Categories
03. Order Type

Stop Order

How a Stop Order Works

Investors and traders can execute their buy and sell orders using multiple order strategies to limit the chance of loss. The basic market order fills an order at the ongoing market price of the security. A stop order is instead placed when an investor or trader wants an order to be executed after a security reaches a specific price. This price is known as the stop price, and it is usually initiated by investors leaving for holidays, entering situations where they are unable to monitor their portfolios for extended periods of time, or trading in volatile assets—such as cryptocurrencies, which could take an adverse turn overnight.

Traders often enter stop orders to limit losses or to capture profits on price swings. These types of orders are very common in both stock and forex trading, where intraday swings can equal big gains for traders but are also useful to the average investor with stock, option, or forex trades. There are two similar-sounding order types that are slightly different. The first, a stop order, triggers a subsequent market order when the price reaches a designated point. A stop-limit order, on the other hand, triggers a limit order entered when a designated price point is hit.

Traders who use technical analysis will place stop orders below major moving averages, trendlines, swing highs, swing lows, or other key support or resistance levels.

Stop-Loss Orders for Bear Markets vs. Stop-Loss Orders for Bull Markets

A stop-loss order is essentially an automatic trade order given by an investor to their brokerage to trigger a sale when a certain price level is reached to the downside. The trade (either a market or limit order) then executes once the price of the stock in question falls to that specified stop price. Such orders are designed to limit an investor’s loss on a position.

The main risk involved with a stop-loss order is the potential of being stopped out. Stopping out happens when the security unexpectedly hits a stop-loss point, activating the order. The stop could cause a loss on a trade that would have been profitable—or more profitable—had not the sudden stop kicked in. This situation can be particularly galling if prices plunge as they do during a market flash crash—plummeting but subsequently recovering. No matter how quick the price rebound, once the stop-loss is triggered, it is triggered.

The strategies described above use the buy stop to protect against bullish movement in a security. Another lesser-known, strategy uses the buy stop to profit from anticipated upward movement in share price. Technical analysts often refer to levels of resistance and support for a stock. The price may go up and down, but it is bracketed at the high end by resistance and by support on the low end. These can also be referred to as a price ceiling and a price floor.

Some investors, however, anticipate that a stock that does eventually climb above the line of resistance, in what is known as a breakout, will continue to climb. A buy stop order can be very useful to profit from this phenomenon. The investor will open a buy stop order just above the line of resistance to capture the profits available once a breakout has occurred. A stop-loss order can protect against a subsequent decline in share price.

Types of Stop Orders

For example, if on January 5, 2018, AAPL was trading for $175 per share at 1:00 p.m., a market order does not guarantee that an investor’s buy or sell price will be filled at $175. The investor may get a price lower or higher than $175, depending on the time of fill. In the case of illiquid or extremely volatile securities, placing a market order may result in a fill price that significantly differs from $175.

On the other hand, a limit order fills a buy or sell order at a price (or better) specified by the investor. Using our example of AAPL above, if an investor places a $177.50 limit on a sell order, and if the price rises to $177.50 or above, their order will be filled. The limit order, in effect, sets the maximum or minimum at which one is willing to buy or sell a particular stock.

Buy-Stop

A buy-stop order is entered at a stop price above the current market price. A sell-stop order is entered at a stop price below the current market price. Let’s consider an investor who purchased AAPL for $145. The stock is now trading at $175, however, to limit any losses from a plunge in the stock price in the future, the investor places a sell order at a stop price of $160. If an adverse event occurs causing AAPL to fall, the investor’s order will be triggered when prices drop to the $160 mark.

Stop Market vs. Stop-Limit

A stop order becomes a market order when it reaches the stop price. This means that the order will not necessarily be filled at the stop price. Since it becomes a market order, the executed price may be worse or better than the stop price. The investor above may have their shares sold for $160, $159.75, or $160.03. Stops are not a 100% guarantee of getting the desired entry/exit points.

This can be a disadvantage since, if a stock gaps down, the trader’s stop order may be triggered (or filled) at a price significantly lower than expected, depending on the rate at which the price is falling, the volatility of the security, or how quickly the order can be executed.

For example, assume that Apple Inc. (AAPL) is trading at $170.00 and an investor wants to buy the stock once it begins to show some serious upward momentum. The investor has put in a stop-limit order to buy with the stop price at $180.00 and the limit price at $185.00. If the price of AAPL moves above the $180.00 stop price, the order is activated and turns into a limit order. As long as the order can be filled under $185.00, which is the limit price, the trade will be filled. If the stock gaps above $185.00, the order will not be filled.

Buy stop-limit orders are most often placed above the market price at the time of the order, while sell stop-limit orders are typically placed below the market price.

Stop-Loss

Using this example, one can see how a stop can be used to limit losses and capture profits. The AAPL investor, if their order is filled at a stop price of $160, still makes a profit from their investment: $160 – $145 = $15 per share. If the price spiraled down past their initial cost price, they will be thankful for the stop.

On the other hand, a stop-loss order could increase the risk of getting out of a position early. For example, let’s assume AAPL drops to $160, but goes on an upward trajectory to $185. Because the investor’s order is triggered at the $160 mark, they miss out on additional gains that could have been made without the stop order.

Categories
03. Order Type

Limit Order

What Is a Limit Order?

A limit order is a type of order to purchase or sell a security at a specified price or better. For buy limit orders, the order will be executed only at the limit price or a lower one, while for sell limit orders, the order will be executed only at the limit price or a higher one. This stipulation allows traders to better control the prices they trade.

