Consider Using Limit Orders

August 14, 2009

Randy Frederick
Managing Director of Trading and Derivatives, Schwab Center for Financial Research

Previously, in "Best Practices for Trading in Volatile Markets," we discussed eight steps to help improve your trading. Here, we'll help you put the third step—Consider Using Limit Orders—to use in your portfolio.

This article covers:

• Limit orders vs. market orders
• Why stock prices can change rapidly: extended-hours trading, big movers and fast markets
• Navigating extended-hours trading
• How to set a limit order

Limit orders vs. market orders

To greatly reduce the chances of buying or selling a stock at a price higher or lower than you want, consider placing a limit order (buying or selling a stock at a specific price) rather than a market order (buying or selling a stock at the prevailing market price).

Although it may seem like common sense to use limit orders, you may be surprised to learn that roughly 40% of all equity orders entered by Schwab clients are market orders. During regular market hours, and when volatility is at reasonable levels, market orders for liquid stocks are relatively harmless. But if you enter a market order while the market is closed, or even during market hours when volatility is high, you may be disappointed.

Keep in mind, though, that even if the market moves and reaches your specified limit price, there's no guarantee your order will be executed. If you're concerned that the market may move away from your price before your order is executed, consider placing a buy-limit order that's slightly higher than the quoted market price, or a sell-limit order that's slightly lower. This allows for a small amount of price movement, while still protecting you from an unexpected execution price.

Markets are not allowed to fill orders at a price worse than the market price, even if your limit order allows for it. Building in a little extra room to ensure your order is filled will not cause you to overpay—you should still be filled at the prevailing market price when your order comes to the front of the line.

Why stock prices can change rapidly

With market volatility and news reports frequently released outside of market hours, many stocks open at prices dramatically different than their close the prior day.

What's more, the stocks of several large domestic companies—IBM, Ford Motor Company, Bank of America, Dow Chemical, etc.—trade on markets in Europe, and evening news reports here can moves prices there. The price fluctuations in these overseas markets, which are open for several hours before domestic markets, will affect opening prices in the United States.

And, of course, when significant or unexpected news is released during normal market hours, stock prices can swing violently.

Effects of post- and pre-market trading

Additionally, post- and pre-market trading sessions have become more popular, providing yet another opportunity for prices to be bid up or sold off outside the normal session.

Schwab offers both pre-market and post-market trading sessions on most days. Orders placed for either session must be entered using the Extended-Hours Trading screen on Schwab.com. On StreetSmart Pro®, select "Schwab Pre Market" or "Schwab After Hours."

Extended-hours trading

Source: Schwab.com

After hours trading screen

Source: StreetSmart Pro

Due to the potential for higher volatility and wider bid/ask spreads during these extended-hours sessions, you may only place limit orders.

Beware of big movers and fast markets

Active traders often find themselves drawn to stocks that are the big movers of the day, or stocks being talked about in the news. If you feel compelled to enter or exit a position on a stock that is the subject of a significant news event, be sure to use a limit order. Even if the quoted price of the stock seems fair to you, be sure to enter a limit order at or near the market price. When trading is fast and furious, a market order could still end up being filled at a price way outside the current quote.

Occasionally, exchanges will declare a "fast-market" environment, which means that quoted prices are only an indication of the true price available, not the actual price. Under fast-market conditions, you may find your execution significantly delayed, and your order is likely to be filled at an unfavorable price. It's far easier to prevent an unexpected fill by using a limit order than to fight for a price adjustment after the fact.

How to set a limit order

Often, investors enter market orders because they haven't been successful in obtaining executions with limit orders. To maximize your chances of getting a limit order executed, you need to look at your order from the perspective of the person you're trading with. While that may be another client, often it's a market maker—a securities firm professional who stands ready to buy or sell stocks at publicly quoted prices at all times.

Before entering your limit order, consider the bid/ask spread—the difference between the highest price a buyer is willing to pay for a stock and the lowest price a seller is willing to sell it for. Here are some tips to keep in mind:

• The wider the spread, the greater your chance of order execution between the bid and ask. The reason a market maker may be more willing to lower the ask or raise the bid in order to trade with you is that he or she knows that investors are less willing to trade at the market price when the spread is wide.
• By contrast, when the spread is $0.05 or less, it will be more difficult to trade between the bid and ask. In such cases, you may want to consider a limit order at the bid or ask, since shaving a penny may not be worth the risk of the order not getting executed.

