Understanding Stock Orders and How to Use Them
By SmartProInvesting.com Stock Investing Team.
February 22, 2008
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As you are not permitted to trade on the stock exchange unless you are a licensed stockbroker, you will have to rely on your stockbroker to carry out your trades. You consequently have to issue instructions or orders to your broker, for the transactions to execute on your behalf. Generally, you would think of a simple buy or sell order. It could be much more. Your orders can be structured to achieve different objectives: usually as a way of protecting your investment or getting the best value of out of a transaction. Here are some order types you could put to use.
- Market Order
This is a plain order to the broker that requests him to execute your transaction at whatever ruling price holds at the time if the transaction. It places no limitation on that action and simply means he can buy at any price. Such a non-restrictive order is, of course, easier for the broker to handle. It also improves the chance of getting the order executed. It may however allow room to drive a transaction to where it hurts your interest. For instance, if the price of the stock you want is powering up and the stockbroker has the stock in place, what stops delaying the transaction to offload to you at a higher price?
Here’s an example of a market order: you take a decision to buy 5,000 units of Neimeth Pharmaceutical currently at N10.72. A market order simply tells your broker to buy 5,000 units of the stock for you. That order could be executed at N10.72 or, more likely, a figure higher than that, since the stock has been on a steady upward climb. That will depend on when the broker is able to buy it out. He is expected to act now, but may not succeed in buying immediately, meaning that the price could shift in the process. What will happen is that you provide enough funds to buy it or your broker could buy for the volume your fund covers, assuming the price is up when he carries it out. If the stock is not readily sourced, your broker will continue to bid to buy it, until he gets your order executed. The reverse happens when you want to sell. The stockbroker sells at what market price he is able to execute your sell instruction.
- Limit order
A limit order introduces some restriction as to price, in your order. With a limit order, you request your stockbroker to buy a stock at a stated price or better. In effect, you are not giving an open-ended mandate that leaves you with the possibility of getting the stock at a price you are not happy with. If the broker wants to buy it and earn the commission, he has to strive to get it done before the price is out of the limit you specified. As is obvious, that is more protective than a market order as to the price at which your transaction is done.
Take this example. You decide to buy 3,000 units of Dangote Flour Mills, but are not happy to pay more than N25.00 for it. So, you instruct your stockbroker to buy the stock for you “at N25 or less”. That’s a limit order. What it says is that he has to push to execute the transaction quickly or possibly miss the commission since he won’t buy if the price crosses your limit. That could prove an incentive for timely action, but more importantly, it aims to do a transaction within a price range you consider acceptable.
A limit order may state a price that is below the current price of the stock. Here, the order to the broker is to buy the stock if the price ever comes below the specified level. It
says, “buy this stock anytime the price is below ‘x’ amount without waiting for my further instruction”. That presupposes that you have a funded account. For a fast-moving stock, that may be a timely instrument that helps the broker execute promptly and save you money.
- Stop Loss Order
A clinical approach to dealing with losses is to use a stop loss order. Usually, this is a standing order you place with your stockbroker. If you can’t arrange that with your broker, it means you have to set the trigger to yourself and if activated, you can then place a sell order.
But what is a stop loss order? It is an order placed with your stockbroker to sell a specific stock once the price hits a particular level. A stop loss order is typically set at a percentage below cost or a specified figure. Take this example. You buy 1,000 units of Dangote Flour Mills at N20.00 per unit and decide you can’t risk more than a 15% loss on the investment. So, you set a stop loss limit of 15% (or you may also say N3.00) on the stock. What this says to the broker (or yourself) is that if the price ever falls to N19.00, it should trigger a sale. In effect, the stop loss order becomes a market order (or still, a stop limit order) to sell. Recognise that the stock may not be sold at exactly N19.00 as much will depend on demand, but the process to sell is triggered at that level. If sold at somewhere less, your actual loss will be more than 15%, except that it possibly would be much worse without an automated trigger.
The benefit here is that the risk of oversight is eliminated. Your stock can substantially lose value before you realize it, without an automated trigger, a kind of circuit-breaker. Also, the sentiment that could dog your decision process and bring confusion or indecision is eliminated. Stock is put up for sale if the set condition is met.
Like with everything, there is a downside. The price fall could be short-lived and stock easily bounces back. You still enjoyed protection but possibly wouldn't have sold, if you were sure it wouldn’t continue. However, when protecting your capital is important to you as a first priority, it is a price worth paying. One way to reduce that possibility is by setting at a reasonable margin of price fall where you can’t risk much further fall.
There are a few order variants which we will look at some other time. The ones highlighted here, however, can help you get a better grip on your transactions. One important way to ensure they have meaning is by documenting instructions you give for your stock orders.
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