Investing Strategies - Part II

Order Types

It just occurred to me that before I get too deep into a discussion of trading strategies, we probably ought to review the basic types of orders and what they do.

There are really four types of orders that are used: market, limit, stop, and stop-limit.

Market Orders - This is the most basic type of order that there is in the stock market. With a market order, you're basically telling the broker to buy or sell at whatever the current price is. During regular market hours, when everything is functioning normally, these orders usually execute in less than a minute and are fairly safe to use. However, there can be downfalls. If they are placed outside of normal market hours, or during a trading halt, there is a possibility - especially strong in the case of a halt - that the stock will gap, or make a major move one way or the other, when it opens. This gap may be beneficial to you, it may hurt you.

Assuming the market is open, a market order guarantees an execution, but not a price.

Limit Orders - This is probably the most common type of order that I handled as a broker. Essentially, with a limit order, you're telling the market what price you're willing to trade at. If you're buying, your limit order specifies the maximum price you're willing to pay. If you're selling, your order specifies the least you're willing to accept. In either case, your order should be considered "or better" meaning you can pay less to buy or can sell for more (ask your broker if your limit is "or better." If they say no, find another broker.) Limit orders can be both beneficial and problematic. The can benefit you by helping to impose a degree of discipline not available with market orders, but I've also watched people change limit orders - trying to be greedy - and they've "chased" themselves right out of a profitable trade. Once a limit order has been placed, it needs to be changed only after some serious deliberation.

Assuming the market is open, a limit order will guarantee a certain price (or better), but not an execution of the trade.

Stop Orders - This and the stop limit are generally misunderstood by most investors. If you place a stop order, you are specifying a trigger price for a market order. It is most commonly used to provide some protection on the downside. For instance, many traders will place a stop order 10% lower than their purchase price so that if the stock drops by 10% they automatically have the position sold so that they protect as much principal as possible. The key is to remember that a stop order triggers a market order once the stock trades at or through the stop, or trigger, price.

During regular market conditions this may not be a big issue. A sell stop order at $50 may produce a trade at say $49.50, during normal trading. Stop orders overnight can be a big, big risk. On a stock that closes at $55 a stop at $50 may produce a trade at $25 or $10 if the stock gaps down overnight. Remember, a stop triggers a market order once the stock trades at or through the stop price. A gap down from $55 the night before to $10 at the open is trading through and will trigger the market order to sell at the first available price. This usually leads to a very unpleasant conversation with your broker (believe me, I've been on the other end of more than a few).

A stop order will guarantee an execution under certain conditions, but the price is almost certainly going to be different than expected.

Stop Limit Orders - Some brokers will try to convince you that the way to protect yourself from the downside potential of the stop order is to use a stop loss. It is your responsibility to know that there is no such order as a "stop loss." What the broker is usually proposing is a stop limit order. The difference between the stop and the stop limit orders is that the stop limit, instead of triggering a market order, will trigger a limit order to be placed once the stop price is passed. It requires that you establish two prices: the stop or trigger price and a trailing limit. The stop price is the one that you would like to sell at, the limit is the minimum that you're willing to accept.

Let's look at our previous example of the stock closing at $55 and gapping down to $10 overnight. We demonstrated that a stop order at $50 would cause you to sell somewhere around $10. If we have a stop limit with a stop at $50 and a limit at $40, then we would not sell at $10, but we would have a limit order on the books to sell at $40. The upside is that the stop limit has given you more time to evaluate the new situation, but the downside is that the stock may be heading even lower as you reconsider - and you still own it.

Another key thing to remember with stop limit orders is that the bigger the spread between the stop and the limit, the more likely the order is to execute. You should almost never set both prices the same - it makes an execution very unlikely. A stop limit order will guarantee a minimum price, given the proper conditions, but it does not guarantee an execution. And it will not stop a loss. Never let a broker convince you that this order is the perfect form of downside protection. It too has its drawbacks.

Also understand that market and limit orders are available on all stocks, but that stops and stop limits may not be available, may be suspended without notice, and that they are executed on as possible. In extremely volatile market conditions, a stop or stop limit may not execute right away if the broker or floor trader is working on filling market and limit orders.

Order Qualifiers

With most all of these orders there are usually also some order qualifiers that can change the behavior of you order and how it is treated. The full list of qualifiers is fairly lengthy, but we'll just touch on a few of the biggies here.

Day Order - essentially this means that your order is good for the day only. AT 4:00 pm, when the market closes, all day orders are cancelled, or outed, and must be replaced the following day. Every type of order can be a day order.

Good 'Til Cancelled - This order can vary from firm to firm. Some firms will treat a GTC order as a sixty-day order. Others will treat as a thirty-day or maybe a one hundred eighty day order. A few firms make it truly good until cancelled with the order never expiring (every once in a while, I'd talk to someone who had had an order from three to five years earlier execute at another firm. It almost always created massive problems for the client). Ask your firm how long their GTC orders are good for - it's important knowledge to have. GTC orders are available on all types of orders, although they will usually only be accepted on market orders in very unusual circumstances - I personally only ever saw one GTC market order and we did it only because there was virtually no market for the stock.

All or None - This qualifier can be used on larger trades to ensure that the entire block of stocks trades at once. This is usually used on very large quantities of a heavily traded stock to ensure that the trader doesn't end up with ten or fifteen different execution prices. The downfall of the AON restriction is that it takes your order off the order book and it is left to the floor trader to trade it on an as possible basis (which means that it may not happen at all). AON also has a cousin known as Minimum Quantities in which you allow the block to be broken up, but only so far. Same downsides.

Immediate or Cancel and Fill or Kill - These two are very similar to each other. The IOC order basically tells the market to fill what the can immediately or cancel the order. FOK tells the market to fill the entire order or none of it, but do it right now. IOC allows for a partial fill, FOK does not. But on both orders you will know within minutes the outcome of the trade. These are usually only used on large trades when someone is trying to get just a tick or two more than the market is allowing at the time.

There are other qualifiers, but they get used so infrequently as to never been seen. Most people never use an order qualifier beyond a Day Order or GTC because the rest of the qualifiers are targeted at large block traders and usually have restrictions or drawbacks that are very detrimental to the smaller, individual trader.