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
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