Understanding Order Types

September 26, 2011

Mark Eidem
CMT, CFA, Active Trader Market Manager, Charles Schwab

About to pull the trigger on a stock, but confused about which order type to use? You're not alone—an often overlooked yet fundamental aspect of trading is selecting the appropriate order type.

When placing an order, it helps to think of each order type as a different tool, each suited to its own purpose. So just as a hammer, screwdriver or wrench is your tool of choice for a given construction job, each order type has its own function. Here, we'll focus on three main types of orders: market, limit and stop.

As you consider which order type you'll need, first ask yourself two basic questions:

• Am I trying to buy or sell?
• What price do I want—the current price, a higher price, or a lower price?

Market order: Do it now

A market order is an order to buy or sell a stock at the best available price. Keep in mind that a market order guarantees execution but does not guarantee a particular price.

Traders should consider using a market order only when their primary concern is getting the trade done—right now!

To understand how market orders work, keep in mind a stock has both a bid price and an offer price. Typically a trader buys a stock at the offer and sells at the bid. The quote on a stock usually includes the last trade price, the highest bid and the lowest offer. Please note that the last trade price may not be "current"—with less liquid stocks, the last trade may have occurred several minutes, several hours or even longer ago. (An illiquid stock is one that typically averages less than 250,000 shares per day over the previous month). It's the current bid and offer prices that are important—not necessarily the last trade price.

Note that a market order should not be placed outside of normal trading hours. If there's a news story after the market closes today or before it opens tomorrow, the market's reaction can cause a significant move in the stock price, resulting in your paying a price different from what you intended. This is known as a gap in price. Just because a story seems positive (or negative) doesn't mean that the stock will move higher (or lower). Remember that it's the market's reaction that matters, not the story itself!

Limit order: When you want a specific price "or better"

A limit order is an order to buy or sell a stock at a specified price or better. It guarantees a price but doesn't guarantee execution.

This is where the two basic questions above come into play. Are you buying or selling? Are you most interested in the current price, a lower price or a higher price? A limit order might make sense if:

• You are buying and want a lower price, because a limit order allows you to specify a price below the current market price.
• You are selling and want a higher price, because a limit order allows you to specify a price above the current market price.

Take a look at the chart below. It shows both market and limit orders to buy and sell for Research in Motion (RIMM).

Market and Limit Orders

Note that prices are used only to illustrate how orders may be used.
Source: StreetSmart Edge®.

Looking at the chart, you'll see:

• A market order to buy or sell would have been executed at approximately $30—the current price—if the market was open at this moment.
• If a trader wanted to buy RIMM at $28 (below the current price), he would place a limit order to buy at $28.
• If a trader wanted to sell RIMM at $32 (above the current price), he would place a limit order to sell at $32.

The "or better" referenced above means that, should the stock price gap lower, then a limit order to buy would be triggered by any trade at or below $28 and become a market order executed on the next trade, although with the cap of $28.00—not $28.01.

Let's say that RIMM opened the next morning at $26. Then, the $28 limit order to buy would be triggered and it should be executed at approximately $26, which is a more favorable price to the buyer. In the same manner, a limit order to sell at $32 would be triggered if RIMM should gap up to $34 and should be filled at approximately $34.

Stop order: Damage control or a turn for the better

A stop order is an order to buy or sell once the price of a stock reaches a specified price.

It's often referred to as a "stop-loss" order. In this context, a trader owns a stock and wants to do everything within his power to limit the downside risk. He identifies a specific price that will activate his order to sell the stock, "stopping" his loss from getting worse. So if the stock drops to that price (or gaps below that price), the stop order to sell is triggered and becomes a market order executed on the next trade.

However, a stop order may be used as a buy order as well. In this case, the trader identifies a specific price that will trigger a purchase of the stock, in essence "stopping" the stock from getting away from him or locking in a profit. This type of order may be useful to a trader trying to identify a point at which a stock's price trend changes from down to up.

Now, let's revisit our RIMM example on the same date as above. In the chart below, you can see that a sell stop is only triggered if the price drops to or gaps below $28, while a buy stop only triggers if price rises to or gaps above $32.

Market and Stop Orders

Note that prices are used only to illustrate how orders may be used.
Source: StreetSmart Edge.

Stop orders and gaps in price

I often hear traders say, "I don't use stop orders—they don't work because my stop was executed at a much lower price." These traders were affected by a gap in price, where the stock closed one day at a certain price and then opened the next day significantly lower.

This gap between one day's close and the next day's open is often due to a sell order imbalance.

The stock market is a real-world laboratory where the law of supply and demand is demonstrated daily. If there are a large number of shares for sale relative to the number of shares to purchase, this produces a relative sell order imbalance. The key word here is "relative." The law of supply and demand dictates that as supply (number of shares for sale) increases, the share price must drop in order to balance with demand (number of shares to purchase). There must always be an equal number of buyers and sellers. While a gap down in price is somewhat rare, it is very memorable when it happens to you.

Take a look at the next chart. It shows Research in Motion (RIMM) when the stock gapped down from about $57 to about $48. A trader may have placed a sell stop at approximately $52 just beneath the recent low price of about $53. Of course, that trader would believe that his sell stop had not "worked" when the stock gaps down and his sell stop is executed at about $48. In reality, it worked as exactly as it should, yet still produced an unexpected result—a lower price.

Gap Down Resulting in a Lower Price

Source: StreetSmart Edge.

When (not if) a stock you own gaps lower—right through your sell stop order—realize that whatever the news may be, it appears that the market is perceiving it as negative and that negative perception is all that matters at that moment. In my experience, I've found that "bad" news rarely gets better with time. The saying on Wall Street is: Your first loss is your best loss.

While I don't have specific statistics to quote, in my experience a gap down is rare. Further, realize that while a gap down is quite painful and therefore very memorable, a gap higher also might occur over a full market cycle of both bull and bear markets. If you experience a gap higher, it will likely be far less memorable than the gap down through your stop.

Limit orders and gaps in price

As I mentioned, gaps higher are also rare. But losses usually hurt more than gains feel good. A gap higher can work in a trader's favor if he has a sell limit, in the same way a gap lower works against the same trader with a sell stop order, as shown in the chart below.

Gap Up Can Work in Trader's Favor

Source: StreetSmart Edge.

In this example, Research in Motion (RIMM) closes one day at about $49. If a trader had a sell limit order at $52, he would be pleasantly surprised when the next morning his order was executed at about $60.

Which timeframe for which order type: Day or Good Till Cancelled (GTC)?

An order can be specified as either day which means it is only valid for the remainder of that specific trading day, or as good till cancelled or GTC. GTC orders are valid for up to 60 days, not forever.

By definition market orders, which request execution on the next trade, are day orders. If market orders are submitted while the market is open, they can't be cancelled. Limit and stop orders may be submitted as either "Day" or "GTC" orders and may be changed or cancelled until actually executed.

Bottom line

When it comes time to execute an order and enter or exit a trade, remember to think in terms of two basic questions:

• Am I trying to buy or sell?
• Which price do I want—the current price, a higher price or a lower price?

Then, based upon your understanding of the different types of orders, select the correct tool for the job at hand. Next month we will examine two more types of orders. Until then, good luck and good trading!