Basics of Stock Orders - II: The Limit Order

In my last post I covered the advantages and disadvantages of the Market Order. In this post I would like to talk about another very popular stock order: The Limit Order.

A Limit Order is very different when compared to a Market Order. Unlike a Market Order, a Limit Order does not execute instantaneously nor does it choose the best available price on the market for the stock. What is the advantage of a Limit Order, then? The primary advantage of a Limit Order is that you are able to set the price at which you want to purchase the stock.

The primary advantage of a Limit Order is that you can "name your own price" for the stock that you want to purchase. This is particularly helpful for stocks that are very volatile during a trading day.

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Assume that there is a stock, say Apple (AAPL), trading on an uptrend one day. If the stock is appreciating and you expect the stock to continue rising in price, you would want to purchase the stock at the lowest price possible so that your gains can also be greater. However, if the stock is behaving in a volatile manner (swinging up and down rather than appreciating in a smooth uptrend), it would be rather difficult to hone in on a low price as the price may change as soon as you execute the order. This would likely be the case when executing a Market Order, as the Market Order will execute immediately and take the best available price available.

So how can you safeguard your decision to purchase Apple stock while still avoiding the volatility of the stock price? The Limit Order can be the perfect stock order to help you in this situation. When setting a Limit Order, you are essentially "naming the price" at which you want to purchase the stock. For instance, if Apple was trading between $326 and $327 the moment at which you wanted to purchase the stock, and you wanted to purchase it at $325.50, you simply input the "$325.50" as the price on your Limit Order.

A Limit Order will only execute when the stock price has reached your target price. In this example, the pink line represents the target price and the blue line represents the stock price. Notice how the stock price intersects the target price, triggering the Limit Order to execute.

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Does this mean that you will end up purchasing Apple stock at $325? Not exactly. See, the advantage of the Limit Order is its precision in choosing price--the disadvantage on the other hand, is that that price may never be reached. So in this case, if Apple stock kept appreciating from $326 to $327 to $328 and onwards, your Limit Order will never execute because you set the price at $325.50! Thus, you would never get the stock in your hands.

However, if the price of Apple stock dipped slightly and hit $325.50, even for just a brief moment, your Limit Order will execute and you will purchase Apple stock at $325.50. From that point onwards, if Apple stock kept on going higher, you would gain more profits than you would have if you executed a Market Order and ended up purchasing Apple stock at $326 instead of $325.50.

If this is still unclear to you, think about it this way. A Limit Order is like a highlighter which highlights a specific price on an entire sheet of prices. You can only highlight one price. Suppose our sheet has every price from $325.00 to $327.00, including all of the decimals in-between. You highlighted only one price: $325.50. Now suppose that Apple stock is swinging between $326.30 and $326.20. Since the stock price hasn't gone down far enough to hit your highlighted $325.50, your stock order will not execute. However, if the stock price is very volatile and swings down and hits your $325.50, your Limit Order will execute and you will purchase Apple at exactly $325.50.

A drawback to the Limit Order is that the stock price may take some time before it reaches the target price. In fact, the stock price may never reach your target price. Thus, the Limit Order may never execute.

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The beauty of the Limit Order is that you can set up a Limit Order and leave your computer and do other activities, since you have the peace of mind knowing that the Limit Order will only purchase the stock at the price at which you specified (or better), or it will not execute at all.

Because of its precision, the Limit Order is a very popular stock order. Unlike the Market Order, a Limit Order has the ability to target a single price and purchase the stock at that price only. The disadvantage to this is that it may take a long time for the stock to hit that price--or it may never even hit that price! To avoid this, many investors use a realistic Limit Order within two decimal places. Suppose Apple is fluctuating between $325.50 and $325.75. It would be more realistic to set a Limit Order at $325.60 than it would be to set a Limit Order at $325.40, since the stock price is not moving at that low of a range yet.

Used in conjunction with the Market Order, a Limit Order can be one of the most important and essential stock orders for any investor!

Look forward to my upcoming post in this series!

Basics of Stock Orders - I: The Market Order

Well after my final exams, I think it's finally time to start posting regularly again!

Today I would like to supplement my previous series, The Basics of Stocks, with a new series: The Basics of Stock Orders.

When executing any stock trade, there are a variety of different orders from which you can choose. Many of these stock orders are confusing for new investors, so I would like to cover them all in separate posts. Today, we will be covering one of the most popular orders: the Market Order.

With a Market Order, there is no haggling on the price since the Market Order will purchase the stock at the best possible price available on the market--thus
getting the stock into your account as quickly as possible.

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What is a Market Order? Essentially, it is a stock order where you prioritize time over price.

Consider the following scenario: suppose you are planning on purchasing Google stock one day. Suppose that it is 3:50 PM and the stock market is close to closing at 4:00 PM. During this time, there is a lot of volume on the NASDAQ, which consequently also means that the price will fluctuate a lot during this brief time period.

If you are really optimistic on Google stock and expect it to appreciate, then you will want to purchase the stock as cheap as possible. However, remember that during the last 10 minutes of the day the stock price is fluctuating quite a lot, and your trade may not get executed at the exact price which you want. Suppose Google had been trading at around $519-$526 a share during the day, and more around $521 during the end of the day (from 3:30 PM onwards). From 3:30 PM onwards, the stock may fluctuate rapidly between $521 ± $1, which may not seem drastic but is indeed a big difference when you are purchasing many shares at once.

If you expect Google stock to appreciate, you would want to own to own it as soon as possible at the best possible price; considering this situation coupled with the final minutes of trading, a Market Order may be a viable stock order.

Image Source: Yahoo! Finance

Additionally, keep in mind that you expect Google stock to appreciate, and thus you want to own shares today. Because of your optimism on the stock's performance, coupled with the time (3:50 PM, 10 minutes from the NASDAQ closing), there is very little space for you to get the price you want as well as your trade executing (remember, in a stock trade there must be a buyer and a seller).

It is during this time that a Market Order will be most beneficial. The Market Order, unlike a Limit Order (which I will cover in the post following this), prioritizes time over price. This means that the Market Order is indifferent on the price of Google stock on the market--it simply wants to get you the stock in your hands as soon as possible (as you want to own it today because you expect it to appreciate either tomorrow, or sometime soon, and purchasing it tomorrow would ruin any profits). Assuming you have sufficient money in your account, the Market Order will execute at the best possible price available on the market.

A Market Order prioritizes speed over price, making it a good order for investors looking for a fast executing order during final minutes of trading.

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The Market Order is an instantaneous order which does not require specifying a price. So if Google happened to be trading at $521.30 the moment right before you executed the Market Order, you may end up buying Google at $522.10, since that may be the best possible price available that instant in which the order was executed (keep in mind that there are thousands of other orders coming in simultaneously during the last 10 minutes of the market). The downside to this is of course, that you purchased the stock for a higher price than you could have gotten it if you had specified your price and waited for the stock to trade at that price. The upside to this however, is that your order was executed instantaneously and thus you own the stock albeit purchasing it for a higher price.

In summary, the Market Order is an instantaneous stock order which has an upside and a downside:

Upside: A Market Order is instantaneous and will purchase the stock at the best possible price available on the market, thus getting the stock in your hands faster than any other order.

Downside: The Market Order is price indifferent--meaning that you may end up purchasing the stock for a higher price rather than a lower price. This may cut in on your profits, but assuming that owning the stock was your priority, this downside is worth the risk.

The Market Order is a very popular order and is often used when an investor prioritizes owning a stock over the price paid for the stock. Paired with other stock orders, the market order can be a wise order given the right circumstances and conditions.

Look forward to my upcoming post on Limit Orders!