches your limit price. This means you won't have to make a trade at a price you aren't comfortable with. But it might also mean that you miss out on a potential trading opportunity — particularly if the company releases an update after you place your limit order that might make you reassess its value.

How long is it valid?

You can set an expiry date when you place a limit order. Typically, this can cover up to 20 business days from the date you first place the order. "Good for day" orders expire at the end of the current trading day.

Keeping limit orders open for long periods might make them more likely to execute, but it also means you might miss out on lucrative opportunities if something about the company changes.

For example, right now, you might think $50 is a fair price to sell your WiseTech shares at, but what if tomorrow the company announces a new strategic partnership that significantly increases its profits? The WiseTech share price might suddenly shoot up to $60. But because your limit trade executed when it crossed $50, you missed out on up to an extra $1,000 of gains!

The point is, just because a limit order gives you some certainty about the outcome of a trade, it doesn't mean that you can entirely "set and forget" your orders. You should regularly monitor the market to make sure things don't happen that might change your opinion of your limit price.

What should beginner investors know about limit orders?

Limit orders can be a great way to lock in the price of a trade — but they still come with risks. As we've already discussed, there is the possibility that you might miss out on additional gains on your investments if you don't stay up to date on the latest company announcements.

When you place a limit order — particularly if you set your expiry date 20 days into the future — continue to monitor your trades to ensure you are still happy with your limit price.

And always remember — although a limit order guarantees the transaction price, it doesn't guarantee that the order will be executed. And even if the order is executed, it may not be completed in full — particularly if you are trying to buy or sell large quantities of shares in a thinly traded company.

This means that if there aren't enough shares available at your limit price, only a portion of your trade will go through — perhaps you will only be able to buy 50 WiseTech shares at $40, rather than the 100 shares you originally wanted. Similarly, you may be unable to sell the total number of shares you wanted if there aren't enough buyers willing to accept your limit price.

If you simply want to ensure your order goes through, you may prefer to accept the current market price rather than placing a limit order. This will guarantee that your order is processed in the shortest possible timeframe, but it will be at whatever price the stock is trading at the time.

Setting the limit price

The price you choose for your limit order should be based on your understanding of the company's underlying fundamentals.

It should be a price you are prepared to pay for the shares — but one that you also think is fair and reasonable based on the company's recent performance and growth trajectory.

When would an investor choose a limit order?

A limit order is advantageous during periods of heightened market volatility when prices change quickly. Rather than obsessively monitoring the market and trying to place a trade at the exact moment the share price reaches the level you want, you can just place a limit order and take the guesswork out of timing the market.

Limit orders are also a good choice when trading riskier and more speculative shares, like some rapid-growth companies. Because the prices of these shares can change quickly in response to new company announcements, setting a price that you are comfortable paying ahead of time helps reduce the risk of overpaying for new investments.

What is the difference between a limit, market, and stop order?

As we've discussed, a limit order guarantees that your trade will only be executed at a price equal to or better than your limit price. However, your trade may not run if the share price never reaches your limit.

A market order, on the other hand, guarantees speedy execution of your trade at whatever the current market price for the share is. A market order may be preferable if you simply want to ensure that your trade is processed in the shortest possible timeframe.

When one becomes the other

A stop order is similar to a limit order. As with a limit order, when you place a stop order, you specify a price at which you would like a trade to be executed in the future. However, unlike a limit order, a stop order typically converts into an ordinary market order once the stop price is passed. This guarantees the trade will execute in full but at an eventual price that may differ from the nominated stop price, especially in volatile or less liquid markets.

Continuing with our WiseTech example, let's say you own 100 WiseTech shares, which are currently trading for $45 a share. You aren't sure how the market will react to an upcoming earnings report, so you want to place a limit on your potential losses in case the report disappoints. You could place a stop order to sell your 100 shares at $40 a share, which would execute if the share price drops below $40. This should cap the amount of your investment you stand to lose if things head south. 

Stop order pitfalls

However, because it converts to a market order, a stop order often isn't as effective at preventing significant losses as you might think. Suppose WiseTech releases a really, really terrible earnings report, and its share price suddenly sinks to just $30. In that case, your stop order will convert into a market order, and your shares might be sold for $30 — or possibly even lower!

To get around this, investors can combine stop orders with limit orders so that instead of converting into a market order once the stop price is reached, it turns into a limit order. You could then set a stop price of $40, converting into a limit order to sell only at or above $35 a share. This gives you greater precision about the price at which your trades will execute – but as with other limit orders, it doesn't guarantee that the trade will occur.

Why would a limit order fail to execute?

Although a limit order gives you the certainty of the price you'll pay for the shares, it still does not guarantee that your order will execute. Nobody can predict where the market will move from one day to the next, which means the shares you want to buy or sell may not reach your limit price before your order expires. 

Remember, if you have placed a limit order to buy shares, but the stock price doesn't fall to your nominated limit price, your order won't execute. Similarly, if you have placed a limit order to sell your shares, the order won't perform unless the market price reaches your limit price or higher.

Can a limit order be cancelled?

Yes, you can cancel a limit order for any reason, so long as it hasn't already been filled. As limit orders can be left open for days, market prices may move a distance away from your original limit price.

As price expectations change, you may wish to cancel old limit orders and open new ones. This can be done relatively quickly through your broker service or share trading platform.