The proliferation of online brokerages has enabled more retail investors to buy and sell stocks on their own. This empowers retail investors and traders to trade the stocks they want and build their portfolio as they wish, while avoiding hefty commissions and sales fees.
Before you can sell and buy stocks on your own, it’s imperative to understand how you should go about it.
This brings us to stock market orders. Stock market orders come in various types and are used towards different purposes. In this article, we will be discussing three of the most common stock order types – market orders, limit orders and stop orders – to help you understand which to use when buying or selling stocks.
What are Stock Market Orders?
Simply put, stock market orders are instructions you give to your brokerage, telling them what you want to do when buying or selling stocks. Provided the stock order is valid, your brokerage will attempt to execute the order on your behalf.
There are several types of stock orders available, and which one you should pick will depend on what you are trying to accomplish with the particular trade. As such, it is important to learn about the different stock order types available, how they work, and when you should use them.
Why are Stock Orders Necessary?
When buying or selling a stock, the current price of the asset isn’t necessarily the final price you will pay or get. You will also notice that during trading hours, prices exhibit a dynamic nature, constantly moving up and down.
This is, of course, a function of demand and supply, which is the principle underpinning all markets. As demand increases, prices go up, and when demand decreases, prices go down.
The mechanism that powers this flux of demand and supply is the bid-ask model. When you attempt to purchase a stock, the price you are willing to pay is called the “bid price”. The price that the seller is willing to accept for selling the stock to you, is called the “ask price”.
When the bid and ask price matches up, the trade is made and the stock changes hands accordingly. All these transactions are performed automatically via online systems.
Stock orders are what you use to initiate a trade, specifying the stock or asset, as well as the quantity you want to trade. Certain stock orders will also allow you to place additional conditions on your trade – this allows you to have a granular level of control and facilitates various goals and strategies.
3 Types of Stock Orders to Know
Stock Order Type 1: Market Order
Market orders are the most basic of the three. When you place a market order, you are attempting to buy or sell the stock immediately, at the current price.
This means that if you’re selling, you’re willing to accept the current highest bid price. Conversely, if you’re buying, you’re willing to pay the current highest ask price.
Note that due to the bid-ask model, the final price at which your trade is settled may be different from the current price. For popular stocks that are highly traded, this difference is typically minimal. However, when trading on stocks that are less popular and with low liquidity, there may be appreciable variance in the settlement price.
When to Use Market Orders
Market orders do not give any consideration to your preferred price – they attempt to fill the order as quickly as possible. Hence, market orders should be used when you are trying to buy or sell a stock with the quickest speed possible.
Additionally, you may also use market orders when you have no price preference, i.e., when you’re willing to accept the current market price the stock is trading at.
Typically, market orders for popular stocks will be filled almost instantaneously if placed during trading hours. Otherwise, they will be filled when the market reopens if entered outside of trading hours.
Stock Order Type 2: Limit Order
A limit order will attempt to fill a trade at a price you specify, or better; until such a price is found, your order will not be executed. This means you can set the maximum price you want to pay for a stock, or the minimum price you want to receive for selling it.
Note that limit orders are filled on a first-come, first-served basis, so even if your specified price is reached, your limit order may take some time to clear if there are other orders ahead of yours.
Hence, there is no guarantee of a limit order being filled, and you may have to wait several hours or even days to complete your order, depending on market conditions.
If your trade is experiencing significant delay in getting filled, you can manually cancel your limit order and replace it with a different price or another order type entirely.
When to Use Limit Orders
Limit orders should be used when you have a price preference for your trade. Savvy use of limit orders can help you achieve more favourable outcomes.
For instance, let’s say META has appreciated and you want to sell your stocks for a capital gain. You have a hunch that the price of META will rise even higher during the trading day, but don’t want to wait around at your computer for that to happen.
You can put in a sell limit order specifying the price you think META will reach, and then logoff and go about your day. If your guess proves correct, and META hits your limit price, your trade will be triggered, allowing you to sell your stocks and reap a higher return.
If, however, your guess doesn’t bear out, and the day closes without META ever reaching your limit price, your trade will not be fulfilled.
At this point, you may decide to keep your limit order open and see if it gets filled the next day or replace the limit order with a lower price if you anticipate a potential downtrend.
Stock Order Type 3: Stop Order
Stop orders attempt to buy or sell a stock when a specified price threshold is crossed (the “stop price”). The trade is fulfilled at the available market price at the time the stop order is triggered.
If the stop price is not reached, the stop order will not trigger, and you can choose to keep it open for another day or replace the stop order entirely.
When to Use Stop Orders
Stop orders sound similar to limit orders, but the key difference is, a stop order does not attempt to fulfil the trade at a specific price. Instead, the next available market price is used.
Stop orders may be useful when:
- You’re attempting to protect unrealised gains on a stock you own. You can set a stop order to sell your stock when the price falls below a certain price, thereby locking in your gains
- You want to limit how much loss you are willing to accept on a stock, say 10%. You can set a stop loss to trigger when the price of the stock falls 10% below its current price.
- You want to buy a stock when it breaks above a price you believe signals the start of an uptrend.
A Note on Price Gaps
A price gap can occur when a stock price makes a sharp move up or down outside of trading hours, due to unexpected announcements or events surrounding the underlying company. This will cause the stock price to open with a significant difference from the previous day’s close.
Since limit orders and stop orders are triggered by stock price, price gaps can impact them in unexpected ways.
Stop Order and Price Gaps
Recall that a stop order triggers when a certain price threshold has been breached, and the trade fills at the next available market price.
Let’s assume that the price of ABC Corp. gapped down overnight from the previous day’s close of USD$30 to open the next day at USD$25. You have a stop order to sell at USD$28, which you were expecting to be filled sometime during the trading day.
However, due to the price gap, the stop order triggers immediately when the market opens for the day. It fills your order at USD$25, creating a larger loss than you expected or intended.
Since price gaps are often transient, without a stop order, you could have chosen to ride out the volatility and only sell your stocks when the price recovers, creating a smaller loss.
Similarly, if the price gapped upwards, triggering your buy stop order, you could end up purchasing a stock at a higher price than you intended.
Limit Orders and Price Gaps
While price gaps could be dangerous for stop orders, they may be beneficial for limit orders. Recall that limit orders execute at the price you specify, or better.
If the price of ABC Corp gapped upwards overnight to USD$40, and you had a sell limit order at USD$33, your limit order would trigger once the trading day begins.
Your trade will be filled at USD$40 (or close to it), netting you a higher profit – USD$10 per share instead of the originally planned USD$3 per share.
Stock orders are vital tools that every investor should have in their trading toolkit. Learning how to use market orders, limit orders and stop orders can make an appreciable difference to your trading experience, as does choosing the right online brokerage as your trading partner.
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