by Ed Elfenbein | March 20, 2014 6:31 pm
Here’s a post that’s geared towards new investors, but experienced investors may find it helpful as well. I want to discuss the different types of orders you can make when buying or selling a stock. Investors have lots of options at their disposal, and each decision has an upside and a downside. Let’s start with your basic market order.
This is the most common type of stock order. In essence, it’s a request to buy or sell a stock at the current market price—hence the name. A market order does not guarantee a particular price; it merely picks up, or dumps, the stock at the current going rate.
What does this mean in concrete terms? Well, for large-cap stocks with heavy volume, you can expect that because market orders are executed more or less instantaneously, there shouldn’t be much of a gap between the price at the moment you execute the trade and the actual price you pay. If you see on your computer screen that the current price is $30 and you execute a market buy order, you might pay $30.10, you might pay $29.50, but the price will generally be close to the one you saw when you pulled the trigger.
The danger, however, lies in trades executed after hours. If you place a market order after the 4 p.m. closing bell, you may find the stock has moved significantly by the time the market opens the next morning. You can easily end up paying a price you didn’t bargain for. A $30 stock may have gapped up to $35 due to an earnings report or a merger announcement. News stories can cause prices to soar, or tank, so be wary: you don’t want to be on the receiving end of one of the market’s irrational spikes.
Another tip: don’t be distracted by irrelevant information. The last-trade price is no guarantee of anything. Ignore it. Instead, if you’re buying, keep your eye on the ask price. If you’re selling, look at the bid price. Also important is the spread between the bid and the ask, which can be very wide indeed on thinly-traded stocks.
With these less-popular securities, you may find the following conditional orders more helpful:
A limit order is an order to buy or sell a stock at a price that you yourself stipulate. Basically, it tells your broker to execute the trade once the stock goes above or below a specified threshold. You can use it to sell a stock once it climbs to a certain peak (thus guaranteeing you a profit) or to buy a stock once it dips to a certain low (thus guaranteeing you a good purchase price).
For example, you’re interested in security XYZ, but you think it’s currently overvalued at $40. You can place a limit order to pick it up at $38. If the stock falls below that threshold, the order will automatically execute and the stock is yours. Later, having acquired the stock, you can execute a limit order to sell it at $45. This order, too, will execute automatically if the stock gaps up, thus ensuring you a tidy profit.
Limit orders have advantages and disadvantages. On the plus side, you can keep them open for a set period of time, and they’re useful for investors who don’t have the ability to monitor their portfolios 24 hours a day. On the downside, if the limit price you set is way off the mark, it’s possible the stock may never reach the threshold and the order will never execute. For that reason, many brokers charge more for limit orders: failed execution means no commission for them.
Also, remember that orders are filled on a first-come, first-serve basis. If you set that limit order at $45, you have to wait till the other orders at that price are executed. Some traders like to snip at the edges and place limits at, say, $44.99, thinking they’re getting an edge on the competition. You can never be guaranteed that your order will be filled.
Stop-market orders are very, very similar to limit orders—so similar, in fact, that many investors have trouble telling them apart. The difference is that they’re used to cut losses, as opposed to maximizing profits.
Like limit orders, stop-market orders (sometimes called stop-loss orders) cause a stock to be bought or sold automatically upon reaching a given threshold. When this happens, they turn into standard market orders and execute at the going market rate. The goal: damage control, pure and simple.
Suppose you buy a stock at $35, and it starts to tank. You can execute a stop-market order at $30 to cut your losses. This means that if the stock falls past that threshold, it’s as though you suddenly placed a sell market order. The final sell price may be $29.50, or it may be $31, but in either case, you’ll have reduced the effects of the sudden dip.
Conversely, if you’re interested in another stock trading at, say, $40 and are waiting for it to drop, but you don’t want it to get away from you, you can execute a stop-market order at $42. If the price shoots up, you might end up paying $42.50, or perhaps $39, but you’ll have achieved your end of minimizing your losses in purchasing a security that you’re especially hot to get hold of.
Stop-loss orders are useful, but be careful. A sudden rumor, or a rapid but temporary drop in the stock price, can cause you to get frozen out of a stock against your will.
Stop-limit orders are stop-market orders’ identical twins—with one difference: when the threshold price is reached, the order changes into a limit order, not a market order.
Why does this matter? Because in theory, the stop-limit order gives you much more control over the actual price at which the stock is bought or sold. When you place the order, you have to specify both a sell price and a limit price, and the combination helps to eliminate the wild-card factor that creeps in with stop-market orders. The drawback, of course, is that as with all limit orders, the trade may not get executed at all.
Consider the following situation. You’ve got your eyes on a stock currently trading at $25. It starts to show some upward momentum, so you place an order with stop and limit prices of $22 and $23, respectively. Once the stock rises above $22, the limit order kicks in. However, if the stop gaps above $23 due to a fast-moving market, the order will remain unfilled.
Trailing-stop orders are yet another variation on the stop-market theme. Here the difference lies in the fact that instead of setting an absolute threshold, you set an order to buy or sell if the stock rises by a certain percentage (or, in some cases, a specified dollar amount). Other than that, all the same rules apply as with other stop orders.
Trailing-stop orders seem to provide some folks with a sense of security. There are traders who set 20% trailing stops on every order they place. Remember, though, that like all stop orders, the brokerage fees are higher than with market orders, so you need to ask yourself if that psychological advantage is worth it.
When you execute a limit or stop order, you can specify one of two options: Day or GTC (good till cancelled). A day order is only valid for the rest of that trading day, while GTC indicates that the order can be carried over into the next trading day and may remain in effect until one of two things occurs: (a) the stock reaches the specified threshold; (b) the investor decides to cancel the order. Be sure to check with your broker about these options: some of them limit the number of days that the GTC option can be in effect.
Another condition you can set on a buy or sell order is AON: the command to fill the order completely or not at all. In other words, the broker must buy all the shares at the price you specify, or cancel the order altogether.
Let’s say you place an AON order for 100 shares of stock XYZ at $9 apiece. If the broker can find 100 shares that fit the bill, well and good. If not, the order is canceled at the close of trading, and the investor must re-submit it the next day. With an AON order, the investor never receives an order that is half-filled—hence the name. In a standard limit order, by contrast, the broker might buy 60 shares at $9, watch the stock gap up, and then have to wait till it dips back down to $9 to fill the rest of the order.
This option instructs a broker to fill an order entirely and immediately or not at all. Its purpose is to guarantee that the investor picks up a stock at the desired price, and it is usually used when buying a large quantity of stock. In practice, this type of trade doesn’t happen very often. Much more common is the good-till-canceled option discussed above.
One piece of closing advice: if you’re a long-term investor, don’t worry too much about paying a price that’s a little bit off target. There are day traders who fight over every last penny, but this is madness. The market is too fast-moving to allow for that kind of precision. Consider that a stock like Bank of America can average 10,000 shares traded every second over the course the entire 6.5-hour trading day. It’s much better, if you’re in it for the long haul, to do your homework, set your orders, and then sit back and watch your portfolio grow.
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