What is a stop-limit order?

• A stop-limit order is a type of trade that combines stop orders and limit orders into one.
• Stop orders set a price to execute an order and limit orders specify how much should be bought or sold at that set price.
• Not all stop-limit orders will execute and there are risks investors should be aware of.

A stop-limit order is a way for investors to exert control over their trades while also managing levels of risk. There are two aspects of a stop-limit order: the stop price and the limit price. The stop price states that you'll buy or sell at a specific price. The limit price sets a standard for buying or selling an amount of stocks when the price reaches the set price.

Here's what to know about this conditional trade type and how it's used.

What is a stop-limit order?

A stop-limit order is a financial tool that investors can use to maximize gains and minimize loss. The Securities and Exchange Commission (SEC) describes a stop-limit order as combining both stop orders and limit orders, which exist individually, into a single tool which investors can use as part of their risk-mitigation strategy.

Stop orders, sometimes referred to as a stop-loss order, is when you set a specific stop price on a stock. Once that stop price is reached, an order is executed to buy or sell a stock. That order then turns into a market order - actively trading on the market right away.

A limit order is a type of order where you buy or sell a stock at a certain price. So if you wanted to buy shares of a stock for $20, you could place a limit order of that amount and the order would take place only if and when the stock price was $20 or better.

Stop-limit orders merge two benefits from stop orders and limit orders into one financial tool. The stop order sets a price to execute an order and the limit order specifies how much should be bought or sold at that set price.

Stop orders alone turn into a market order trading immediately, whereas a stop-limit order turns into a limit order that will only be executed at a set price or even better.

"A stop-limit order is an order to buy or sell a stock at the market when it reaches a specified price, but then as soon as the stock has been bought or sold, the order becomes a limit order for an amount below the triggering price," explains Jenna Lofton, a former Certified Financial Advisor with an MBA in Finance and founder of StockHitter. "This type of order gets one last chance to fulfill before it's canceled without any execution. It helps protect against whipsaws and sudden spikes - especially on highly volatile stocks."

Understanding how stop-limit orders work

Stop-limit orders combine the features of stop orders and limit orders to create a powerful strategy for investors to control costs. Investors need to set two price points:

• The stop price
• The limit price

The stop price and limit price don't have to be the same amount. The stop price you set triggers execution of the order and is based on the price that the stock was last traded at. The limit price you set is the limit that sets price constraints on the trade and must be executed at that price or better.

"When trading, you can observe the market price and decide to buy or sell at any given moment, or you can condition the process so that it only activates once the price hits or exceeds the price point A (the stop) but does not break through the price point B (the limit). The latter option is called a stop-limit order," explains Adam Garcia, founder of TheStockDork.com. "So you're basically looking to buy the stock once it starts getting on an upward trajectory. On the other hand, there's only so much that you can afford to pay, which is why you need to cap it."

Let's say you have a stop price of $50 on a sell stop limit order and your limit price is $45. If market conditions are appropriate and the price of a stock reaches $50 it would trigger a limit order that would only activate at the limit price of $45 or better.

Important: Just because you place a stop-limit order doesn't mean it'll actually go through. The market conditions must activate the order set by your stop and limit prices.

An investor can execute a stop-limit order on their trades through their investment brokerage firm, though not all brokerages may offer this option. Additionally, brokerages may have different definitions for determining if a stop or limit price has been met.

Traders set a period of time when the stop-limit order is effective or can choose from good-til-canceled (GTC) option. Through these options, the stop-limit order is active until the price is triggered to buy or until the transaction expires. Stop-limit orders are executed during market hours.

You set a stop price which triggers the execution of an order. The limit price helps lower risk by stating that orders must be traded below or up to the limit price.

"You need to specify the timeframe in which this trade is going to be executed. But considering that this trade is conditioned, there's no guarantee that it will actually happen. To make matters worse, this timeframe only includes regular trading hours. If a portion of your order gets executed today and the rest of it gets allocated across several days, your broker may charge several commissions instead of just one," warns Garcia.

Quick tip: Find out if your brokerage firm allows for stop-limit orders and how they set the parameters to execute an order. For example, some may use the last-trade price whereas others use quotation prices.

Pros and cons of stop-limit orders

Before deciding if a stop-limit order is a good strategy for you, consider the pros and cons.

Quick tip: Evaluate how much money you're willing to put into a buy stop-limit order and the amount you're willing to sell to minimize any losses as part of your investment strategy.

The financial takeaway

Using stop-limit orders as part of your investment strategy is one way to have greater control over how you invest and at what cost. You can set limits for both buying and selling and set parameters for executing orders on your terms.

While this strategy has its benefits, you should be aware that price fluctuations throughout the day can trigger an order and be "substantially inferior" to the closing price of the stock for that day, according to Investor.gov.

Be sure to check if this option is available at your brokerage firm and how they define prices so you know when your order would execute.