Understanding Market, Limit, and Stop Orders

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Narrator: You've chosen a stock or ETF you want to invest in, and you know how many shares you want to buy. Now, you've just got to place the order.

For novice investors, that may be trickier than it seems because before placing that order, they have to choose an order type.

Simply put, order types are instructions to your broker about how to execute your trade.

You don't need to know the complicated jargon or hand signals traders used to use on the floor of the New York Stock Exchange, but you should understand the basic order types and how they affect your trade.

Let's focus on the basics of how an order is placed, then three common order types: market orders, limit orders, and stop orders.

First up: how an order is placed. When you select buy or sell, your order is sent to your broker, who attempts to fill it on the market.

Prices can change constantly, and the system for routing orders has lots of moving parts, all of which impact how quickly and at what price your order is actually filled.

Using the right order type can impact these factors and make a big difference in whether your trade works the way you intended. So, it's important to understand the main order types.

Let's start with market order. This order type indicates that you want your order filled immediately at the next available price.

If prices are changing rapidly, the next available price could be different than the price quoted when you initially placed the order. Investors who use market orders tend to be more concerned about the speed of a trade than the price.

The lack of restriction on price means this order type has the best chance of being filled, but it also has the risk of being filled at a different price.

For example, if the price is plummeting and other investors are also trying to sell, the price could drop further by the time the market order is filled. This could lead to a share sale at a price lower than what the investor intended. Likewise, if an investor places a market order after hours, the price could be very different when the order is filled at market open. Because of this, investors typically use market orders during trading hours and in highly liquid markets. This increases the chances of getting an order filled closer to the requested price.

If your priority is to buy or sell at an exact price or better, you may want to use a limit order instead. With a limit order, you specify a price, and the order won't be filled until the stock can be bought or sold at that price or better.

However, because of the price restriction, there's no guarantee the order will be filled quickly—or at all.

Investors generally use limit orders when they have a target entry or exit price and are willing to wait for the market to move in their favor.

Let's say, for example, that a stock is currently trading at $55, but an investor believes it'd be a good value at $50 or less. This investor could place a limit order to buy the stock at $50.

If the stock never reaches the limit price, the order would never be filled. If the stock does drop to $50 or below, with enough volume available at that price, the order will fill, and the investor will buy the stock for $50 or less.

The last order type is a stop order, which is actually just a market or limit order with an activation price that triggers the order.

When the stock reaches the activation price, the order is executed according to its order type.

Stop orders can be used in various ways. Investors can use buy-stop orders to buy securities when they reach the activation price. Or they can use sell-stop orders when trying to limit potential loss in an investment.

For example, an investor might set a sell-stop order on a stock she owns, specifying that if the stock falls to a certain price or lower, it'll trigger an order to sell the stock at the next available market price. This could possibly prevent more serious losses by getting out before the stock falls too far.

There are three types of stop orders: stop market, stop limit, and trailing stop. If the investor in this example uses a stop-market order, when the trigger price or lower is reached, an order will be placed to sell the stock at the next available price. The benefit is that a stop-market order may help get the investor out of the falling position quickly. The risk is that the next available price could be lower than what the investor anticipated.

If the investor uses a stop-limit order, when the stock falls to the stop price, it'll trigger an order that seeks to fill at the limit price or better. A potential benefit is being able to control what price the stock is sold at. But there's also a risk of the stock falling so quickly that the stop is triggered, but the limit order is never filled because the stock has fallen below the limit price.

Investors can also use a trailing stop order.

With a trailing stop order, instead of setting a specific activation price, you set a "trailing amount", or a certain dollar amount or percentage away from the market price. On a long position, you'd typically set a trailing stop below the market price in an attempt to lock in profits as the stock rises.

So, let's say you own a stock trading at $100 and place a trailing stop order $5 below the current price. If the stock price increases to $110, the stop price would rise from $95 to $105, staying $5 below the market price. But if the stock were to start slipping, the trailing price would stay at $105, minimizing your potential loss on the position.

Each order type has its advantages and disadvantages. Investors should plan ahead and decide which type of order is right for each scenario.

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