Forex Trading - Market, Limit and Stop Orders

To understand limit and stop orders it's best to contrast these with the ordinary (and still extremely common) market order. A market order is one that is placed by the investor to execute at the current market price whatever that is at the time it's filled. It's very important to keep in mind that in Forex, 'current' changes even faster than in the stock market.

As a result of the inherent high (relative) volatility of Forex, any market order can be expected to deviate from the price shown on the investor's screen some of the time. When a stock trader requests a market order right this instant to sell Microsoft at, say, $28.25, he or she can expect to get that price very often. The odds of selling at exactly the price shown on the screen right now is smaller in Forex trading.

As a result, other order types are more common in Forex trading. The most common are limit orders and stop orders.

In essence, a limit order is a request to guarantee you will not sell for less, or buy for more than the limit price, or nearly so. No broker will guarantee execution at an exact price, though this is often achieved.

Suppose, for example, that you bought euros at $1.1905. The market then rises to, say, $1.1955. Placing a limit sell order on your euros at, say $1.1945 would allow you to lock in a minimum profit of 40 pips or better.

Alternatively, you may want to buy in at no more than a specified price. Suppose the market for British pounds (GPB) is currently at $1.7750, which seems too high to you. You could place a limit buy order to buy GBP at $1.7705. In other words you are telling the broker you don't want to pay more for GBP than $1.7705 per pound.

If the time limit expires before the price drops or rises to the limit price, the limit order simply expires unfulfilled.

A stop order used to be more commonly called a stop-loss order. That type is still used, by that name, incidentally. That gives a clue to what stop orders are primarily for: to stop losses.

It's what can or does happen before and after that makes the difference between a limit order and stop order. A limit order is an order to buy or sell AT a specified price or better. A stop order is an order to buy or sell ONCE a specified price is reached. After that it becomes a market order and is subject to fluctuation.

Suppose you bought euros, using dollars in your account, at the then current exchange rate of $1.1903. Now suppose, as often happens in Forex trading, the exchange rate changes to, say, $1.1888. The market appears to be on the way down. In order to protect yourself from either a) having to input more cash to cover the equivalent of a margin call, or b) enduring an even larger loss, you wisely put in a stop order.

You tell your broker you want to sell those euros once the exchange rate reaches $1.1803, for example. If during the trading period, the price reaches $1.1803, your euros will be sold at the market price saving you from incurring further losses.

Note that the price used for executing the order is the market price! This is the most current exchange rate at the time the order is executed and not necessarily the threshold specified in the stop order ($1.1803). This means you may only get $1.1802, or 1.1801, or 1.1800 or lower depending on what the market price is at the moment your order is executed.

To prevent this from happening the stop-limit order may be your best friend. It's a combination of a stop order and limit order. Like stop orders, your order will be executed once the market reaches a specific price. Once that price is reached, it becomes a limit order, so your order will only get filled at the chosen limit price, or a better price if there is one available.

These are techniques every investor should very quickly adopt as a habit, most especially novice investors. Forex trading is a roller coaster ride. Don't get thrown out of the car. Use a seat belt... Use limit orders and stop orders liberally in your trading strategy. Market orders are simpler, but much more risky. Control your investments.