Hey everyone,
About a year & a half ago, I opened my own personal stock portfolio to gain some exposure to the markets & practice utilizing some concepts I had learned about through the CFA licensing I’ve been pursuing for a little under 2 years now. Throughout that year & a half that followed opening my personal stock portfolio, I learned a lot, to say the least. The market is a cruel mistress that can make you feel like a king one week and then turn around and make you feel as if you don’t have a clue the next week. I presume that is a sentiment shared amongst the majority of the retail investment community seeing as, the common number thrown around online states that, 95% of traders lose money on a 6-month basis.
One reoccurring trend I’ve noticed among beginning investors & traders alike is the consistent placement of market orders rather than their alternatives. While market orders have their place, I want to share insight into the pros & cons of the various order types, seeing as limit & stop orders seem to better align with the results most investors are looking for in their investments. In addition to inching you closer to the desired yield in an investment I’ll touch on how Order Types for stocks can make a difference in your trading psyche & strategies along with furthering your gains and limiting your losses.
PROLOGUE
First things first, before we touch on the order types, I wanted to share with you the concepts of an Ask Price & Bid Price in the markets.
An Ask Price is what sellers are willing to sell the stock for. Subsequently, the ask price is what the buyers will pay to buy the stock with a market order.
A Bid Price is what buyers are willing to buy the stock for. Subsequently, the bid price is what sellers will receive when the stock is sold with a market order.
ORDER TYPES
Market Orders
Market orders are, in essence, an order to buy or sell a stock, that is to be executed (i.e. fulfilled, completed, processed) immediately at the current market price. So, as aforementioned in the prologue on order types, if you are placing a market buy order, you will pay the ask price the sellers of the stock are asking for the stock. On the other hand, if you are placing a market sell order, you will receive the bid price the buyers in the market are willing to bid for the stock. This is considered universally as the most basic type of order type & from my understanding is the default order type on nearly all trading platforms.
So while you are taking the other party to the transaction’s price, the upside to market orders is that you either receive or sell the stock immediately. Market orders can be beneficial when the certainty & immediacy of order’s fulfillment is preferred over the price you pay or receive for the stock.
An example of when a market order may be beneficial is when a stock’s price is tanking downward and you want to sell out of your position. In this scenario one might prefer to be out of the stock immediately to avoid further losses, or to lock in any gains before they become losses rather than be picky about the selling price they receive per share. On the flip side, when a stock’s price is skyrocketing upwards, an investor may simply want to buy into the position and ride the upward movement rather than hope the stock falls back down to a desired price sometime soon.
Limit Orders
Buy Limit Orders set a ceiling on the amount the investor will pay to purchase the stock. This, in essence, places the order for the investor to buy the stock at your personal bid price rather than paying the sellers ask price. With a Buy Limit Order, the order will not execute at any price above the limit price specified. If the stock is currently trading at a price greater than the buy limit price, the order will be executed when an asking price is either equal to or less than the limit price and the order will be executed at the bid price or better.
Sell Limit Orders set a floor on the amount you will receive to sell the stock. This, in essence, places the order for the investor to sell the stock at your personal ask price rather than paying the buyers bid price. With a Sell Limit Order, the order will not execute at any price below the limit price specified. If the stock is currently trading at a price lower than the sell limit price, the order will be executed when a big price is either equal to or greater than the limit price and the order will be executed at the ask price or better.
Limit Orders can be beneficial when the price an investor pays or receives for a stock is preferred over the certainty and immediacy of executing the order & owning or selling the stock. However, it is near impossible to ever guarantee 100% a stock will hit a specified price, so with limit orders, there is always the possibility that the order is never executed if the stock never hits the specified price.
