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The stock market can be a volatile place. Many first-time traders, after watching some stock movies, imagine buying a specific stock as a straightforward affair and are confused by the different orders they can place and what they mean. Sure, the most basic principle is that everyone wants to buy low and sell high, but how do we balance our price expectations with actual market movements?
This is where the ability to differentiate between different order types, create a portfolio in Excel, and formulate a strategy around them comes in handy. The rationale behind order variations is to provide the trader with price flexibility and reduce the need to actively manage the trading portfolio at all times. Since predicting price fluctuations is the main challenge of trading, having the option to choose the buying and selling prices that suit your needs are common tools at the account holder’s disposal.
"Opportunity comes to the prepared mind" - Charlie Munger
The most accessible, and therefore the most commonly used order type, is the market order. A market order means the order is placed at the current market price and is determined by the spread, or the difference between the current bid (buying) and ask (selling) prices.
Newcomers to financial markets are generally advised to place market orders on their trades as they represent the least complicated trading order, which, in most cases, is filled in mere seconds.
Let’s consider an example of a trader who wishes to buy Tesla stock (NASDAQ:TSLA) at market price. If we assume the current ask price for one Tesla share is $745.50 and the bid is at $745.75 - this gives the trader a spread of $0.25, meaning that placing a market order could give the trader a price difference of up to 25 cents, depending on the trading volume during that specific trading session.
Therefore, the market order can guarantee the execution of the trade but does not guarantee the price at which the trade will be executed.
For the more seasoned trader, market orders might represent a quick solution during short-term price volatility. When there is the expectation of a sudden hike in the market price of a particular stock, the trader might disregard the potential loss on the spread to capitulate on the rapidly rising price. One instance where market orders could come in handy is right before the company in question submits a new regulatory filing or publishes a financial report.
On the other side of the coin, limit orders provide traders with the option to buy or sell at the price of their choosing.
Say a trader wishes to buy a specific stock under $5 at the price of $4.75, and the stock is currently hovering around $4.99. If the trader submits a limit buy order at $4.75, the order will not be filled unless the price falls to $4.75. The same exact principle applies to selling the stock.
The key benefit to using limit orders is the convenience of controlling prices and only buying and selling at the desired price.
Another advantage occurs when the market opens below the trader’s pre-submitted limit buy order, at which point the order is filled at market price.
Referring back to the example, if the market opens at $3, the order will be filled at that price, thus providing a net positive for the trader.
Limit orders are typically not very complex and are often viewed as the next stepping stone for new traders after they’ve already had sufficient experience with placing market orders.
More advanced traders typically trade using complex strategies that include a certain degree of risk mitigation. During exceptional price volatility, more risk-averse traders might opt to safeguard their portfolios from sudden losses.
A trader who purchases a specific stock at $10 and places a stop-loss order at $8.50 knows that their maximum loss per share will be $1.50.
Another upside to using stop-loss orders is that they are free to place. Trading commission fees are only charged after the stock hits the stop-loss price and the stock is sold.
A strategy that is aimed at minimizing losses can also be implemented to guarantee a certain profit margin. Consider this; if the price of the stock purchased by our aforementioned trader reaches $15, and they submit a stop-loss order at $13, they can rest assured that they will at least obtain a profit of $2 per share, even if the price continues to fall below the purchase price of $10.
Stop-loss orders provide traders with greater flexibility as well as an increased awareness of their own risk tolerance.
For the more experienced and risk-tolerant traders who tend to profit more from price dynamics and choose to sell stock short, buy-stop orders are a way to cover the potentially infinite losses they could incur while short-selling.
When a trader sells a stock short, they are essentially placing a bet that the market price of that security will decline. This sounds straightforward on paper, but traders must keep in mind that the upside of any tradable stock is potentially infinite. Therefore, if a trader chooses to sell a stock short, the downside risk for their portfolio is also infinite.
To mitigate such an enormous risk, buy-stop orders give investors the opportunity to set an order at a specified price, providing a “price ceiling” at which the order is filled as either a market or limit buy order.
The price at which the stop order is filled is called the strike price, and it serves as a turning point for the trade.
Buy-stop orders are usually part of the trading strategy from the start, or they serve as an inclination that the trader has lost confidence in their initial judgment of the trade and is seeking downside protection.
Trading is a complex activity where everyone’s funds are constantly at risk. But just how much risk is tolerable for a given trader?
That question can be answered by understanding the fundamental principles behind each order type and what scenarios they are best suited for.
By mastering the order types and knowing how they function, traders can form robust strategies that suit their needs and risk tolerance, guiding them through the coming bull and bear markets alike.
Limit orders are orders which are filled only at a specified price provided by the trader. If the limit price is not met, the order will not be executed and can be canceled. Buying a stock at a limit guarantees the investor to buy at a predetermined price or less.
The main order types are market, limit, and stop orders. Stop orders can be classified as stop-loss and buy-stop orders.
The most widely used and easy-to-access order types are market orders. Market orders are typically executed right away and let the trader buy or sell a security at the current market price.