Saturday, January 30, 2010

Why a Limit Order?

Whether knowingly or not, many retail traders enter market orders to buy stock and that can sometimes be quite dangerous. A market order to buy simply instructs the broker to buy shares at whatever the market price may be at the time the order is filled. Ordinarily, there may be no problem, but every once in a while, there could be. Witness the following scenario.

Once upon a time a small pharmaceutical company issued a new release dealing with the effectiveness and use of its new drug to treat a specific form of cancer. The news media interpreted the release as indicating that the drug was a cure for the cancer and used that as the headline for their stories. A woman who occasionally bought stock for investment decided that shares of the pharmaceutical stock would be a good addition to her portfolio and saw that the stock had been trading around $20 a share and placed an order with her broker to buy 1000 shares "at the market." Of course, on the news of a cure for cancer, the stock price rocketed. By the time her order reached the market and took its place in line of buy orders the stock price was rising. When her order was filled, the price had increased four-fold to $80 a share where her order was filled.

The woman had expected to pay around $20 a share, but because the stock ran so quickly and there were so many orders, it had moved $60 a share before her market order was filled. That, however, is not the end of the story. The news media has misinterpreted the company's press release. In fact, the press release was basically a rehash of some old news about their confidence of success an early phase review by the FDA and a belief that the drug could be helpful in the treatment of (not cure) the specific cancer. The news story was corrected promptly and the stock fell to $18 a share. All this happened within a single day. The investor thought she was going to buy 1000 shares at $20 for an investment of $20,000. Her market order resulted in her buying those 1000 shares at $80,000 for a total investment of $80,000. The stock then dropped to $18 and she was upside down to the tune of $62,000.

I have no idea whether that story is true or not but is the concept that has convinced me to always use limit orders when buying. Of course the dramatic price moves in the story are highly unlikely though certainly not impossible. Nevertheless it would not be so unusual to see sharp price moves before getting filled, particularly if the investor phones his order to a broker and the broker delays even a little in forwarding the order. In any case I opt for better safe than sorry.

In my own trading, I always buy on a limit order. The limit order instructs the broker to buy, but at no more than a specified price per share. So in our example above, had the lady placed a buy limit order to buy 1000 shares at a limit of $21, she simply would not have been filled on the run-up since the price was already higher than her limit of $21.

There are many orders available to traders and knowledge of their purpose and use can be extremely advantageous to traders. In my book, "Trade Your Way to Wealth," for example, I discuss seven different orders and explain their use in detail. Using orders to your advantage can definitely improve one's trading and make it easier as well.

by Bill Kraft, Editor
Copyright 2010, Makin' Hay, Inc.
All Rights Reserved

P.S. Save $50 PER MONTH on my subscription trading newsletters!
SAVE on my Under $10 Stock Trader Service!
SAVE on my Option Trader Service!
SAVE on my Trend Trader Service!

Technorati tags:

To comment on Bill's article click on the "comments" link below.


Anonymous said...

There has been a lot more money lost on limit orders than there has been on mkt orders.....I have personally handled a few million orders on the the equity and options exanges in the past 50 years........Here is the problem, people put a limit order on and the stock takes off and they never buy it......tell them to put a limit 5% or so above where they think it is....$20, buy at /$21 etc...........that works best....those orders should be marked "or better" so the floor broker or otc guys know you price it a little high....or low, whatever.............Dick Casey...

Terry Riggs said...

Thank you for this post. As a new investor, I've never understood the value of the Limit Order, but I sure do now. I've already experienced one situation where I thought I was buying a stock at it's current price and by the time my market order got filled the price was considerably higher and with a small cap stock that can make quite a bit of difference.

On another note, I've had your book "Trade Your Way To Wealth" sitting on my desk for over 2months and I've not read it yet, but this has really encouraged me to pick it up and read it.

Thanks again for this post.

Bill Kraft, said...

Thanks, Dick. I certainly didn't mean to imply that there could be no room in a limit order only that it is foolhardy to place a market order to buy. Better a lost opportunity than a lot of lost cash. Money that was never had in the first place isn't lost. Of course I don't disagree that the limit order might well be placed a bit above an optimum buy point, but if placed too far above, it sets the trader up for a greater loss in the event he is wrong on the direction.
Bill Kraft

Bill Kraft, said...

Thanks for writing, Terry. I wish you well in your trading and investing. Thanks, too, for buying "Trade Your Way to Wealth," I hope you find some useful and valuable information in the book when you find the time to read it.
Bill Kraft

Anonymous said...

Good article, especially adding Dick's comment about leaving some room above the current price. Buffett said ne of his errors has been to fail to pay just a bit more to get into a position that later proved to be very profitable.

This is particularly beneficial in thinly traded stocks, where the spread is larger than normal.

Bill Kraft, said...

Thanks, Anonymous. No doubt leaving some room above the current price to place the limit can be a good idea. The issue, of course, is how much above the current price and that is a personal decision for each trader. The point, as far as I am concerned, is to avoid leaving oneself too exposed. It only takes once to be wiped out as was the case of the lady in the anecdote in this week's article.
Bill Kraft