While this is a very basic topic, it’s crucial to understanding how to make money trading stocks. Since 90% of traders are known losers, it’s obvious that elementary lessons like this are essential nonetheless.
When you enter an order to trade a stock, your broker gives you the option of either buying, selling, selling short or buying to cover using a market order, meaning an order that will be executed at the current market price, or a limit order, which is an order that will be executed only at a price at or better than the price you specify.
In a decade of incredibly active trading, I’ve never used a market order – not even once – preferring instead to use limit orders. Because I’ve never wanted to buy or short sell a stock badly enough to be willing to throw my money into the ring without carefully considering the price I’d pay for that stock.
Don’t get me wrong, I’ve made plenty of bone-headed trades on stocks I had no business trading in the first place. But even then, I never questioned using limit orders.
It comes down to trade management
Forget about wild price swings of several dollars per share, often times the
difference between success and failure on a trade comes down to execution -
meaning how close your actual entry and exit points are to your expected price
Since it costs the same to use a market or limit order (forget about adding
or removing liquidity from a market, that’s a topic for another time),
why even risk your execution getting away from those price points when you use
a market order? After all, that is what you’re risking when you choose
a market order over a limit order and the only people I know who follow that
dangerous route are those whose trading is influenced by their emotions.
If a trade is based on hype or greed, you want to get in or out of a stock
immediately- no ifs, ands, or buts. No matter how perfect a chart setup, a company’s
fundamentals, or breaking news is that you must be wary of getting bad fills
at all cost. Traders must learn to ignore these emotions and focus on getting
the best prices possible in order to give yourself the best chances at profiting.
Now I know what many of you are thinking – you never worry about this because
you’re trading the world’s most actively traded companies, stocks
PowerRating) and Citigroup
PowerRating), where the spread (the difference
in price between the bid and ask) seems permanently fixed at only a penny or
two per share. Well, as improbable as it may seem, sometimes important company,
industry or market news is released the very second you place your order, greatly
influencing a stock price in either direction, and if you use a market order
you may find yourself with a very poor execution.
And while the chances of that happening are slim, it’s even more common
for brokers and market makers to take advantage of your desperation for a trade
execution and fill your order at a slightly worse price; costing you anywhere
from hundreds to thousands or even tens of thousands of dollars depending on
the size of your order.
For me, when I buy or sell short a stock, it isn’t about what I think
the company is truly worth – my opinion is meaningless. What matters is what
others think and what price they’re willing to pay based on that thinking.
By using limit orders, I ensure a satisfactory execution. And, if none or only
some of my order executes – as often times stocks run too hard and too fast,
blowing past my limit price – then it’s probably for the best because
experience has taught me not to chase stocks. Obviously buying to cover into
a short squeeze is an altogether different animal – on those you need to get
out as soon as possible – so I just place my limit far above the current price,
still cautious not to wildly overpay or open myself up to getting taken advantage
of by many of Wall Street’s nefarious players.
And, of course many people don’t trade the most active stocks. Instead
they look for an “edge” or better odds in less popular names. Maybe
they focus on stocks like True Religion Apparel
PowerRating) or Third Wave
PowerRating), since both are currently breaking out to new
52-week highs, and in these cases it’s even more important to use limit
orders because the price spread can range anywhere from $0.03 to $0.40 per share.
No matter how small or large your order is, the difference between a good and
poor execution is no longer just an afterthought: now we’re talking 1,
2 and 3% price swings.
Perhaps most importantly are the two key advantages to using limit orders,
good-till-canceled (GTC) orders, and using the greed/impatience of others to
receive better fill prices.
Since you’ve designated a certain price for your order, you have this
option to keep your order open for 30-90 days, depending on the brokerage firm.
In essence, you’re letting the price come to you so you’re not forced
to limit your timeframe to just one trading day, as those who place market orders
And even better, since many specialists, market makers and other traders have
the mindset of raking in steady profits and commissions, if you display some
added patience and place your limit order aggressively, meaning your order price
is not close to the current market price, the chances of it executing are slim.
But you might just catch one or more of these market players asleep or in a
Stop losses can get taken out and push the price to your limit, or other traders
may wind up needing to use their capital elsewhere, or they may just want the
commission from the trade execution. Either way, you get executed at your aggressively
priced limit. And that execution price is truly ideal because you weren’t
rushed as so many others in this industry are. Achieving ideal entry and exit
points dramatically increases your odds of trading successfully.
So, demand more from yourself whenever you place a trade. Be disciplined, be
cautious, and be wary. Thinking this way will surely cost you a few missed opportunities,
but the money saved over time from minimizing poor executions and emotionally
charged trades will make it well worth your while.
Timothy Sykes writes the blog timothysykes.com,
is a former hedge fund manager, star of the TV show Wall Street Warriors,
and author of the book, An American Hedge Fund: How I Made $2 Million as
a Stock Operator & Created a Hedge Fund.