In this section I want to provide an outline of each type of order you can use to execute your trades. Each order type has different uses and different advantages and disadvantages.
There are three basic types of orders for entering and exiting your trades:
- Market Orders
- Limit Orders
- Stop Orders
Each of these are explained below with links to each of the special variants of each for further explanation.
A market order is simply an order that will be filled at the prevailing price in the market at the time the trade is placed. Market orders are generally always filled, however, you may not get the price that you really want because the order is filled at whatever the market is currently offering.
Let’s assume you are buying ABC stock. The current bid is $10.25 and the ask is $10.30. This means at this moment buyers are offering $10.25 per share and sellers are asking for $10.30 per share. If you place a market order to buy then you will be filled at $10.30 (assuming there is enough volume on offer at that price). If you place a market order to sell then you will be filled at $10.25 (again assuming there is enough volume on offer at that level).
If you have a highly liquid market and you are trading relatively small quantities then market orders can generally give you a reasonable price under normal circumstances, however, there are many cases where a market order will not give you a good price such as:
- Your trade size is large
- The market is moving quickly
- The instrument you are trading is illiquid without much volume on offer
- There is a delay in placing your order into the market
A market order will execute at the prevailing market price when the order hits the market. This means that if any of the above situations occurs the market order could be filled at a price quite different from what you expect.
The primary advantage of a market order is that it will generally always be filled…it is really just the price that is in question
Most markets and trading platforms will accept market orders. You will find that market orders generate the highest slippage…but they are executed more frequently than limit or stop orders.
There are three other types of market orders that are useful to understand:
Limit orders are an order type that specifies the price you are willing to pay up to (if you are buying) or sell down to (if you are selling).
Limit orders are used when you want to be sure you know exactly what the worst price you will pay is assuming your trade gets executed.
For example, let’s assume you are buying ABC stock. The current bid is $10.25 and the ask is $10.30. You know that the stock can be illiquid and you realize that the current spread is a little wider than normal, so you don’t want to incur too much slippage.
Instead of placing a market order (which would be filled at $10.30), you decide to place a buy limit order at $10.24. This order sits in the market and will only be executed if the offer (the lowest price the sellers are willing to sell at) drops to $10.24. When this happens you should be executed at this price. In this case you have specified that $10.24 is the highest price you are willing to pay to buy the stock.
If the market never comes back to the price of your
limit order, then your order will not be executed
Similarly when using a limit order to sell, you set the minimum price at which you are willing to sell the stock, and if the bid price reaches that level then your order should be executed (provided the bid price stays at that level long enough and there is sufficient volume buying interest at that price).
Limit orders generate no slippage because you have specified that you are only willing to trade at a certain price…however, your trade may not be executed if the price never hits the level you specify.
Stop orders are orders that are placed above the current market price for buyers or below the current market price for sellers. These orders are only triggered if the price hits the level specified. Once the level specified is reached, the order is converted to a market order and placed into the market.
For example, let’s assume you are buying ABC stock. The current bid is $10.25 and the ask is $10.30. You are not sure if it is going to continue on its upward trend, so you place a buy stop order at $10.35. This order remains dormant until the market price rises to $10.35, at which time it is converted to a market order and placed into the market.
Now let’s say you want to sell ABC stock, which is again trading at $10.25/$10.30, but you only want to sell it if the stock continues to fall to $10.20. So you place a sell stop order at $10.20 which will be dormant until the market drops to $10.20 at which time it will be converted to a market order and placed into the market.
Once a stop order is triggered and placed into the market, it has all of the qualities of a normal market order discussed above. The only difference is that you have specified a price at which you want your order to be placed into the market.
There are several types of stop orders that are useful to understand:
Conclusion On Order Types:
It is important to understand exactly how each order type is going to be executed in the market before you place your order. In fact, this should come right back to the trading system development process in which you need to select which order types you will be using.
As a very simple example of how order types should be considered in trading system development, let’s say you are working a full time job and you are not able to look at the markets during the trading day. If this is the case, you may not be able to place market orders to execute your trades…you may have to select from the various limit order or stop order types.
Not every order type is available on every market or from every broker. Once you understand what order types you want to use and what markets you want to trade, you will need to find a broker who can meet your needs, or else adjust your trading system accordingly.
The trading order types that you will be using should be documented in your trading plan so that you can hold yourself accountable to executing in a consistent and disciplined manner.
It is always critically important that your trading system fits you and meets your objectives. Determining which order types you should be using is an important component of ensuring your system fits you (as illustrated by the example above). I recommend you consider Van Tharp’s home study course ‘How to develop a winning trading system that fits you’.
This course will help you design a trading system that matches your beliefs, objectives and lifestyle preferences / flexibility. If you do not match your system to these things your chance of success is probably pretty low, and you will also be in for a very stressful ride in the markets. On the other hand, if you do match your trading system to your beliefs, objectives and lifestyle preferences you have a greater chance of following the system, generating profits and avoiding stress in your trading.