Using stops and limits to manage risk

Lesson 3 of 3

Using limits

Limits are useful for controlling how much you pay or make on a trade, and when used properly – often in combination with stops, to enforce a particular risk-reward ratio – they are a very useful tool for achieving trading success.

Using a limit-close

A limit-close order lets you specify the level at which you want an open trade to be closed, to secure your desired profit. If you’re long a market then this would be above the current market level, and if you have a short position open, it will be at a lower level.

You can set limit-close orders in the ‘deal’ tab of the deal ticket. Let’s take a look at an example.

Example

XYZ Ltd is trading at 135.52/136.25. Your analysis says this stock will fall, so you decide to sell 1000 shares to open a short position, giving you an exposure of $10 per cent of movement.

You can choose to set your limit at a particular monetary target, or a number of points away, using the drop-down next to the ‘limit’ field:

Your profit target on the trade is $1000, so you set a limit-close order at 134.52 – 100 cents below current price, with each cent of movement worth $10. If the market does drop in your favour, your position will be closed out and you’ll take the $1000 profit.

Setting a limit-close order gives you greater control over the profit you’re taking – helping you resist the temptation to snatch a profit too early and instead increasing your chances of meeting your profit targets. You can use them to manage the ‘reward’ part of your desired risk-to-reward ratio. We’ll look at using limits together with stops in more detail shortly.

Using a limit-entry

A limit-entry order enables you to enter a trade automatically at a more favourable price than current. You’d use this if, for instance, you were bullish on a market but thought it was currently overpriced, or if you were bearish but thought the market underpriced. In other words, this order is useful when you believe there will be a short-term adverse move in a market before it reverts to the direction you want.

If you’re buying, your limit-entry will be lower than the current market price, and if you’re selling it would be above.

You can place limit-entry orders in the ‘orders’ tab of the deal ticket. As with stop-entries, you’ll know when you place a limit-entry – the execution button will update automatically with the order type.

Example

Let’s say Netflix is currently trading around $500. You think that the price is going to drop and then rally, so you want to take a position to try and capitalise on the rally. However, you only want to enter the trade if it drops as low as $490, which you’ve identified as a key level of support. So you set a limit-entry order to buy at $490.

If the market drops to $490 your limit-entry order will be triggered and your position opened. If the market then rallies as you predicted, you’ll have a profitable position.

So, you might use a limit order to open if your analysis indicates that a market will drop before rebounding (if you want to go long) or rise before dropping (if you were to go short on the market), and you know you want to open a trade at that sweet spot of support or resistance before the change in direction.

Things to consider

Like stops, both limit-entry and limit-close orders are subject to slippage if the market gaps through the order you’ve set. This can result in positive slippage – where your limit is executed at a more favourable level than you were expecting. In times of market volatility this means your position could actually be opened or closed at a better price than you set.

On the flipside, there’s also a possibility that your order won’t ever be executed if the market never reaches your order level, as it would never be triggered.

When you use a limit to open, you’re placing an order against the current market trend – which is a risk. The market is probably more likely to move against you in the shorter term, so you might find that your order is triggered only for your position to immediately go into loss. So, if you were long on a position and the market fell instead of rebounding, or if you were short and the market kept rising.

Using limits with stops to enforce your risk-reward ratio

Using stops and limits together can guarantee a balanced risk-to-reward ratio.

If you wanted to trade with a 1:2 risk-to-reward ratio, you would place your limit order twice as far away from the opening price as you place your stop order. This would ensure that you stand to lose half as much if your stop was triggered as you would gain if your limit was triggered.

It’s easy to see your risk-to-reward ratio by position in the platform, as well as your stop and limit levels and the amount of money you’ll win or lose if they’re triggered. Just click on your position in the ‘positions’ tab, and take a look at its chart.

To change your stop or limit, just drag them to where you need them to be. Your risk-reward ratio will update automatically. You can set stops or limits on an open position like this, too.

Example

Let’s say you open a long position on ABC PLC at 1476.60, and you set your limit order at 1626.60, 150 points away from your entry level. To achieve a 1:2 risk-to-reward ratio, you’d set your stop order 75 points away from your entry level – at 1401.60.

The market moves in your favour by 50 points to 1526.60, and you move your stop up by the same amount, to 1451.60, improving your risk-to-reward ratio to 1:6.

The market moves in your favour by another 50 points to 1576.60, and again you move your stop up by the same amount so it’s at 1501.60.

You have now locked in a profit of 25 points, as your stop is now above your entry level and your limit is now closer than your stop level (50 points vs 75), meaning it has a higher probability of being triggered.

However, the market then reverses direction, triggering your stop loss and going on to drop beneath your original stop level of 1401.60, without ever hitting your 1626.60 limit level. But even though the market never hit your limit, you have still capitalised on the market trending in your favour – locking in profit by actively moving your stop.

In this scenario, you may feel you could have traded better by closing at the most profitable point. But without the benefit of hindsight, you have executed a strategy that started with a solid risk-to-reward ratio and you then consistently reduced the risk, whilst still allowing the opportunity for the trade to continue all the way to your desired profit target.

Question

Imagine you have a short position on ABC plc, opened at 400 pence. You see that the price has fallen to 385 pence, and you’re tempted to close your position and take the profit, but your analysis suggests it will drop further – and that if it drops as far 378 pence the trend might reverse. So you set a limit order to close your position at 378 pence. The price falls to 376, then begins to rise again. What happens to your trade?
  • a Your limit order is triggered and your trade closed at 376 pence
  • b Your limit order doesn’t trigger, and your trade stays open
  • c Your limit order is triggered and your trade closed at 378 pence

Correct

Incorrect

Your limit order is triggered at 378 pence as the market through this level, and you take the profit. Remember, this does mean you won’t be able to take advantage of any further movement in your favour.
Reveal answer

Lesson summary

  • Limit orders can be used to open and close positions, and give you more control over how much you could make on a position
  • Limit orders can be subject to positive slippage – meaning your position could be closed at a better price than you expected
  • You should be aware that limit orders may not be triggered if the market doesn’t move as you predicted
  • Use stops and limits together to manage your risk-to-reward ratio
Lesson complete