What is a limit order?

Introduction

When buying and sell stocks and ETFs, you should always try to execute your trades using limit orders. This article explains what a limit order is and why they should be used.

When you buy or sell a stock or an ETF through a broker, you can execute trades in a variety of fashions. The two most common methods are:

A market order is where you tell your broker that you will buy or sell the security at whatever the prevailing price on the stock market currently is. A limit order is where you tell your broker that you will only buy or sell the security if you receive the minimum price that you specify at the time you place the order. If you don't receive the minimum price, then your order is never executed. On many broker websites, the default order type is a market order.

With large cap common stocks like Pepsi or Amazon, you don't have to worry too much about how you execute trades because if you issue a "market" order on a stock, odds are your trade will be executed within seconds and it will be executed at the price you are expecting (the current market price). This is the case because the trading volume is high and at any one point in time there are lots of buyers and sellers who have placed orders that are open to buy or sell the stock at values that are close to the current market price. Stated another way, for a highly traded stock like Pepsi or Amazon, the differences, or "spreads", between "bid" and "ask" prices are small. With the stock market, any open order to buy a stock is called a "bid" and any open order to sell a stock is called an "ask".

Small stocks and ETFs with low trading volumes can be trickier to buy and sell because market orders can be risky. If you buy or sell a small stock or ETF with a market order, the trade may be executed at a price you aren't expecting. With lower trading volume comes higher differences between bid and ask prices. And there are a much smaller number of open orders sitting on the stock exchange, waiting to be executed. So, occasionally, if you place a market order to sell an ETF that you think has a market value of $35.40 per share, your order may get executed at a price of $32.00 per share, a much bigger difference than you would normally expect.

This happens because buyers and sellers can issue limit orders at whatever prices they want to enter. So even though an ETF can currently be trading at $35.40 per share, a buyer can enter a limit order at any time in which the buyer offers to pay only $32.00 per share (in other words, the buyer "makes a bid" of $32.00 per share). Normally, this low bid would not get executed, because there normally would be lots of other buyers who have entered bids at higher prices, or who have entered a market order bid. But with a thinly traded stock or ETF, there may not be very many "open orders" or "open bids" sitting on the stock exchange, waiting to be executed. So if you enter a market order to sell a stock or ETF, and the only open bid is a bid at $32.00 per share, that order will be executed at the $32.00 per share price. This is an extreme example that is rare, but it can happen.

Placing Orders Takes A Few More Minutes

It is up to you to decide the price of your limit order. If you set the limit order really closely to what you think is the market price, you limit order may not get executed.

For example, if you are trying to sell a stock that you think has a market price of $35, and you enter a limit order of $35.00, you trade may not get executed if your stock is going down in value. By the time you place your order, the market price may have dropped to $34.99. If there are no open bids at $35.00, your limit order will not get executed.

So how long do you sit there and let your limit order of $35.00 not be executed before you cancel it and enter a new limit order at $34.97? It takes a little practice and trial and error before you get the hang of how picky you can be with limit orders.

Conclusion

Be careful buying and selling small stocks and ETFs with low trading volume. Always execute "limit orders" rather than market orders. You can save yourself hundreds of dollars by just being a little more careful.


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