by Jaclyn McClellan

Placing an order to trade a security is as simple as telling your broker to buy or sell. But the type of order you place impacts transaction costs and the odds of having the order completed or filled. Depending on your broker, your order can be routed to more than 40 different execution venues where trades occur, and prices between those venues can change very quickly. Therefore, it is important to understand the exact instructions you are giving to your broker.

This article reviews the various types of order instructions. Though we use stocks as an example, the information also applies to exchange-traded funds ( ETFs) and closed-end funds (CEFs) .

Investing Long Versus Trading Short

The most basic way to invest in individual securities is to buy, or go long. When you enter into a long position, you purchase shares; you actually own stock in a company. In order to lock in your profits, you sell the stock you own and receive money in return. This works in the same way as profiting off of any asset you ownyou hope to sell it for more than you paid. When you are buying stock, or going long, you are betting that the share price is going to increase. Why would you buy shares of a stock if you thought it would go down in price?

A more risky way to enter the stock market is to sell short. Through your brokerage firm (e.g. Scottrade, TDAmeritrade, etc.), you set up a margin account. A margin account is essentially a credit line backed by the securities and the cash in your account. With a margin account, the broker lends you a portion of the funds at the time of purchase and the security you purchase acts as collateral. To sell short you essentially sell shares of a stock on the open market that you dont own. The stock you are selling short comes from the brokers inventory and it works similar to a loan. Eventually, you must close the short position, or buy to cover. In this step, you use your actual funds to buy the stock in the open market in order to pay back the broker. When you sell short, you are betting that the stock price is going down. You want to pay back less than what you received from the short sale. Theoretically, it doesnt sound difficult, but selling short is risky business with finite upside (a stock can only fall to $0) and the potential for unlimited losses.

Market Orders Versus Limit Orders

Buying and selling stocks works similar to an auction. Buyers set a bid price based on the amount they are willing to pay for a given security. Sellers feel that their investment is worth a specific amount, so they choose the lowest price they are willing to sell it for and that becomes the ask price. However, buyers will pay the ask price and sellers will accept the bid price. The difference between these two prices is the bid-ask spread. When you are trading highly liquid securities, like a popular large-cap stock, the bid-ask spread will tend to be narrow (often one cent). This reflects both the high level of competition among orders and the fact that buyers and sellers generally agree on the current market value of the security. On the other hand, less liquid securities such as small-cap or micro-cap stocks have greater bid-ask spreads. This is because there are fewer competing orders to buy or sell. The lack of investors willing to step in the middle or place market orders gives buyers and sellers more room to disagree about what the prevailing market value is.

Market orders are orders that investors place to buy or sell an investment immediately at what is known as the national best bid and offer, meaning the best available price. If it is a highly liquid stock, the chance that your market order will get filled is essentially guaranteed. If you are a buyer, you are agreeing to pay the best ask price available. Since high-liquidity stocks typically have a high trading volume and buyers and sellers generally agree on a price, the ask price you pay will be relatively close to the bid price. Investors must remember that the last traded price doesnt necessarily equate to the price at which a market order will be filled. Also, you are not guaranteed that the total amount of shares you desire will be purchased at one price. Investors typically use market orders when price is less important, when they want a quick entry or exit point and when they are trading highly liquid securities.

Limit orders, conversely, specify a price to be received or paid for a security. This is done by stating the minimum price at which a stock will be sold (if you are selling a security) and the maximum price at which the stock will be bought (if you are a buyer). Limit orders are used to remove slippage costs and exercise more control over a trade. Slippage refers to the difference between the expected price of a trade, and the price at which the trade actually executes. Investors open themselves up to this type of risk when using market orders.

For example, say you want to purchase 100 shares that cost $20 a share. You submit a market order for this trade. Only 70 shares are available at the best price of $20 a share. The rest of your order (30 shares) will be purchased at the next best ask price, which could be $21 a share. In this example you pay more than you expected for part of your order.

Limit orders eliminate this problem by specifying a price. The trade will be executed at the specific price you set or at a better price. One major caveat with limit orders is that they arent always filled. A limit order can go unfilled if the trade price moves away from your specified price (above your buy limit or below your sell limit). The further away from the bid-ask spread you set your limit price, the less likely it is that your order will be filled. In addition, if the total amount of your order cannot be filled at the specified price, a portion simply goes unordered. For example, if you wanted to buy 100 shares, and only 70 are available at the limit price you set or better, only 70 shares will be filled.

Discussion

Edward Broderick from MA posted 4 months ago:

I would like to know how to place an order to limit losses. This article fades out near the end and does not cover how to set a stop loss with any detail. In general this is a typical lazy article banged out as an add leader with generalities and lacking any examples. It’s presence lowers the overall quality of AAII as a resource.

Vaidy Bala from AB posted 4 months ago:

There is nothing like an example, how it is done. This will greatly help, each case by itself. It looks like from the described, it is always advantageous to the hidden computer that trades or humans that got involved, so when does the investor has some feeling he/she got a fair price to sell or buy? I have been doing this for 11 years, and always felt, I cannot control the buy or sell at my fair price! Computer trading certainly likes market price at any time! That is my experience in the wide open universe of Investing.

Jesse Seegmiller from Virginia posted 4 months ago:

The description of stop orders above is typical in that it states that the order is filled once the stop price has been reached. In practice, brokers execute stop orders based on bids and asks and they don’t seem too anxious to disclose this unless you dig deep into the fine print. What this means is that your stop order can be executed at a disadvantageous price to you and (in the case of thinly traded securities) the price may never even hit your stop, yet you are stopped out (in the case of a protective stop). I learned this the hard way. As a result, what I do now is to place a market order (you could use a limit also) CONTINGENT on the last trade reaching my desired stop price. This effectively duplicates a stop order but is only executed if the security actually trades at the desired price. It also has the added advantage that it keeps my order out of the market until the stop is actually hit.

Jackie McClellan from IL posted 4 months ago:

Mr. Broderick, I’m sorry you are not pleased with the level of detail the article went into. It was meant to be a basic article, as why it’s in the Beginning Investor section. Stop loss orders can be tricky. Are there any questions I can answer in particular?

Mr. Bala, you feel the same as many others! Because there are many many execution venues, different ways that orders can be filled and time delays, investors don’t always get what they consider their fair price. It’s more important that you’re aware of this! A common misconception is that an online account connects the investor directly to the securities market, when in fact that is not the case.

Andrew Coco from Pennsylvania posted 4 months ago:

Jesse Seegmiller’s idea on stop orders sounds like a good one. How do you actually execute the contingency? Do you mean the last trade of the day? I’m new to this. thanks

Pete Stoehr from New York posted 4 months ago: