posted: May. 10, 2010 @ 10:59p
Public Service Announcement
In reading the comment in other threads, I am shocked by the lack of understanding of stock order types, what they mean, and when to use them. Uneducated (or worse, people that think they are educated) are jumping into the market without understanding basic mechanisms and, in effect, exposing themselves to significant risks
If you learn nothing else, learn this: DON'T USE MARKET ORDERS!!!
Market Order: Immediately execution(1) at National Best Bid and Offer (NBBO). The definition of immediate execution is undefined.
When you place a market order, you are effectively telling your broker "Give me XXX shares of ABC at the best price right now!." Your order is then routed to an exchange (2).
The benefits of market order is that you are guaranteed to have your trades execute (as long as there are bids/offers).
The risk in market orders is that there is a chance that NBBO at a given time may be far from the last trade amount. Let's use an example where a stock's last trade is at $145. If for some reason (technical glitch, after hour trading, low liquidity), the best bid on the book is 0.05. You put in a market order for 100 shares, you will execute at $0.05 rather than $145. So instead of netting $14,500, you net $5.
Another example is say the current bids are:
100 57.9400 100 54.0000 800 0.0001
And you put in a market order to sell 500 shares, 100 sells @ $57.84, 100 sells @ $54, and 300 sells at $0.0001. This is most likely not what you intended.
DON'T USE MARKET ORDERS
Limit Order: An order to sell or buy at a set price or better.
When you place a limit order, you are telling your broker "Give me xxx shares of ABC at $yy.yy or lower". Your order will then be routed to the Limit Order Book to be matched. Everyone in the market can see your order.
The benefit of Limit Orders is that you are guaranteed to only trade at a given price. You know what price you'll buy or sell at.
The risk in a limit order is that in a fast moving market, your limit order may not hit. For example, if it is currently trading at $145 and you put in a limit order to sell at $146, it may never hit $146 and your order will not execute.
Stop Order: A stop order turns into a market order when the last traded price touches the stop price.
When you place a stop order, you are effectively telling your broker "IF the last traded price for ABC is $XXX, sell yyy shares IMMEDIATELY." Your stop order stays at your broker (it does not get published out to the market). When the stop price hits, the broker sends out a market order for the stock.
The benefits of a stop order is that it can be used to cut your losses in a crashing market or lock in your gain. Say that you bought AAPL @ $195 and it's currently trading at $254, you may want to set a stop at $210 so that if the market does crash, you can lock in a gain of $15.
The risk of stop order is that you can easily get knocked out. Using the above example, let's say that AAPL somehow drops to $209; your stop executes; you sell your shares at $209. Later on in the day, AAPL rallies back to $250. You would have sold your shares for a lot cheaper than you should have. (This is called, "getting stopped out")
Unscrupulous market makers, institutional investors, and hedge funds sometimes use this to their advantage. A market maker may be able to detect a large number of investors setting stops at a certain price (3). With that knowledge, they would force the price to that level, trigger the sells and buy the stocks at a cheap price.
Stop Limit Order: A stop limit order turns into a limit order when the last traded price is the stop price.
When you place a stop limit order, you are effectively telling your broker "IF the last traded price for ABC is $XXX, put in a limit order for yyy shares $ZZZ"
The benefits of a stop limit order is similar to the stop order as well as the benefit of knowing at what price it'll execute.
The risk is the same as a stop order. In addition, there is a chance that your trade will not execute. For example, if you put a stop limit order of $210 stop/$209 limit, there is a chance that in a high volatile market, the stock gaps down from $210 to $205 and never touches $209. At this point, your trade won't execute.
Trailing Stop Order: A trailing stop order is a type of stop order that sets a stop that adjusts according to the current market price. This is a good strategy for investors that don't regularly follow the market and don't want to be wiped out by unexpected market crashes. This is also known as colloquially as letting the gains ride and cutting your losses quickly.
When you place a trailing stop order, you are effectively telling your broker "IF the stock is trading xx% below it's market high, send in a market order to sell yyy shares."
For example, a standard trailing stop is 10%. Let's just say that you bought AAPL at 200. Since you don't follow the market often and you want to let your gains ride and cut your losses or capture the gains, you put in a trailing stop for 10%. Your trailing stop is now 180. The next day, AAPL hits 215, your trailing stop is now 193.5. The next day, AAPL jumps to 250, your stop is now 225. Next day, it rises to $260, your stop is now $234. Next day, AAPL drops to $230. Your stop would have triggered at 234 and you would have sold around there. As you can see, this is a very easy hands off method of investing.
The benefits of a trailing stop order is that it is very hands off. You let your winnings ride and cut your losses.
The risk is the same as a stop order. In addition, you are guaranteeing yourself that you will always sell 10% down from peak. In a highly volatile market, your order can get hit unexpectedly.
In addition to order types, there are also a number of optional order attributes that can be place on your trade. These effect the execution of your trades.
All or None (AON): Either all of your order quantity gets executed or none of them. This can only be done with minimum of 300 shares. The risk of using AON is that a trade may not get executed.
I use this a lot when I place trades. Let's say I have 500 shares of AAPL that I want to sell. If I put in a order for 500 shares, I don't want only 350 shares to sell and 150 shares sitting in my account. This annoys me for two reasons: 1) if I want to sell 500 shares, I want to sell all 500 shares. 2) if I have to put in another trade for 150 shares, I'd need to pay 2 commissions
Fill or Kill (FOK): The trade either executes immediate or the trade is cancelled. Say you put in a market or limit order and there are not enough sellers or bids to fill your trade request, your entire order is cancelled.
Immediate or Cancel (IOC): Any part of the trade that does not get immediate fill will be cancelled. So, for example, if you put in an IOC limit trade, any part of your trade that is not filled immediately will not execute.
Good for Day or Day Order: The order will only be active during the days trading session. If your order or any part of your order is not filled by the closing of session, the order is cancelled. Your orders will not go into extended hours or the next day. This is the default order time type. In most cases, this is the order type that you currently use.
Good 'Til Cancel (GTC): The order will be active until it is manually cancelled. This saves you the time to book an order every day. So for example, if you put in a GTC order to buy GOOG at $400 today, it may execute in 2 weeks. People normally do this for stop loss orders.
(1) SEC regulation does not require trades to be executed in certain time period, unless your broker specifically advertises their speed of execution. For example,
ETrade advertises a 2 Second Guarantee;
TD Ameritrade advertises a 5 Seconds Guarantee; and
I can't seem to find a guarantee for Charles schwab. However, SEC regulations require brokers to capture and report execution statistics. Schwab Stats,
(2) This is a gross simplification. According to SEC regulations, the broker has the option to route the order to an exchange, a market maker, an ECN, or executed within the firm, whichever one the broker deems has the best price at any given time. source
(3) There are a number of ways to detect stops. In the past, stops were published out to market so market makers could see the levels. Nowadays, most brokers handle the stops within the brokerage. Even then, finding stops is very doable. One way is using a little behavioral analysis. Novice investors set stops at logical levels (200, 210, 150 rather than 195.95). If everytime the stock trades at a certain price, large market orders enter the market, you know that is a level that people set stops. This strategy is called Stop Hunting
SEC: What Every Investor Should Know about Trade Execution
Limit order vs Market Order
CANNOT REITERATE ENOUGH, DON'T USE MARKET ORDERS