How do you avoid paying too much for stocks? Is there a way to limit losses in the marketplace? Yes, there is – limit orders are one such way. Read on to find out more.
Buying limit or limit buy order is one side of a limit order. A limit order is what you may give your broker to tell him that you are interested in a particular stock but do not want to pay too much for it.
Take for example, a stock that is priced at US$ 10 today. You have studied the company and are satisfied that the stock is worth buying and that it has a growth potential for up to, say, US$ 20. You call your broker and give him a limit order for US$ 20.
As the stock starts selling, the market reacts to a favorable circumstance and the price of the share rises. Your broker will try and pick up your stock before the price crosses the US$ 20 limit you have set.
Why is this important? Assume that the price of the stock rises sharply and reaches US$ 80. You know from your analysis that the fundamentals of the company do not support this price. However, in the absence of a limit order, your broker has bought you some stock at this price. When the favorable circumstance is removed, the price of the stock starts to fall, and dips to the US$ 20 level you know is appropriate. You have lost US$ 60 per share!
This is precisely what the limit order seeks to protect you from. If your buying limit was known to your broker, the stock would not have been bought at anything over your set limit and you would not have suffered the loss.
The flip side of this protection is that in case the price rises too sharply, the broker may not be able to buy your stock before the price crosses the US$ 20 limit and you may end up with no stock at all.
Have you used a limit order while trading in stocks? How was your experience? How do you work out these details with your broker? What is your arrangement for sudden fluctuations in the market that impact your limits reliability?
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