A stop limit is typically used when you’re trading during a volatile market and want to target a specific price as closely as possible. When placing a market order, the price you pay is the best price available in the market at the time the order is executed. With a market order you can’t be sure of the price you’ll get, especially for more thinly traded securities or larger orders that may need to be handled in multiple transactions.
A stop order instructs your broker to buy a stock only when it is selling at or below a specified price (or if you’re selling, when it is at or above a certain price). Once the stop is triggered–in other words, once your specified price is reached–your order becomes a market order and is executed at the market price. However, if markets are volatile or the security is illiquid, the market price can change between the time the stop is triggered and when the order is fully executed. If you’re buying a stock and that price is lower, you benefit, but if the execution price is higher, you may pay more than you expected. For example, if you’re buying a thinly traded security and your order isn’t fully executed before the end of the trading day, you could run the risk of the market opening up strongly the next day—a phenomenon sometimes known as “gapping up”—potentially taking the price of your targeted stock with it. Conversely, if you’re selling a stock and the price moves lower before the trade is fully executed, you might make less from the sale than you intended.
A stop-limit order puts a limit on the price you’re willing to pay for your purchase (or accept if you’re selling). It mandates that a purchase be executed at a specific price or better; that price can be different from the stop level that triggers a trade, and increases the odds of the transaction meeting your expectations. If you’re selling, a stop-limit order also can be used to set a minimum price for the sale. Stop limits are typically good for a specific time frame, such as a day, a week, or a month.
Why wouldn’t everyone use a stop-limit order with every trade? Because they typically cost more to use than market orders. As a result, a stop limit probably makes the most sense for large orders in volatile markets, when a difference of even a penny or two per share can mount up.
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