By using a buy limit order, the investor is guaranteed to pay that price or less. While the price is guaranteed, the filling of the order is not, and limit orders will not be executed unless the security price meets the order qualifications. If the asset does not reach the specified price, the order is not filled and the investor may miss out on the trading opportunity.

This can be contrasted with a market order, whereby a trade is executed at the prevailing market price without any price limit specified.

KEY TAKEAWAYS

  • A limit order guarantees that an order is filled at or better than a specific price level.
  • A limit order is not guaranteed to be filled, however.
  • Limit orders control execution price but can result in missed opportunities in fast-moving market conditions.
  • Limit orders can be used in conjunction with stop orders to prevent large downside losses.

Volume 75% 2:43

How Do Limit Orders Work?

How Limit Orders Work

A limit order is the use of a pre-specified price to buy or sell a security. For example, if a trader is looking to buy XYZ’s stock but has a limit of $14.50, they will only buy the stock at a price of $14.50 or lower. If the trader is looking to sell shares of XYZ’s stock with a $14.50 limit, the trader will not sell any shares until the price is $14.50 or higher.  

By using a buy limit order the investor is guaranteed to pay the buy limit order price or better, but it is not guaranteed that the order will be filled. A limit order gives a trader more control over the execution price of a security, especially if they are fearful of using a market order during periods of heightened volatility. 

There are various times to use a limit order such as when a stock is rising or falling very quickly, and a trader is fearful of getting a bad fill from a market order. Additionally, a limit order can be useful if a trader is not watching a stock and has a specific price in mind at which they would be happy to buy or sell that security. Limit orders can also be left open with an expiration date.

Real-World Example

A portfolio manager wants to buy Tesla Inc’s (TSLA) stock but believes its current valuation at $325 per share is too high and would like to buy the stock should it fall to a specific price. The PM instructs his traders to buy 10,000 shares of Tesla should the price fall below $250, good ’til canceled. The trader then places an order to buy 10,000 shares with a $250 limit. Should the stock fall below that price the trader can begin buying the stock. The order will remain open until the stock reaches the PM’s limit or the PM cancels the order.

Additionally, the PM would like to sell Amazon.com Inc.’s (AMZN) stock but feels its current price of $1,350 is too low. The PM instructs his trader to sell 5,000 shares should the price rise above $2,500, good ’til canceled. The trader will then put the order out to sell 5,000 shares with a $2,500 limit.

Limit Orders vs. Market Orders

When an investor places an order to buy or sell a stock, there are two main execution options in terms of price: place the order “at market” or “at limit.” Market orders are transactions meant to execute as quickly as possible at the present or market price. Conversely, a limit order sets the maximum or minimum price at which you are willing to buy or sell.

Buying stocks can be thought of with an analogy to buying a car. With a car, you can pay the dealer’s sticker price and get the car. Or you can negotiate a price and refuse to finalize the deal unless the dealer meets your price. The stock market can be thought of to work in a similar way.

A market order deals with the execution of the order; the price of the security is secondary to the speed of completing the trade. Limit orders deal primarily with the price; if the security’s value is currently resting outside of the parameters set in the limit order, the transaction does not occur.

Categories
03. Order Type

Market Order Definition

How Market Orders Work

A market order is considered the most basic of all orders. It is meant to be executed as quickly as possible at the current asking price for security. That is why certain brokerages include trading applications with a buy/sell button. Hitting this button generally executes a market order. In most cases, market orders incur the lowest commissions of any order type, as they require very little work from either a broker.

Market orders are well-suited for securities traded in very high volumes, such as large-cap stocks, futures, or ETFs.

It’s a different story for stocks with low floats and/or minimal average daily volume. Because these stocks are thinly traded, the bid-ask spreads tend to be wide. As a result, market orders sometimes get filled slowly for these securities and often at unexpected prices that lead to significant trading costs.

KEY TAKEAWAYS

  • A market order is a request by an investor to buy or sell a security.
  • It is well-suited for high-volume securities such as large-cap stocks, futures, or ETFs.
  • A trader will execute a market order when they are willing to buy at the asking price or sell at the bid price.

Market Order vs. Limit Order

Market orders are the most basic buy and sell trades. On the other hand, limiting orders allow investors to have more control over the bid or sell price. This is done by setting an acceptable maximum acceptable purchase price amount or an acceptable minimum acceptable sales price.

Limit orders are good for trading securities that are trading thinly, are highly volatile, or have wider bid-ask spreads.

The E-mini S&P or stock market orders such as Microsoft tend to fill very rapidly without issue.

Example of a Market Order

Say the bid-ask prices for shares of Excellent Industries are $18.50 and $20, respectively, with 100 shares available at the ask. If a trader places a market order to buy 500 shares, the first 100 will execute at $20.

The following 400, however, fill at the best asking price for sellers of the next 400 shares. If the stock is very thinly traded, the next 400 shares might be executed at $22 or more. This is precisely why it’s a good idea to use limit orders for these types of securities. The trade-off is that market orders fill at a price dictated by the market as opposed to limit or stop orders, which provide traders more control. Using market orders can sometimes lead to unintended, and in some cases, significant costs.

Special Considerations

Any time a trader seeks to execute a market order, the trader is willing to buy at the asking price or sell at the bid price. Thus, the person conducting a market order is immediately giving up the bid-ask spread.

For this reason, it’s sometimes a good idea to look closely at the bid-ask spread before placing a market order—especially for thinly traded securities. Failure to do so may result in very high costs. This is doubly important for individuals who trade frequently or anyone utilizing an automated trading system.