Limit Orders Help Overcome Human Fallibility

Limit Orders

Limit orders are conditional orders to buy or sell securities dependent on a particular price level being reached. The principle applies to forex, stocks and bonds, although forex is used in these examples.

A limit order will be used to instruct a broker to buy or sell a currency pair at a specific level.

A buy limit order will be set below the market price and a sell order above the spot price.

For example, if GBP/USD is trading at 1.2550, a buy limit order could be set at 1.2505. GBP/USD will be bought if the price reaches 1.2505.

A sell limit order could be set at 1.2595 and GBP/USD will be sold if the price reaches 1.2595.

A very important aspect of limit orders is to improve decision making, take advantage of opportunities and avoid some clear pitfalls of human nature.

Valuable tool at key levels

Limit orders are also extremely important when asset classes are close to key levels.  For example, if USD/JPY is trading just above the 100.00 level, an investor may be looking to buy at the 100.00 level. Watching the markets closely is time consuming and the desired level could easily be missed.

One way to achieve the objective would be to place a limit order fractionally above the 100.00 level.  If this level is reached, the buy order will be executed.

If market conditions are extremely volatile, there may be big jumps in the price and the order might actually be filled at a lower price. There is of course also a risk that the target price will not be reached.

Trading in different time zones

Limit orders are an extremely important tool for investors looking to trade outside their normal time zone. If a key interest rate decision or piece of economic data is due for release when a trader is normally asleep, the use of limit orders is an important alternative to trying to trade at unsociable hours. This is particularly important, especially as trading outside normal times can increase the risk of bad decision making.

Even when trading within a normal time zone, limit orders remove the need to be constantly monitoring markets. The order can be placed and, crucially, the length of time the order stays in force is also determined. An investor could cover potential price moves over a few minutes or for several days at least.

Imposing trader discipline

One of the most important functions on limit orders is to maintain discipline. This is important when looking at trading, investment and commercial decisions.

A trader will assess market conditions and look to execute orders at certain levels. When markets approach target levels, it is extremely easy and tempting to have a change of mind and look to target a more attractive level.

There are, however, clear dangers in this approach as the price is liable to suddenly move in the opposite direction. Limit orders also help avoid impulsive trading.

Using a limit order is an important tool in avoiding this type of problem as it is less likely that a limit order will be cancelled.

Example: A trader considers that there is value in selling EUR/GBP at 0.9000. Once the spot price reaches this level, a decision is made that the rate might move higher and the trade is not taken. After a brief move to 0.9010, there is a sharp slide to 0.8920.

By leaving a sell limit order at 0.9000, the trade would have been taken.

Taming volatile markets

The use of algorithms (algos) to execute trades has increased rapidly over the past few years and now plays an extremely important role in short-term trading strategies.

Individual traders can’t compete with the speed of algos, but limit orders can be used to fill prices automatically. Traders can also look to take advantage of price moves which do not appear to be justified.

Limit orders can be used effectively in very volatile markets. If there are sharp currency moves, it can be extremely difficult to manage market conditions. Traders can cut through this volatility by placing limit orders at key levels.

Taking advantage of reversals

Limit orders can be used to take advantage of uncertain events and potential reversals.

This can be particularly important for political events or events with a binary outcome. In the event of one particular outcome, there would be the risk of a sharp move in asset prices, but an investor could also judge that the outcome would be only temporary.

An example of this would have been the US Presidential election. Investors could have determined that a Trump victory would have weakened the dollar sharply, but that the move would be short lived.

Example: If EUR/USD was trading around 1.1000, a limit order could be placed to sell above 1.1150 on the assumption that EUR/USD would move sharply higher in an initial response and then weaken.

Limit orders protect profits

A very important function of limit orders is to protect profits and minimise losses. Again, this is a key element in protecting trades and investors from temptation and inertia.

If a trade is in profit, there is a strong objective to maintain the position as long as possible and extend profits. There is, however, a clear danger of inertia in letting profits slip into losses.

Traders can place a limit order below the market price to protect profits at a certain level.

An order can be placed above the current market level to close the contract with a guaranteed profit.

It is important to note that the order may not be filled at the exact price if there are big market moves. Guaranteed stops levels can be used, although there will be a cost.

Example: EUR/USD is bought at 1.0510 and the spot price has moved to 1.0610. An stop order can be placed to close the trade at 1.0574 in order to protect profits.

Alternatively, a limit sell order could be placed at 1.0645 to close the trade if there is a move to this level.