By Robert Penney
Order combinations can be very complex and confusing to the first-time trader, and one of the first hurdles to overcome when placing a trade in the stock market, virtual or otherwise, is knowing the different order types and how they are used to enter and exit trades. The goal of this article is to present the necessary information to help prepare you to begin placing orders on the exchanges.
To simplify, let’s group all orders into two types: the market order and the limit order. As complex as the market and brokerage windows might appear, there are only two order types that are filled at the exchanges. The way those two orders are placed and triggered is what complicates things.
The Market Order
The U.S. Securities and Exchange commission defines a market order as "an order to buy or sell a stock at the current market price." When you place a buy or sell order at a brokerage house, the order type will default to placing a market order. The main advantage of market orders is that they guarantee your transaction will take place when there is another party willing to take the other side of your trade (for example, a seller or sellers must be willing to part with the requested number of shares).
The biggest disadvantage is that you are not guaranteed to get the currently quoted price for that security. Your brokerage has the duty of best execution for your transaction, meaning that they are required to find the best price available for your trade, but that best price could be slightly different or drastically different from the price at which you intended to purchase the security. Let's look at two examples to help explain why and how the prices might be different:
Example #1: Slightly Different Fill Price
Suppose that you want to buy 100 shares of a stock with the ticker XYZ which trades on the NYSE. The exchange is currently open, meaning you are placing the order between 9:30 a.m. and 4:00 p.m. EST on a weekday. You look at a quote screen in your EdutraderTM software or at your brokerage and see that there are currently five lots, or 500 shares, available for $38.92. You see the quote, bring up your broker-entry screen, and enter a Buy 100 XYZ market order. In the meantime, a person sees the same quote and places an order to buy 1,000 shares of XYZ before you can get your order entered. Immediately, the shares you saw for $38.92 are all purchased, including 300 shares for sale at $38.93 and 100 shares for sale at $38.94, filling that person's 1,000 share order. Your order arrives just in time to take a piece of the 400 shares available at $38.95, which becomes your fill price. The three cents difference between what you wanted to buy at ($38.92) and the price you ended up with ($38.95) is called slippage. In this case, your slippage was relatively small and is what can typically be expected when placing a market order.
Example #2: Drastically Different Fill Price
Perhaps you want to buy 100 shares of a stock with the ticker XYZ which trades on the NYSE. The exchange is currently closed, meaning you are placing the order outside of the 9:30 a.m. and 4:00 p.m. EST or on the weekend. You look at a quote screen in your Edutrader software or at your brokerage and see that there are no active orders, but you do see that the last trade was $39.92. You consider $39.92 to be a reasonable price and bring up your broker-entry screen and enter a BUY 100 XYZ market order. Your order is now entered and awaiting the market to open the next weekday at 9:30 a.m. EST. Between now and then, positive news comes out for the company behind the ticker and the market gets excited over the stock, causing the stock price to gap up into the open. The stock that closed at $39.92 now opens significantly higher at $42.34, and your market order activates. Your brokerage does its job and gets you the best available price; however, that price is $2.42 higher than what you intended to pay when the order was entered.
In the two examples above, we see the advantage of the market order in terms of guaranteeing an entry on the stock of interest, no matter what the price. However, the controlled reward versus risk and the related desired entry zone that is part of the master trader plan is completely ignored, resulting in the potential occurrence of very large discrepancies between the original plan and the final result. The limit order (to be discussed in next month’s issue) gives the trader some additional control over defining what price is too high when making a stock purchase.
Use a Market Order…
1) When you would like to exit a stock immediately and have a reasonable expectation that the price of the stock will not move significantly during the time between the placing and filling of the order. Stocks that are actively traded (a large number of shares available on the Bid and Ask at any given time, i.e. liquid (improper)) are prime candidates for using market orders for immediate exit. The master trader might use a market order when sitting in front of the market, and needs to exit stock before an earnings release.
2) In combination with stops (triggers) for use in exiting trades on a move against the position, either taking a loss at the initial risk or locking in a profit. The master trader will do this for virtually all of her/his trades.
3) When you absolutely have to get out of or into a stock at any price. This sort of action should be a very rare occurrence for the master trader.