It's always best to determine what price you're willing to pay or accept for a particular stock, and then set your limit price accordingly. When you're trying to buy a stock, starting with a lowball price and chasing it as it moves away from you may cause you to end up paying more than you originally intended, as your anxiety may drive you to avoid missing an opportunity.

Likewise, when you're trying to sell a stock, entering an unrealistic price and then lowering it as it moves away from you will often cause you to end up selling the stock below what you would have taken initially, as you watch your unrealized profits dwindle.

When you set your limit price, pick a price you're comfortable with and try not to adjust it, at least until the last 15 minutes of the day. Even then, only adjust your price if you can't wait until the next day to trade.

Examples of limit orders

When you enter a limit order, balance your desire to get the price you want with the likelihood of that order being executed. One way to help optimize your limit price for both of these factors is to enter a price that slightly favors the person on the other side of the trade. Here are a few sample quotes with suggested limit prices:

Medium spread

XYZ: bid 10.99–11.12 ask, suggested limit price to buy 11.07 to 11.09
XYZ: bid 10.99–11.12 ask, suggested limit price to sell 11.04 to 11.06

Wide spread

WXY: bid 90.78–91.23 ask, suggested limit price to buy 91.01 to 91.05
WXY: bid 90.78–91.23 ask, suggested limit price to sell 90.96 to 91.00

Tight spread

QRX: bid 28.34–28.36 ask, suggested limit price to buy 28.35 to 28.36
QRX: bid 28.34–28.36 ask, suggested limit price to sell 28.34 to 28.35

To simplify this process, enter buy-limit orders slightly above the midpoint between the bid and ask, and enter sell-limit orders slightly below the midpoint between the bid and ask. Notice that the tighter the spread, the less flexibility you'll have.

Two other factors to consider

1. Daily volume. Often, the spread between the bid and ask is directly related to the daily volume—the higher the volume, the tighter the spread. When you enter limit orders between the bid and ask prices, you'll have a better chance of execution on stocks that trade larger volume. Why? Because when many investors are trading a stock, a multitude of market orders (as well as limit orders) to buy and sell are entered at various prices throughout the day. If you happen to be the highest bid to buy (or the lowest ask to sell) when a market order comes in from another customer, your order will be executed.

By contrast, on infrequently traded stocks, you and the market maker may look at each other's price all day long, and if neither of you is willing to budge, nothing gets done.

Always be aware of volume when entering an order. And if the volume is relatively light, consider moving your limit price a few pennies closer to the market price.

2. Time and sales. If you're trading on a platform that displays time and sales information, pay close attention to it. By watching the prices at which other orders are being executed, you may get a feel for how far above the bid (or below the ask) you can enter your order and still have a good chance of execution. If the majority of executions are taking place at the bid and ask prices, it will likely be more difficult to trade in the middle.

Time and sales

Source: StreetSmart Pro

Limit orders also can help prevent you from overspending your account. If you trade on margin, an execution at a price slightly higher than you expected may not be a big issue, unless it caused you to exceed your available buying power. If this happens, you may be asked to sell another position or deposit additional funds in the account to cover the trade.

If you're trading in an IRA, overspending can be more problematic. Assume you get up early one morning to research a stock you're interested in buying. You have a cash balance in your IRA of $26,200, and before you leave for work (two hours before market open), you decide to enter a market order to buy 1,000 UVW at the market. UVW closed last night at $25.98, so you figure you have more than enough to buy the stock and cover the commission. An unexpected positive news item is released an hour later, and the stock opens for trading at a price of $26.74. Since you entered a market order, you would likely be filled very close to the opening price. If you end up paying $26.74, your account would be overspent by at least $500, plus commissions. If you've already made your annual IRA contribution, this type of situation could force you into selling another stock in the account that you had intended to keep.

You could have avoided this situation by entering a limit order at the highest price you were willing to pay. If you had entered a limit order at, say, $26.10, you would have missed out on the stock (but avoided overspending your account), or your order would have been executed later in the day if the stock had dipped low enough to fill at your limit price.

Consider using limit orders in your trading

The next time you're entering a trade in volatile conditions, consider whether it would be smarter to enter a limit order. Limit orders at Schwab can be placed with a "Time in Force" (TIF) of DAY, GTC, FOK or IOC. For more details regarding these order types, see "Order Types: Getting to Know the Basics," or contact a Schwab trading specialist at 800-435-9050.