Limit orders are great at limiting losses or guaranteeing profits. Since stock prices constantly oscillate up & down to varying degrees, utilizing a limit order, one could set a limit order in accordance of the direction they believe it is headed at a price they believe the stock will hit. For example, let’s say an investor buys 10 shares of AAPL at $150.25 a share. AAPL is currently trading at $160.25 a share. The investor could place a sell limit order at $155.25 a share and guarantee that even if the stock starts to trend downward, the stock will yield at least $5 profit per share if the price went equal to or less than $155.25. $5 profit per share x 10 shares = $50 profit. In essence, this places a safety net on the investors investments in the scenario the stock tanked downward while the investor was not monitoring it.
Conditional Orders
Stop Loss Orders are similar to a limit order, in that execution of the order occurs when the price of the stock reaches a specified price. However, once the stock hits that price it converts the order to a market order, filling it at the best bid or ask price available when the order is converted. However, due to how quickly market prices can move, there is the possibility the stock hits the specified price, but then shoots up or down to a different price quickly afterwards.
Stop Loss orders are great at limiting losses or guaranteeing profits in the same way Limit orders do the trick. However, they are tailored more towards taking advantage of short-term upward or downward trends. In another illustrative example, let’s assume an investor buys 100 shares of stock ABC at $11.50 a month ago. Stock ABC is currently trading @ $10.50, but the investor believes that upon the upcoming quarterly earnings release, the stock will rebound upward and trade around $12 a share. Currently the investor has a loss of $1 per share. To set a safety net in case they are wrong in their forecast for the stocks movement, the investor sets a Stop Loss order at $9.90. If the stock rebounds upward as the investor expects, the order does not get executed and the investor locks in a gain on the stock, so long as it rebounds higher than $11.50. However, if the stock tanked downward following the earnings release, the investor has set the ceiling floor as to the max amount they would be willing to lose on the stock.
One disadvantage to Stop Loss orders is that there is no guarantee that the order will be filled at the price the investor sets. Additionally, the investor must be conscientious on the price point the order is placed at. If the order is triggered by a short-term fluctuation, the investor is out of luck if the stock rebounds. Therefore, in placing a Stop Loss order, it is important to be aware of the stock’s volatility to avoid premature execution.
Stop-Limit Orders combine a limit order & a stop order. Once the stocks price reaches a specified level, it converts to a limit order rather than a market order. Stop-Limit orders can be beneficial when trying to avoid long-term downward trends or to take advantage of long-term upward trends. For example, when a stock is fluctuating by relatively small amounts around let’s say $18 & any time the stock gets to around $20, it trends back down to around $18 and repeats the cycle of it’s variation around that price level again. However, the investor believes that if the stock breaks that $20 price level, it will continue to trend upward. In this scenario, the investor could set a Stop-Limit Buy Order with a Stop price of $20 & a Limit price of $20.50. If the Stock hits $20, the stop price will convert the order to a Limit Buy order & subsequently if the stock hits $20.50, it could be a signal reaffirming the investors speculation on a continuous rise and execute the order to buy the stock at that price.
As aforementioned, these Stop-Limit orders can be beneficial to investors who can’t constantly watch their investments & additionally to set a limit on the investor’s max loss preference.
TIMING OF ORDERS
One last topic I wanted to touch on quickly is the time-limit placed with each order placed.
Day Orders these orders last until the market closes for the day the order is placed.
Good-Til-Cancelled Orders last until the investor cancels the order. However, some brokers place limits on these, such as a 90-day limitation, so it is important to know your own individual broker’s policies.
Market-Close Order takes place AT market close for the day, where some stocks have single price auctions, looking to sell the stock at a lower price simply to sell it that day rather than hold it overnight or over the weekend until the market opens again.
Market-Open Order takes place AT market open for the day, where again, some stocks have single price auctions, looking to sell the stock at a specified price to avoid upcoming variations the seller presumes the stock will undertake throughout the day.
CONCLUSION
In conclusion, while Market Orders have their place in the Order Hierarchy, Limit Orders and Stop Orders have their own associated benefits that can help an investor tailor their own investment strategy towards their desired yield through various ways. For anyone with any further questions, feel free to reach out via email or comment below & I’ll reply as soon as possible. I hope this insight is beneficial to your future success.
Cheers,
Zach Veencamp