A friend of mine finally caught the bug to start investing in stocks. I suggested that he open an account with Questrade, a discount brokerage firm, as their commissions per trade are as low as $5. The trading platform is mediocre, nothing compared to the one provided by Interactive Brokers, but sufficient and easy to use for a newbie.
He called me a few days ago with a question regarding the difference between Limit Orders and Stop Orders. If any of you are not familiar with these order types and are content placing Market Day Orders the following information may be of some use to you:
Market Orders:
A market order is an order to buy or sell a specified number of shares at the best available
market price. Market orders are usually placed as Day orders since for most liquid stocks the order will get filled almost instantaneously. Simply put, the market price is the current price that a stock is trading at and can be viewed using any trading system or public sites such as Yahoo Finance. More importantly, it is the price of the last trade i.e., the price of the highest bid and lowest ask that were matched. What this means is that if you are looking at the price of a stock that is rapidly rising and you place a buy order, chances are that your order will be filled at a price higher than the price at the time your order was placed.
Limit Orders:
A limit order allows you to buy or sell shares at a particular price or better. For example, if you wanted to buy 100 shares of company ABC that is trading at $10.50 but you wanted to pay no more than $10 then you would place a Limit order and specify a price of $10. This will ensure that your order is only filled when the stock is trading at $10 or under. This type of order is called a Limit Buy order.
A caveat here is that you run the risk of being a bystander as a stock continues its climb upwards. I've been greedy a few times and placed limit orders slightly under the last trade price only to miss the boat. A strategy more commonly used by some traders is to first pick a company that they really like. Perform some technical analysis in it to locate a support point and place a Good Till Canceled Limit Buy order around that price. I'll talk more about this and other strategies in a later post.
Stop Orders:
Stop orders are used when you already have a position in a particular security. The most commonly used one is the Stop Loss order. A stop loss order is an order to sell a security when the stock price declines to or falls below a certain amount, thus limiting the loss or protecting a paper profit. Stop loss orders become market orders when the stop price is reached.
Let's say you already owned 100 shares of company ABC that you bought at $10.50. Your analysis has shown that if the price ever dropped below $8 then all bets are off. Short of sitting in front of the computer watching the stock price like a hawk, your best friend is the Stop Loss order. You would place a Sell order marked as Stop Loss for the 100 shares at $8. If during the trading period, the stock price was ever to reach $8 or lower, your shares will be sold at the market price thus saving you from incurring further losses. Figuring out the Stop Loss price is an art and you have to be really savvy or you might become another victim of market fluctuations.