With the proliferation of digital technology and the internet, many investors are opting to buy and sell stocks for themselves online instead of paying advisors large commissions to execute trades. However, before you can start buying and selling stocks, it's important to understand the different types of orders and when they are appropriate.
In this article, we'll cover the basic types of stock orders and how they complement your investing style.
- Depending on your investing style, different types of orders can be used to trade stocks more effectively.
- A market order simply buys (or sells) shares at the prevailing market prices until the order is filled.
- A limit order specifies a certain price at which the order must be filled, although there is no guarantee that some or all of the order will trade if the limit is set too high or low.
- Stop orders, a type of market order, are triggered when a stock moves above or below a certain level; they are often used as a way to insure against larger losses or to lock in profits.
Market Order vs. Limit Order
The two major types of orders that every investor should know are the market order and the limit order.
A market order is the most basic type of trade. It is an order to buy or sell immediately at the current price. Typically, if you are going to buy a stock, then you will pay a price at or near the posted ask. If you are going to sell a stock, you will receive a price at or near the posted bid.
One important thing to remember is that the last traded price is not necessarily the price at which the market order will be executed. In fast-moving and volatile markets, the price at which you actually execute (or fill) the trade can deviate from the last traded price. The price will remain the same only when the bid/ask price is exactly at the last traded price.
Market orders do not guarantee a price, but they do guarantee the order's immediate execution.
Market orders are popular among individual investors who want to buy or sell a stock without delay. The advantage of using market orders is that you are guaranteed to get the trade filled; in fact, it will be executed as soon as possible. Although the investor doesn't know the exact price at which the stock will be bought or sold, market orders on stocks that trade over tens of thousands of shares per day will likely be executed close to the bid/ask prices.
A limit order, sometimes referred to as a pending order, allows investors to buy and sell securities at a certain price in the future. This type of order is used to execute a trade if the price reaches the pre-defined level; the order will not be filled if the price does not reach this level. In effect, a limit order sets the maximum or minimum price at which you are willing to buy or sell.
For example, if you wanted to buy a stock at $10, you could enter a limit order for this amount. This means that you would not pay one cent over $10 for that particular stock. However, it is still possible that you could buy it for less than the $10 per share specified in the order.
There are four types of limit orders:
- Buy Limit: an order to purchase a security at or below a specified price. Limit orders must be placed on the correct side of the market to ensure they will accomplish the task of improving the price. For a buy limit order, this means placing the order at or below the current market bid.
- Sell Limit: an order to sell a security at or above a specified price. To ensure an improved price, the order must be placed at or above the current market ask.
- Buy Stop: an order to buy a security at a price above the current market bid. A stop order to buy becomes active only after a specified price level has been reached (known as the stop level). Buy stop are orders placed above the market and sell stop orders placed below the market (the opposite of buy and sell limit orders, respectively). Once a stop level has been reached, the order will be immediately converted into a market or limit order.
- Sell Stop: an order to sell a security at a price below the current market ask. Like the buy stop, a stop order to sell becomes active only after a specified price level has been reached.
Market and Limit Order Costs
When deciding between a market or limit order, investors should be aware of the added costs. Typically, the commissions are cheaper for market orders than for limit orders. The difference in commission can be anywhere from a couple of dollars to more than $10. For example, a $10 commission on a market order can be boosted up to $15 when you place a limit restriction on it. When you place a limit order, make sure it's worthwhile.
Let's say your broker charges $7 for a market order and $12 for a limit order. Stock XYZ is presently trading at $50 per share and you want to buy it at $49.90. By placing a market order to buy 10 shares, you pay $500 (10 shares x $50 per share) + $7 commission, which is a total of $507. By placing a limit order for 10 shares at $49.90, you would pay $499 + $12 commissions, which is a total of $511.
Even though you save a little from buying the stock at a lower price (10 shares x $0.10 = $1), you will lose it in the added costs for the order ($5), a difference of $4. Furthermore, in the case of the limit order, it is possible that the stock doesn't fall to $49.90 or less. Thus, if it continues to rise, you may lose the opportunity to buy.
Additional Stock Order Types
Now that we've explained the two main orders, here's a list of some added restrictions and special instructions that many different brokerages allow on their orders:
A stop-loss order is also referred to as a stopped market, on-stop buy, or on-stop sell, this is one of the most useful orders. This order is different because, unlike the limit and market orders, which are active as soon as they are entered, this order remains dormant until a certain price is passed, at which time it is activated as a market order.
For instance, if a stop-loss sell order were placed on the XYZ shares at $45 per share, the order would be inactive until the price reached or dropped below $45. The order would then be transformed into a market order, and the shares would be sold at the best available price. You should consider using this type of order if you don't have time to watch the market continually but need protection from a large downside move. A good time to use a stop order is before you leave on vacation.
These are similar to stop-loss orders, but as their name states, there is a limit on the price at which they will execute. There are two prices specified in a stop-limit order: the stop price, which will convert the order to a sell order, and the limit price. Instead of the order becoming a market order to sell, the sell order becomes a limit order that will only execute at the limit price or better. This can mitigate a potential problem with stop-loss orders, which can be triggered during a flash crash when prices plummet but subsequently recover.
All or None (AON)
This type of order is especially important for those who buy penny stocks. An all-or-none order ensures that you get either the entire quantity of stock you requested or none at all. This is typically problematic when a stock is very illiquid or a limit is placed on the order. For example, if you put in an order to buy 2,000 shares of XYZ but only 1,000 are being sold, an all-or-none restriction means your order will not be filled until there are at least 2,000 shares available at your preferred price. If you don't place an all-or-none restriction, your 2,000 share order would be partially filled for 1,000 shares.
Immediate or Cancel (IOC)
An IOC order mandates that whatever amount of an order that can be executed in the market (or at a limit) in a very short time span, often just a few seconds or less, be filled and then the rest of the order canceled. If no shares are traded in that "immediate" interval, then the order is canceled completely.
Fill or Kill (FOK)
This type of order combines an AON order with an IOC specification; in other words, it mandates that the entire order size be traded and in a very short time period, often a few seconds or less. If neither condition is met, the order is canceled.
Good 'Til Canceled (GTC)
This is a time restriction that you can place on different orders. A good-til-canceled order will remain active until you decide to cancel it. Brokerages will typically limit the maximum time you can keep an order open (or active) to 90 days.
If you don't specify a time frame of expiry through the GTC instruction, then the order will typically be set as a day order. This means that after the end of the trading day, the order will expire. If it isn't transacted (filled) then you will have to re-enter it the following trading day.
A take profit order (sometimes called a profit target) is intended to close out the trade at a profit once it has reached a certain level. Execution of a take profit order closes the position. This type of order is always connected to an open position of a pending order.
Not all brokerages or online trading platforms allow for all of these types of orders. Check with your broker if you do not have access to a particular order type that you wish to use.
The Bottom Line
Knowing the difference between a limit and a market order is fundamental to individual investing. There are times where one or the other will be more appropriate, and the order type is also influenced by your investment approach.
A long-term investor is more likely to go with a market order because it is cheaper and the investment decision is based on fundamentals that will play out over months and years, so the current market price is less of an issue. A trader, however, is looking to act on a shorter-term trend in the charts and, therefore, is much more conscious of the market price paid; in which case, a limit order to buy in with a stop-loss order to sell is usually the bare minimum for setting up a trade.
By knowing what each order does and how each one might affect your trading, you can identify which order suits your investment needs, saves you time, reduces your risk, and, most importantly, saves you money.