Buy low and sell high. That’s what every investor wants to do. If you sell a stock for more than you bought it for, you make a profit. That’s the goal in investing.
So prices are important to investors. But how important are they? When you buy or sell a stock, is it important to set a specific price to buy or sell at? Or is it ok to let the market choose the price for you? The short answer is: It depends.
Let’s start out by explaining the three different ways you can submit an order to a stock market: market orders, limit orders and stop orders.
‘Market orders’ are orders for a specific number of shares of a specific stock. But in market orders, no price is set. The investor submitting the order allows the market to dictate the price – meaning you buy or sell at whatever the price is at that moment in time.
The advantage of market orders is that your order is almost always filled. It allows you to get into or out of a stock quickly.
But the problem with market orders is that in order for your order to be filled quickly, you have to give up on a specific price. On an average day when there are lots of buyers and sellers, this generally isn’t too much of a problem.
But market orders can run into trouble when dealing with shares of small companies or when trading turns volatile (swings strongly up or down). In these situations there is often an imbalance of buyers and sellers. This means that the market may have some trouble connecting a buyer with a seller. Even though market orders look for the “best price available”, the best price is one that has to move so that the order can get filled. In these situations, you may be disappointed to find that the market’s “best price” may not meet your expectation of “best price.”
But if you’re looking to invest for the long term, giving a bit on price is not much of a sacrifice for the confidence of being able to get in and out when you want. Just be careful with small companies, and on days that the marking is fluctuating.
Another type of order is called a ‘limit order’. Like a market order, limit orders have a specific number of shares of a specific security. But unlike a market order, these orders include a specific price. When you sell shares, you want to get the highest price possible. So a limit order to sell shares sets a price BELOW which you will NOT sell your shares. If you submit a limit order to buy, you want the lowest price possible, so your order sets price ABOVE which you will NOT buy your shares.
The odds of your order filling depend entirely on how far your price is away from the current market price. If there is a big spread, it is unlikely that your order will fill. But often the market will move to your price and your order will fill.
Limit orders are often used as a way to plan your portfolio far into the future. If you like a company and want to add it to your portfolio, but the price is too high, you can set a buy order at a low limit price and wait for the market price to come down. If the price of that company’s shares slide to that price, your order will fill, giving you the bargain you were looking for.
This strategy also works when you sell stocks. If you own shares of a company and want to maximize your return, you can set a limit order to sell at a price above where the market it currently trading. If the price of those shares hit your target, your shares will sell, thus unlocking the profit you were looking for.
These limit order strategies are a great way to build discipline into your buy and sell decisions. Just make sure you keep track of your limit orders and change them if market conditions change.
Also note that in order to close your position, there has to be an investor willing to meet your price and size conditions. It sometimes happens that even if the market hits your price, your order cannot be filled because a matching buyer or seller cannot be found at the price and the number of shares you require. Limit orders are rigid and must trade at the specified price. So it sometimes happens that the market will touch the price you want, but your order will remain unfilled
The obvious weakness of limit orders is that there is no guarantee that they will fill at all. If the market cannot meet your price, your order will not go through. By sticking to a specific price, investors take the risk of missing out completely on getting in or out of a stock.
The final type of order is a ‘stop order’ (also known as a ‘stop-loss order’). It’s something of a hybrid of a market order and a limit order. It behaves like a limit order, in that it carries a set price. But it behaves like a market order in that once the market hits the target price, the order is triggered as a market order. So it allows you to have price assurance with the added benefit of almost certain completion.
Stop orders are frequently used as way to prevent excessive loss. An investor can set a stop-loss order for a security that they own, to have it triggered when a stock drops below a set level. For example, if you bought Apple at $95, you can set a stop-loss order at $90 so that you limit your maximum loss to $5 per share.
Another other version of a stop-loss order is a ‘trailing-stop order’. In this order, you can set a loss limit, but instead of tying it to your purchase price, the limit is tied to the actual trading price of the stock. So if you buy Apple at $95 and set a $5 trailing stop, the stop would initially be set at $90. But if Apple’s price moves up to $100, then training strop would move up too, and would now be set at $95.
Trailing stops are a great way to have flexibility in your stop losses. It is also a way of managing risk in your portfolio without you having to pay constant attention to it. If you travel or are busy, stop orders and stop-losses are a great way of preventing unexpected loss in your portfolio.
The only warning about limits and stop losses is that they can sometimes be triggered inadvertently. Market fluctuations can sometimes throw stocks into sudden, quick drops. In May 2010, the New York Stock Exchange saw a sudden and unexpected 1,000 point drop, hammering many notable stocks in its wake. Within 15 minutes, the exchange had recovered to previous levels, but that drop would have triggered thousands of stop orders, wiping out billions of dollars of investor savings.
These events are very rare, but show the vulnerability of stops. They can allow you to plan into the future, but even with all of the best laid plans… things can still go wrong.
So what’s the conclusion? Should you be setting a price for your buy and sell orders?
First of all, there is nothing wrong with using market orders for most of your transactions. If you buy and hold for the long term, this strategy will work well. The impact of not getting a perfect price is not tremendous over the long term.
But, if you build a targeted plan for buying or selling stocks, then limit orders are a terrific idea. You can then get stocks when they go on sale and lock in profits when your stocks rise.
And finally, if you can’t pay full attention to your portfolio, or you feel you need some protection against loss, then stop orders may be right for you too. Just make sure you use them carefully.