Katherine Gustafson is an author and personal finance expert from Portland, Oregon. She writes about investing for Wealthsimple as well as having written for Forbes, Business Insider, TechCrunch, and LendingTree. Katherine is a past recipient of the Izzy Award for outstanding achievement in independent media. She has a BA from Amherst College and an MA from Boston University.
You’re interested in starting to invest and you have a little saved up in the old piggy bank… You’re ready to become the next Warren Buffett. But how do you actually go about buying or selling a stock? How do you buy something at the right time when the price is constantly shifting? It’ll be hard reaching Buffett-like status if you don’t even know how to execute a trade.
What is a limit order?
A limit order is an order to buy or sell a stock at a particular price or a better price. There are two kinds of limit orders: a buy limit order and a sell limit order. A buy limit order directs the purchase of a stock at a set price or lower, while a sell limit order directs the sale of a stock at a set limit price or higher.
Whether you call your broker to make a trade or push “Enter” on an online brokerage website, your instruction is not executed immediately. Your order is fielded by the broker, who decides which market to use to execute it and when to do so. Don’t assume you’ll get the price that you see on the screen when you tell your broker you want to buy. It may have changed by the time the broker sends your request to the market.
SEC regulations have no requirement that a trade to be executed within a certain time period[KG1] , and it’s impossible to predict how fast a given brokerage firm will act on your instructions. That’s why it’s essential to have a trigger built into your order that only allows the purchase to go through when certain pricing conditions are met.
A broker will only execute on a limit order if the stock’s price hits the stipulated threshold. This system ensures that you won’t pay more than you mean to for a given stock or sell any of your stock at a price lower than you intend.
How does a limit order work?
Stock prices fluctuate often and quickly, and usually only apply to a specific number of shares. An investor who directs a broker to buy at a specific moment may not be able to get the same price a moment later when the broker actually makes the purchase.
A limit order helps you account for the unanticipated changes in the market that are likely to occur during the time between directing the purchase and completion of the transaction. You can maintain some amount of control over what buy and sell prices you end up with, even if you are giving up control over how and when the trading is done.
Brokers can execute trades in a variety of markets, and which one they choose to do business in may affect the pricing of the stock, making having a limit order all that much more important.
If you’re ordering a stock that’s listed on a certain exchange, like the New York Stock Exchange (NYSE), you might assume that your broker will do business in that exchange. And that is quite possible, but it is also possible the broker will turn to some other exchange or to “third
” firm that will give your broker a small fee for routing the trade through them, a practice called “
OTC market maker:
If you’re ordering a stock that trades in an over-the-counter (OTC) market, such as the Nasdaq, your broker might route the order through an OTC market maker in the stock.
Electronic communications network:
Electronic communications networks (ECN) are designed to automatically match buy and sell orders so buyers and sellers looking for the same price can find each other. This type of mechanism is particularly useful for limit orders.
Your broker might buy or sell your order out of their brokerage firm’s inventory, a method called “
Regardless of how your broker handles your order, the broker is required to ensure the best execution possible is undertaken. The broker has a duty to periodically assess all of its orders as a whole to make an informed judgment about which markets, market makers, or ECNs will provide the best terms.
When judging how to make a trade, a broker should be looking at the potential for the price to improve between the time of the order and the time of the execution, the speed at which the order can be executed, and the likelihood that the order will be able to execute at all.
Limit orders that have limits that are too high or too low will not execute, and you’ll end up without a trade. It is more difficult to figure out which price range will work if the market is extremely volatile.
How to make a trade using a limit order
All of this may sound confusing if you had assumed that buying a stock from a broker would be similar to purchasing a pair of shoes from your favorite retailer. When you buy those shoes, you see the price, pay it, and get to wear them home. But when you buy stocks it’s as if the price tag is changing minute my minute. What the price tag says when you try them on may have changed by the time you get to the register.
The fact that it’s such a different way of doing business can make new traders predictably hesitant. But limit orders can help you deal with this strange situation; they aren’t anything to be scared of. In fact, they’re a part of the business designed to allow you to trade most effectively using a broker.
Making a purchase with a limit order is a very straightforward process. It can be accomplished in four simple steps:
Select the stock you want to buy
Choose a limit order
Execute the trade
While these steps look straightforward, they are hardly easy. Knowing which stock to buy and which limit orders to set is an art that a trader can spend an entire lifetime pondering.
How do you learn to figure out which limits to set on your order? In general, you set the limit below ask price if you’re buying or above the bid price if you’re selling. But don’t set it too much above or below because the goal is for the sale to execute quickly before the market changes. With practice you can learn how to set limits effectively.
Market order vs. limit order
A limit order isn’t the only kind of stock order. A market order, for example, is an order to transact on a stock at the best price available. Unlike a limit order, this type of order is meant to be executed right away. The broker will find the best available price at that moment and execute the order at that price. In markets that change quickly, the purchase price can be quite different than what the price was when the buyer or seller put the order in.
A market order is different than a limit order because there’s no bottom or top limit that will constrain the final price for the sale. Limit orders provide a level of protection against being caught in a bad deal due to market fluctuations, while market orders direct the broker to take whatever price the market will bear at a given time.
Stop order vs. limit order
A stop order (also called a stop-loss order) is an order to buy or sell a stock at the time when the price reaches a particular threshold, called the “stop price.” The stop price acts as a trigger that turns a stop order into a market order, at which time the broker proceeds with finding the best available market price and making the order. This means that the stop price might actually end up above or below the executed price, since the price may shift between the time that the stop price is reached and the time that the order is executed.
If you want to prevent your stop order from ending up with a price you didn’t anticipate, use a stop-limit order. In that scenario, the stop price acts as a trigger that turns a stop order into a limit order. The disadvantage of this is that the order may not execute if the ask or bid price doesn’t reach the limit price.
Investing is a complex business, but ultimately it’s all about buying and selling—that is, matching up people who want to buy at a given price with those want to sell at that same price. Limit orders are a way of doing that, and knowing how such things work is the first step toward jumping in.
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[KG1]Source: Under “Trade Execution Isn’t Instantaneous”https://www.sec.gov/reportspubs/investor-publications/investorpubstradexechtm.html