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3 Order Types: How and When to Use Them

3 Order Types: How and When to Use Them

The final decision in placing a trade comes down to order type. Learn about the uses in and differences between three of the most common kind.

About to pull the trigger on a trade, 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 may be 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:

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

1) Market orders: 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 immediately.

To understand how market orders work, keep in mind that 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 fewer than 250,000 shares traded 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 considerably different from what you intended. This is known as a gap in price, and we'll cover how gaps affect Stop and Limit orders later.

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.

2) Limit orders: 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're buying and want a lower price, because a limit order allows you to specify a price below the current market price.
  • You're 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 a given stock.

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

Market and limit orders
Looking at the chart, you'll see that the last trade price was approximately $84.00.

  • A market order to buy or sell would have been executed at approximately $84.00—the current price—assuming that the market was open at the moment of the order.
  • If you wanted to buy the stock at $80.00 (below the current price), you'd place a limit order to buy at $80.00.
  • If you wanted to sell the stock at $88.00 (above the current price), you'd place a limit order to sell at $88.00.

The "or better" referenced in the header above means that, should the stock price gap lower, then a limit order to buy would be triggered by any trade at or below $80.00 and executed on the next trade, although with the cap of $80.00—not $80.01.

Let's say JNJ opened the next morning at $78.00. Then, the $80.00 limit order to buy would be triggered and it should be executed at approximately $78.00—a more favorable price ("or better") to the buyer. In the same manner, a limit order to sell at $88.00 would be triggered if JNJ should gap up to $90.00 and would be filled at approximately $90.00.

3) Stop orders: Damage control OR don’t let this stock get away

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

A sell stop order is often referred to as a "stop-loss" order. In this context, you own a stock and want to try to limit the downside risk. You identify a specific price that will activate your order to sell the stock, in essence "stopping" your 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, you identify a specific price that will trigger a purchase of the stock, in essence "stopping" the stock from getting away from you as it breaks to new highs at a level that may indicate a potential new uptrend. 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 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 $80.00, while a buy stop only triggers if price rises to or gaps above $88.00.

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

Market and stop orders

Stop orders and gaps in price

You may have heard a trader say, "I don't use stop-loss orders—they don't work because my stop was executed at a much lower price." These traders were probably 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 shares bought and sold. While a gap down in price on a stock you own may not happen that often, it is very memorable when it does happen to you.

Take a look at the next chart example. It shows a stock that gapped down from about $24.30 to about $20.50. You may have placed a sell stop at approximately $22.50 just beneath the recent low price of about $23.00. Of course, you might believe that your sell stop had not "worked" when the stock gaps down and your sell stop is executed at about $20.50. In reality, it functioned as exactly as it should, yet still produced an unexpected result—a lower price than you were expecting.

Source: StreetSmart Edge.

Gap down resulting in a lower price

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. The saying on Wall Street is: Your first loss is your best loss.

Limit orders and gaps in price

In my experience, losses have usually hurt more than gains have felt good. A gap higher can work in your favor if you have a sell limit, in the same way a gap lower works against you with a sell-stop order, as shown in the chart below.

Source: StreetSmart Edge.

Gap up can work in trader's favor

In this example, a stock closes one day at about $21.25. If you had a sell limit order at $22.50, you'd be pleasantly surprised when the next morning your order was executed at about $23.50.

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” (GTC). GTC orders are valid for up to 60 days at Schwab, 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 generally cannot be cancelled. Limit and stop orders may be submitted as either "Day" or "GTC" orders and may be changed or cancelled unless actually executed.

Bottom line

When it comes time to 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.

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