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“By knowing when and how to use these orders, you can effectively manage your trades.”
Among the various types of forex orders, limit orders and stop orders typically get confused for one another. This confusion may be rooted in the fact that both are pending orders. However, they serve different purposes, and are used in different trading scenarios. In this article, we will explore the key differences between them, and help you understand when and how you should use each one in your trading strategy.
Jump to a Section
- What is a Limit Order?
- What is a Stop Order?
- Key Differences Between Limit Orders and Stop Orders
- Buy Limit, Sell Limit, Buy Stop and Sell Stop
- When to Use Limit Orders
- When to Use Stop Orders
- Final Thoughts
What is a Limit Order?
A limit order is an order to buy or sell a currency pair at a specific price or better. It ensures that the trader gets the desired price or a better one, but does not guarantee that the trade will be executed. For a buy limit order, the order will only be filled at the limit price or lower, while for a sell limit order, it will only be executed at the limit price or higher.
Example: Suppose that the EUR/USD is currently trading at 1.1000, and you want to buy if the price drops to 1.0950. You would set a buy limit order at 1.0950. If the price falls to 1.0950 or lower, your order will be executed at that price or better. However, if the price does not reach 1.0950, your order will remain unfilled.
What is a Stop Order?
A stop order is an order to buy or sell a currency pair once it reaches a specified price, known as the stop price. When the stop price is reached, the stop order becomes a market order and is executed at the next available price. This type of order is often used to enter the market in the direction of a trend.
Example: Suppose that you believe the EUR/USD currency pair, currently trading at 1.1000, will continue to rise if it breaks above 1.1050. You want to buy if the price reaches 1.1050 because you think it will continue to move upward. To do this, you place a buy stop order at 1.1050. If the price of EUR/USD rises to 1.1050, your buy stop order will be triggered, and you will enter a long position (buy) at the next available price. If it does not rise to 1.1050, your order will remain unfilled.
Key Differences Between Limit Orders and Stop Orders
Execution Condition
Limit Orders: They execute only at the limit price or better. The order may remain unfilled if the market does not reach the specified price.
Stop Orders: They are triggered when the market reaches the stop price, then executed as a market order at the next available price.
Purpose
Limit Orders: They are used to enter the market at a specific price or better. Traders use them to ensure they get the price they want.
Stop Orders: They are used to enter the market in the direction of a trend once a certain price level is breached.
Buy Limit, Sell Limit, Buy Stop and Sell Stop
Let’s explore how each of these orders are set. The red dot in the image below represents the current market price.
As you can see, the limit order is set at a more favourable price with the expectation that it will bounce back. The stop order, on the other hand, is set at a less favourable price in the belief that it will continue in the same direction. In other words, we observe the following:
Buy limit is set to be lower than the current price (which is more favourable for a buy position).
Sell limit is set to be higher than the current price (which is more favourable for a sell position).
Buy stop is set to be higher than the current price (which is less favourable for a buy position).
Sell stop is set to be lower than the current price (which is less favourable for a sell position).
When to Use Limit Orders
Limit orders are ideal when you have a clear price in mind and want to buy or sell at that specific level or better. They are useful in ranging markets where prices fluctuate within a certain range, allowing you to enter or exit positions at optimal prices.
When to Use Stop Orders
If you want to enter the market only when the price breaks out of a specific level, a stop order can help you do that. They are useful when entering the market in the direction of a trend. In other words, traders set them when they believe that the price will continue in the same direction.
Final Thoughts
Understanding the differences between limit orders and stop orders is crucial for any trader looking to manage their trades effectively. Limit orders allow you to control the price at which you enter a trade, making them useful for executing trades at favourable prices. Stop orders, on the other hand, allow you to buy or sell at the market price once a specified price is reached. By knowing when and how to use these orders, you can effectively manage your trades.
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