Mastering Market & Limit Orders: Enjoying Profitable Trading

When you're ready to engage in stock or fund transactions, you have two primary methods to determine the trading price: market orders and limit orders. The key distinction between a market order and a limit order lies in the immediate execution triggered by market orders, which involve buying or selling a stock at its current market value. On the other hand, limit orders offer the flexibility to postpone transactions until the stock reaches a specified price. While this represents the fundamental dissimilarity between market and limit orders, the suitability of each type depends on the specific trading scenario. Here are the factors you should consider.

Market Orders: Execute the trade immediately

The primary advantage of a market order is its swift execution by your broker. By instructing the broker to secure the best available price at that moment, a market order ensures a prompt transaction. In the case of buying a stock, the market order will be fulfilled at the seller's asking price, while in selling, it will be executed at the buyer's bidding price. Consider opting for a market order when:

• Quick execution is paramount, regardless of the cost. This can usually be during price action trading.
• Trading a highly liquid stock with a narrow bid-ask spread, typically just a penny.
• Trading only a few shares, for example, less than 100.

Drawbacks of Market Orders

The primary limitation of a market order is the inability to specify the trade's price. Nevertheless, this might not be significant in many cases. For large and highly liquid companies that trade in high volumes, the bid-ask spread (the difference between buyers' bid price and sellers' ask price) is usually minimal, often just a penny or two. This slight difference is inconsequential unless you are dealing with an extensive number of shares. However, there is a risk of trading at a significantly different price if the market experiences rapid price movements. While this occurrence is rare, it is plausible. A more likely scenario is doing after hours trading and placing a market order after the stock market closes, and subsequent news affecting the stock's price is announced. Failing to cancel the order before the next day's market opening may result in trading at a vastly different price than intended.

Another potential drawback arises when dealing with illiquid stocks, those with low trading volumes. Initiating a market order in such cases can influence the stock price dramatically, either causing a spike or a drop, as there may not be enough buyers or sellers at that moment to accommodate the order. This leads to a substantially different price compared to moments before when the order influenced the market.

Limit orders: Execute trades when the price aligns

The primary advantage of a limit order lies in the ability to dictate the price, and if the stock attains that specified price, the order is likely to be fulfilled. In some cases, the broker may even execute the order at a more favorable price. Typically, limit orders can be set to execute up to three months after placement, allowing for a more relaxed monitoring approach to secure your desired price. For certain illiquid stocks, the bid-ask spread can sufficiently cover trading costs. For instance, if the spread is 10 cents and you're purchasing 100 shares, a limit order set at the lower bid price could save you $10, an amount adequate to cover commissions at many leading brokers. Consider using a limit order when:

• You wish to stipulate a specific price, potentially different from the current stock value.
• You are trading a stock with low liquidity or a considerable bid-ask spread, typically exceeding 5 cents.
• You are dealing with a substantial number of shares, for example, more than 100.

Drawbacks of Limit Orders

The most significant drawback is the lack of a guarantee that the stock trade will be executed. If the stock never reaches the specified limit price, the trade will not be carried out. Even if the stock reaches the limit, there might be insufficient demand or supply to fulfill the order, a scenario more likely for small, illiquid stocks. Another drawback, particularly with an order capable of executing up to three months in the future, is the potential for significant stock movements. Your trade may be fulfilled at a price substantially different from what could have been obtained under different circumstances.

Consider the scenario where a company like Apple announces a potentially groundbreaking product, causing its stock to surge from $190 to $210, while you have a limit order to sell at $192. Unless you closely monitor the news, you might end up selling at $192 when a higher price was possible. Conversely, if bad news emerges, such as a disappointing earnings report, a limit order to buy may result in purchasing at a much higher price than originally anticipated or perceived as the stock's true value.

Market Orders vs. Limit Orders

Market Order:

• Simple to initiate as it does not require a specified price.
• Typically executed promptly as it matches the current market price.
• Lacks an expiration, commonly resulting in immediate fulfillment.
• Often favored for stable investment scenarios.

Limit Order:

• Requires the investor to stipulate the triggering price for the order.
• Risk of non-execution if the market fails to meet the limit order price.
• Frequently set with an expiration date, after which the order closes if unfilled.
• Preferred for investments characterized by volatility and unpredictability.

Some Special Considerations

The inherent risk associated with limit orders lies in the potential failure to execute if the market price does not align with the specified limits. Additionally, even if the target price is reached, insufficient liquidity in the stock may prevent the order from being filled when its turn comes. There is a possibility of a limit order receiving only a partial fill or no fill at all due to its price restrictions. In the provided example, the investor may only acquire 10 shares of a firm at the limit order price of $5, based on the liquidity of the shares being sought. The remainder of the order may expire if not triggered. Executing limit orders is generally more complex than market orders, leading to the potential for higher brokerage fees. However, for low-volume stocks not listed on major exchanges, where determining the actual price may be challenging, limit orders become an appealing option.

Conclusion

Limit orders can be advantageous in reducing commission costs, especially for volatile stocks with fluctuating bid and ask prices. Adopting a buy-and-hold approach to investments not only minimizes selling transactions and associated commissions but also helps avoid capital gains taxes, which could surpass trading costs. Additionally, staying invested allows compound growth to exert its positive impact over time.