Using Limit Orders to Reduce Risk

Probably one of the biggest mistakes most traders make is using market orders. Let say I want to buy some shares of Microsoft at $30. A market order will execute a trade at whatever price your broker can grab it at. Sometime they will find you a great deal, but many times they will just get the first one they come across, so they can give the better deals to those that have inputed limit orders. After all they want to make commission off everybody right. So if you left no specifications, then why waste them on your trade?

Limit orders allow traders to set a maximum price they are willing to buy a stock at. With market orders, there is no maximum. Limit orders are especially good when it comes to stocks that aren’t as liquid. The spread between the buy (ask) and sell price is larger.

In our example that included Microsoft, a market order may not impact you as heavily as other stocks. Microsoft is obviously a very liquid stock, so the difference (spread) between the current market price and the buy (ask) price is not that much. In less liquid stocks those differences could be a dollar. A limit order allows you to lower your risk.

A less liquid stock means there are not as many shares being bought and sold at a given time. Simple economics says less supply higher prices, thus the reason for larger spreads. With a market order, your broker may grab some share $2.00 higher than what you wanted it. Again, with a limit order we can control what we want.

The importance of limit orders remains the same on buy and sell orders.

In most brokerage settings, market orders are the default; however, they can easily be changed. Use your brokerage support system if you have trouble finding how to use a limit order when conducting a trade.