What Do I Use: Market vs. Limit Trades
Throughout my investing career, I have made hundreds to thousands of trades. During the course of that long time frame, you begin to pick up on a few “do’s and don’ts” in executing various trading strategies. What I found out is that very rarely will I use market orders, but now I’d rather use limit orders on any trades that I undertake.
Why do I prefer limit trades over market trades? Read below to find out.
The Differences: Market vs. Limit Trades
Before we begin, let’s look to define market and limit orders. Both types of orders will allow you to buy stock, it is simply that the mechanics of how you buy that stock are different.
Trading Strategy: The Market Order
The market order is the most basic way that you can buy a stock. When placing this order, you are letting the stock exchange know that you want to buy a certain number of shares at whatever the market price happens to be. Basically, you are ready to buy the stock at whatever the current ask is.
“Ask” Definition: the current price that a seller is willing to accept to sell a security.
Example: you might think that Microsoft is that great a deal so you input into the system that you are going to buy 10 shares of Microsoft as a market order – whatever the current market price is. The price that you happen to buy the stock at will be the current ask price. Keep in mind that this price changes at a moment’s notice depending on the current trading activity associated with the particular security.
The caveat with the market order trade is that you must know what the bid and ask price happens to be. This is because if you elect to buy 10 shares of whatever Microsoft is, whatever platform you are on is going to look at the latest stock price to execute the order. In live markets, this could be large swings, especially if there is updated news.
An Example of a Market Order Trade
Let’s say you want to buy Microsoft at $245/share, which you think happens to be a great price point. You look up the stock and see that the ask price is $245. In placing a market order, you are most likely to get that ask at $245/share.
However, let’s say a large player comes in and buys up a few hundred thousand shares at that exact same time you are reviewing the trade. If the ask goes up to $246 in that time period and you place a market order, by the time you click the button, you will execute that order not at the $245 that you originally saw but rather the $246/share new ask price. You are essentially buying whatever the current ask is.
Market Order: The Pros
- Easiest way to execute a trade on the market.
- You buy your stock instantaneously and can
Market Order: The Cons
- You buy whatever the trade currently is – there can be quick changes which affect pricing.
- You can’t hold a market ordre for a better price.
Trading Strategy: The Limit Order
Now let’s move onto the limit order. A limit order is an order that you put through to buy a stock at a predetermined price. The nice thing about a limit order is that you set the price and you determine the time frame that the limit order will be in effect until. This helps in executing a trading strategy, especially when you know the ideal price point at which you want to buy a security.
Simply put, you determine the price at which you want to buy the stock and let the technology do the rest.
An Example of a Limit Order Trade
When placing a limit order, you dictate the price that you specify to the market what price you are willing to pay for the particular stock. You are setting the “bid”.
“Bid” Definition: the highest price that a buyer is offering to buy a security.
Example: you want to capitalize and buy 20 shares of Apple at $120. However, the market is currently at $125/share. In placing a limit order to buy Apple shares at $120/share, you are essentially setting the new “bid” price at which you are telling the exchange to execute on buying the shares.
The beauty of the limit order trading is that if you input that you want those 20 shares at $120/share, the trading platform will not execute that purchase unless the price is within the limit order criteria.
For many investors, limit order trading is definitely the way to trade when buying a stock. This is because if we’re completing our due diligence properly, we should have an ideal predetermined price point at which we would like to buy a stock.
Limit Order: The Pros
- You buy a stock at the predetermined price point that you want, not simply the market price.
- You can execute a trading strategy out into the future (my current brokerage allows me to do 180 days into the future), without being involved in the markets on a daily basis – great for those with limited time during the day.
Limit Order: The Cons
- Your capital is tied up in trades that are yet to be executed.
- If the market continues to go up, you may be missing out on gains if you are waiting for lower price points.
Previously, I used to not execute limit orders as much as it seems like the trading platforms were not well equipped to handle it from a technological perspective. Keep in mind this was 5-10 years ago, where if you wanted to place a limit order, it was usually only good for a maximum of a few days.
Now, I can place limit orders good for 6 months at a time, which definitely helps me buy up shares at solid price points.
Once I have discovered a stock I want to buy and the price point at which I’d like to purchase that stock, I look at setting the limit order for various time frames – sometimes only a few days, sometimes for 180 days.
A rule of thumb – the longer the limit order is in place for, the more risk you are taking on. This is because many events could happen over the course of six months. In executing an order so far out, you are stating that you are confident in your position at that particular price point. If the market tanks, you could end up buying up the limit order positions, only to watch the stock trend further downwards.
Therefore, I’m cautious in having limit orders too far out. Typically I will set limit orders for a week to one month and if not executed in that time frame, let those orders expire and reanalyze my stock screeners.
The reason why I made the switch to utilizing limit orders is because one time on the market order I had a scenario come up where the market shifted on me very quickly and I ended up buying up a stock at a much higher price point than expected. Story time.
Market vs. Limit Order Trading: Real Life Example
Setting limit orders helps me avoid situations like the one I ran into a few years back.
What happened was over the weekend, I was reviewing which stocks that I wanted to buy with the cash position that I had on hand. One of the cash positions that I needed to deploy was in my Roth IRA. I had roughly $2,000 to invest and decided to put in a few market orders to deploy that capital.
In my review of the Dividend Stocks Watchlist, one of the stocks that I ended up liking was Discover Financial Services ($DFS). I put in a market order to buy $500 worth of shares at whatever the market price was on Monday open. I had done this many times before and it had executed very close to the price point listed in my screener.
What ended up happening over the weekend was that $DFS had some better-than-expected news and jumped a few dollars in the premarket open price.
The Roth IRA ended up still executing my market orders, which included $DFS and other stocks, though the price point at which I ended up buying Discover was more than the amount of stock I had on hand in the account. The result was that I ended up buying the stock on margin. Personally, I was surprised that a Roth IRA account would allow me to buy on margin in the first place. I figured that if I didn’t have enough cash on hand, that I wouldn’t be able to buy the stock.
Now, in a margin situation, you must quickly satisfy the cash collateral – which in this case meant transferring in the amount of cash that the company put up in margin. If I wasn’t able to do this in a day or two, the firm will sell the shares at current market price to satisfy the obligation. Keep in mind that it was only a few hundred dollars extra that I bought on margin, so it wasn’t that big of a deal from a dollar perspective.
Though in this case the issue that I ran into was that I was already fully maxed out on the maximum contribution limit of $6,000 on my Roth IRA account. Because I had to infuse more cash into the account to satisfy the margin call, I was over contributed for the year at $6,600. In the eyes of the IRS, I was over contributed for that tax year and would need to sell off certain positions and pay an early tax on any gains that I had.
Needless to say, I was a frustrated that my retirement account allowed me to buy the stock on margin, as now I had to figure out the taxable consequences of doing so. I went to the IRA website, and found out that I needed to not only sell a certain position in my stock, but then I also needed to calculate how much tax I owed on the sale and file additional forms with the IRS at tax time.
It took a little bit of leg work to figure this out, and even my accountant was a little confused by this transaction, but the end of the day I did get it figured out, I did sell the shares, and ended up reporting the taxable gain plus the 10% early tax penalty on my tax return.
The lesson I learned was to only utilize market orders in certain, quick trading situations. More often than not these days, I find myself placing limit orders that last a week to a month.
This article originally appeared at MoneyByRamey.com.
Category: Stocks
