For a concept as simple as “buy and sell,” trading stocks has garnered an air of mystique. All the jargon, obscure techniques, and insider knowledge make Wall Street seem less like a street and more like a (10- foot thick, 100-foot high) wall – impossible to penetrate.
And, unfortunately, some don’t even try.
The truth is, the psychological barrier is perhaps the biggest hurdle that keeps potential investors from taking control of their financial destiny.
But when you signed up for Wall Street Insights & Indictments, you took the first step in dispelling all the mystery of finance – and the first step toward your financial future.
The next step is learning how to trade, how to use the same tools the pros use to build real, lasting wealth.
In today’s markets, “buy and hold” doesn’t work anymore. The investor of today needs to be nimble, open-minded, aware of their risk tolerances and goals.
Investing in this way, calls for the use of every single piece of ammunition available. And different order types are crucial ammunition. It’s important to understand what they are, how they work, and – importantly – what they can accomplish for you.
This understanding is no longer optional…
But the good news is that it’s easier than you might think to get started. And you’ll find that your understanding can make – and save – you a lot of money. That’s because using the appropriate order type in the right situation can be a powerful risk management tool… and a powerful profit engine.
Let’s get started…
Cut Through the Jargon
Wall Street is known for using terminology that might as well be classified as a foreign language at times, but many of the investing concepts are designed with simple purposes: to make trading easier and safer.
You may have already seen trading recommendations like this:
- Buy XYZ Stock at market and set a 25% trailing stop…
- Open a limit order to sell half of your XYZ Stock position at X% and create a free trade…
- Use a 12-month calendar stop based on today’s date…
- Enter an order to sell half your holdings in XYZ Stock at $X, good ’til cancelled…
- Use our protective stop at $X…
- Buy XYZ Stock at market and use 20% stop loss to protect profits…
I know this might seem complicated at first blush, so let me break it down…
There are only three basic order types in existence; Market orders, Limit orders and Stop orders. Every other order type is an extension of the basic three.
And these orders are made on the basis of your convictions, or beliefs, or – if you’re lucky – even hard information that you have. You may have a bullish belief, that is, you expect share prices to rise. Or you may have a bearish belief, where you expect share prices to fall. There are ways to make money in either case, as you’ll see.
Starting with the simplest, a market order instructs the broker to get the trade done right now. In other words, the broker tries to execute the trade at the best possible price. One thing to keep in mind is that the broker cannot guarantee the execution price and the last-traded price is not necessarily the price at which the order will be filled.
A market order can be attached to both buy or sell orders (“buy at market” or “sell at market”).
With a buy limit order, the buyer sets the order below the current market price because he is looking to buy at the lowest possible price.
The limit price is the maximum price you are willing to pay for a stock, and the broker is instructed to buy below or at a set price once the limit price is reached.
In other words, when you set a buy limit order, you are hoping for a pull-back in the stock before it goes higher. You’re bullish on the stock long term but you want a lower price. By setting the order below the current market price, you are effectively taking advantage of short-term fluctuations and hoping that the stock will go lower before it goes higher.
Of course, the broker cannot guarantee that the specified price will be reached, and the order may go unfilled.
Here’s a perfect example:
Let’s assume that you wish to buy 100 shares of AAPL stock currently trading $97 per share. You believe that at $97 per share, the stock is overvalued but at $85, the stock is a good buy.
You would then place a buy limit order at $85 on 100 shares of AAPL. As long as the stock reaches the limit price, the order becomes a market order and is filled at $85 or below.
Naturally, limit orders are also available to current holders of the stock, which brings us to sell limit orders.
A sell limit order instructs the broker to sell shares at a designated price or higher, effectively placing a limit order above the current market price.
A sell limit order is for those who would like to sell but only at price above the current market price. The limit price is the minimum price you are willing to accept in order to sell your shares and it is a great way to maximize profit-taking.
You may be bearish on the stock, and believe prices will go down. But you believe that market volatility, or changes in price, will push the stock higher, hence offering a better selling point.
Let’s assume that you own 100 shares of APPL stock, currently trading at around $97. You would like to sell the shares and take profits if the stock reaches $125, since you believe $125 to be a fair price.
In order to maximize the profit taking, you would place a sell limit order at $125. Once the APPL stock reaches the limit price and remains there, the sell limit order becomes a market order and your request is filled at $125 or higher.
The third and final basic order type is a stop order. There are two sides.
A buy stop order, just like the limit order, tells the broker to execute the trade at a specified price which is different from current market price.
In this case, the buyer of a stock is placing a stop above the current price and therefore instructing the broker to buy if the stop price is breached.
In other words, the investor is bullish on the stock but wants to buy at a higher price. Now, if this seems counterintuitive, it is. After all, why would any buyer take a higher price over a lower one?
The answer is momentum.
With a buy stop order, an investor is taking advantage of expected upward momentum in the stock and wants to be first in line once the price momentum is confirmed.
By the time other traders are just firing up their brokerage account program, you are already riding the upward trend!
Here is an example:
Let’s assume that you wish to buy 100 shares of APPL stock, currently trading at $97, but believe that the stock will really take off once it reaches $110.
In order to be first in line, you place a buy stop order $110. Once the APPL stock reaches $110, the buy stop order becomes a market order and your request is filled at next best price.
The last basic order type is a sell stop order, also known as stop-loss order.
The sell stop order is intended to protect you from steeper losses as a current holder of a stock and it is placed below the current market price.
Here is how it works…
By placing a sell stop order on your current holdings of a stock, you are instructing your broker to sell a stock below the current price. Once the stock trades at or below the price you have specified, it becomes a market order to sell.
Ultimately, an investor placing a sell stop order is bearish on the stock as he/she believes that it will go down. In order to guard from a possible selloff, the broker is instructed to sell once the price reaches a predetermined level.
A sell stop order is a way to limit losses and collect profits once a stock is showing downward momentum, which could easily turn into large losses.
Here is how it usually plays out:
Let’s assume that you own 100 shares of APPL stock, currently trading at $97, and you believe that if the stock reaches $85, it will trigger a much larger sell-off.
To avoid the possible train wreck, you place a sell stop order at $85. Once the APPL stock reaches the stop price, the sell stop order becomes a market order and your stock is sold at $85 or lower.
Regardless whether you are a buyer or a seller of a stock, both limit and stop orders can add value to your portfolio. Broadly speaking, they allow you to close a position automatically once certain conditions are met.
A limit order is intended to help you get more upside and allows you to buy/sell at a specific price or better.
And think of a stop order as a tool to prevent losses from getting worse if prices start moving against you.