Doing This Right Can Maximize Your Profits
For beginner investors or traders, one of the most fundamental and important things to understand is the type of order. Putting in the wrong type of order can cost you. Using them smartly can help increase your profits.
There are three order types: market, limit, and stop. Let’s take a look at each.
A market order is the most passive.
When You Just Want to Get It Done
At the trade screen, when you pull up the stock you wish to trade, you will see the Bid and Ask price quotes displayed. The Bid is the current highest bid from a potential buyer. The Ask is the current lowest offer from a potential seller.
When you enter a market order, you are telling the broker to trade the stock immediately at the best available price. For example, if stock XYZ had a Bid of $30.15 and an Ask of $30.25, by entering a market order, as a buyer you can expect to buy the stock at about $30.25, and as a seller you can expect to sell at about $30.15.
Beware the Risk
However, understand that when you put in a market order, you are not guaranteed to trade at the quoted price. Remember that the quotes are changing all the time, so by the time your order is processed, the best available quote probably changed already.
For widely traded stocks during normal trading days, this shouldn’t matter very much. The price you get likely won’t differ very much from the prevailing quote when you submitted the trade request. This is because there will be many Bids and Asks near the same price point. But if the stock is thinly traded or if the price is moving quickly when you enter your trade, it’s possible to end up with a significantly different price.
In the example I gave above, if by the time you submit the trade someone already bought XYZ from the seller offering $30.25, and the next best Ask was $30.50, then your market order would fill at $30.50, almost 1% higher than what you thought you would pay.
What Is a Limit Order?
To make sure that you don’t get unlucky, you can use a limit order.
A limit order tells the broker that you will only do the trade at a certain price or better. So if you enter a buy limit order for XYZ at $30.25, your order will only execute at $30.25 or lower. And if you are the seller and enter a sell limit order at $30.15, this means your order will only execute at $30.15 or higher.
By default, the limit order will expire at the end of the trading day if it doesn’t fill. However, you can choose to change the setting to “good til canceled” (GTC) and the order will be good for many days. Depending on the broker, the GTC order could be good for up to 90 days. This comes in handy if you want to buy a stock if it pulled back to a certain level.
The risk of the limit order is that it’s possible it does not fill and you end up having to do the trade at a worse price. So if you really want to buy or sell a stock, it makes sense to set a limit a little higher (if you’re buying) or lower (if you are selling) than the prevailing quote. This increases the chances of the order filling but also prevents you from getting hurt from a sudden unfavorable price move.
What Is a Stop Order?
A stop order is an order telling the broker to execute a trade once a stock reaches a certain price. If you own XYZ but you worry that the stock will fall fast if something goes wrong, you can set a sell stop order at, say, $28. If the stock does fall past $28, your stop order becomes a market order. This type of order also works for short sellers who want to cover once the stock breaks through a certain point. In both scenarios, the goal is to cut losses. Hence, the order is also called a stop-loss order.
You may have already noticed a potential problem with the stop order: it becomes a market order. This means that you are exposed to the risk of a market order discussed above.
Bad Memories of the Flash Crash
During the Flash Crash of 2010, U.S. stocks lost about $1 trillion in market value in a blink of an eye and recovered within 40 minutes. Stop-loss orders were triggered en masse and investors lost their shares at abnormally low prices. Thankfully, many of the trades triggered by the Flash Crash were cancelled, but the incident highlighted the danger of stop orders.
Brokers offer another type of order that fixes this weakness. You can choose a stop-limit order, which combines the features of the stop and the limit orders. After the stop price is breached, instead of a market order, the stop order becomes a limit order. You set both the stop and limit prices when you enter your order.
Of course, the risk of the order not filling also applies here.
As you can see, none of the trade types are perfect. However, with experience you can really use them to your advantage.
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