Buying or selling stock couldn’t be easier with today’s technology. Investors can go online or call an automated trading platform to instantly place a trade. But just because it’s easy, it doesn’t mean you can’t make a mistake. There are a number of different order types that can be used to help you protect losses and maximize gains if used properly.
Market orders are the most common and easy to understand of the order types. A market order is simply an instruction to buy or sell the securities at the current market price. Unless you give different instructions, this is the type of order that will be placed. Market orders are almost always guaranteed to be executed as long as there are active buyers and sellers in the market.
One of the drawbacks of market orders is that the investor is at the mercy of the bid and ask spread. Buy orders are filled at the ask price, and sell orders are filled at the bid price. Depending on the individual stock and market activity, the bid and ask spread could be fairly significant. Another drawback is that in fast moving markets, you may receive a different price from what the current quote is.
Limit orders do just as they say, and allow investors to set a limit on the buy or sell price. While market orders will be executed at whatever the market price is, a limit order won’t execute unless your limit is reached. Limit orders can be either buy or sell orders.
Buy limit orders are executed only when the price of the stock you want to buy is at, or lower than your limit price. For example, if you wish to purchase 10 shares of XYZ stock at $20.15 and the ask price of the stock is currently at $20.20, your order will remain open. If the ask price never drops to $20.15 or lower throughout the trading session, your order will never be fulfilled. If the stock does move lower, and the ask jumps to $20.10, your order would be filled.
Sell limit orders work the same way, only in reverse. If you currently own 10 shares of XYZ stock and you want to sell the shares for $20.25, yet the stock’s bid price is $20.15, the order will not be filled and remain open. If at some point the bid price reaches $20.25 or higher, the order would be fulfilled.
The risk with limit orders is that the order may never be executed. If you wanted to buy a stock at a set price and it is on a run and rapidly increasing in price, your order wouldn’t be filled and by the time you could place another order, you may have missed out on substantial gains. The same goes for sell limit orders never being filled. If you wanted to unload a stock at a set price and it continues to fall, you can realize additional losses as the stock declines and your order goes unfilled.
The stop order is generally used to protect profits or minimize further losses. A buy stop order is always placed at a price above the current market price, and a stop sell order is always placed below the current market price. When that stop price is reached, the order turns into a market order and will be executed at the current market price. For example, if you have a stock that you purchased at $20 that is now trading for $30, you can protect some of that profit by setting a stop sell order. You could place the stop at $25 so that if the price does fall to $25 or below, your order will be converted to a market order and executed.
The advantage of stop orders is that it makes it so an investor doesn’t need to monitor the stock market every second of the day. Investors can place various stop orders to protect gains and minimize losses without being around the computer.
The main disadvantage of stop orders is that you can get “stopped out” by a quick price movement that may not be warranted. A rumor or press release may send traders into a frenzy and briefly send the stock into your stop territory only to reverse course moments later when things settle down. Since stop orders turn into market orders when the trigger price is reached, you also have the possibility of executing the trade for a price that is different from the stop price.
Like a regular stop order, investors use these orders to protect profits or minimize losses. The difference is that this order turns into a limit order when the stop price is reached, not a market order. This type of order gives you more control of when and at what price the order will be executed at. With this added control comes the possibility that the order may never be filled.
The reason this can happen is because if a stock is moving rapidly and hits your stop point, it may continue to move rapidly past your limit order, leaving the order unfilled. This could result in even further losses or losing some profit as the market moves past you. On the other hand, the stop-limit order can help you from getting stopped out early from a quick price movement that doesn’t hold.
All of the orders discussed so far are typically placed as day orders. This means that when you place an order, they are only good for the trading session that they are placed. So if you place an order at 10 a.m. and it doesn’t get filled before the market closes at 4 p.m., you’ll have to place another order the next day if you still want to make the trade.
Good ‘Til Canceled Orders
If you don’t want to worry about placing orders each day in the event they don’t get filled, you can place a good ’til canceled, or GTC order. These orders are good until executed or you decide to cancel it. This can mean an order could stay open for days or weeks. Even so, many brokerage companies have limits on how long GTC orders can be left open.
Other Order Types
There are a number of other order types, but the ones referenced above are the most common, and should be available to all brokerage platforms. The other order types are usually contingent on other factors, and may or may not be provided by your brokerage, so you will want to check before placing any trades.
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About the Author: Jeremy Vohwinkle is a Chartered Retirement Planning Counselor® and spent a few years working as a financial planner. Today, he helps people make the most of their money by writing about personal finance here and elsewhere on the web. Jeremy is also Coach at Adaptu and a regular contributor for other publications such as Intuit, and American Express. Be sure to follow Jeremy on Twitter or Google+.