The following originated from a FINRA alert.
When you place an order to buy or sell securities, you may get more or less than you expect. In some cases, a price quote may not exactly match what you pay for securities. Quotes may be delayed. Trades take time to execute. In highly volatile markets, millions of shares can trade in microseconds, causing price swings.
The type of order you place can help you exercise some control over these factors. Understanding the benefits and risks can help you avoid unintended losses. Let's ensure your trades are executed in a timely manner and at an acceptable price.
Common Order Types
Orders fall into three primary categories:
- Market Order–This is the most common type of investor order. Unless you specify otherwise, brokers typically default to this. Market orders are generally executed immediately because they don't have any restrictions tied to them. The buy order is to obtain the best price available during normal trading hours (9:30 am to 4 pm). There is no guarantee that you'll receive the price you were originally quoted, especially in fast-moving markets. If you place your order before or after normal trading hours, keep in mind that news events or other factors may significantly impact the price of the security when the market opens again.
- Limit Order–This type of order is for investors who know the price they want for a particular securities transaction and want to manage market risk. Limit orders provide a guarantee that buy orders aren't executed above a maximum price, and sell orders aren't executed below a set minimum. Limit orders are often used when obtaining the right price is more important than quick execution. The major risk is that there is no guarantee the order will be executed. The security may simply not reach your limit price within the specified time limit, in which case the order will expire. Or, in a fast-moving market, prices might move right past your limit price before the order can be made. For example, if a stock is trading at $120 and you place a sell limit order at $100, a flurry of market activity could cause it to rapidly move below $100 without the order being executed. Thus, your order may never be filled.
- Stop Order –This type of order is similar to limit orders. Brokers often recommend–and investors use–stop orders as a tool for managing market risk. You can generally use sell-stop orders to limit a loss or protect a profit position in the event the stock's price changes. If you have a short position, you can generally use buy-stop orders to limit losses in the event the stock's price increases. Some investors like stop orders because they don't have to continually monitor price movements to sell (or buy) at a specific price target. Stop orders, once triggered, become market orders. The same risks are immediately inherent with a market order, among other potential risks. In particular, during volatile market conditions, these orders may be executed at prices significantly above or below the "stop price" you set. Like other market orders, it's guaranteed to be executed fully and promptly at the current market price, but you may not like the price you get in a fast-moving market. For example, if the current price of a stock is $80 and you want to protect against a significant decline, then you could enter a sell-stop order at $75. If an execution in the market occurs at $75 or lower, then your stop order is triggered and a market order is entered to sell at the next available market price. In a market where prices are falling quickly, you run the risk that the next available market price could be significantly lower than $75. Stop orders may be triggered on a short-lived, dramatic price change. During periods of volatile market conditions, the price of a stock can move significantly in a short period of time. This triggers a stop order. However, the stock may later resume trading at its prior price level. If your stop order is triggered under these circumstances, you may end up selling at an undesirable price–even though the price of the stock may stabilize during the same trading day. Stop order risks don't stop with you. Sell-stop orders may intensify price declines during times of extreme market volatility. The activation of large numbers of sell-stop orders may add downward price pressure on a security. During a precipitous price decline, this might cause your sell-stop order to be executed well below the stop price. To help manage the risks with stop orders, consider placing a "limit price" on a stop order (see chart below). A stop order with a limit price (called a "stop-limit" order) becomes a limit order when the stock reaches the stop price. By using a stop-limit order instead of a regular stop order, you regain a guarantee on the price you'll receive. However, you also lose certainty that the order will be executed because it will be treated as a limit order. Brokers cannot sell stock for a price lower (or buy for a price higher) than the limit price selected.
Orders With Time Restrictions and Other Conditions
Market, limit and stop orders can include time restrictions and other conditions. The order types available to you will depend on the market where your security is traded and what your financial institution allows. For example, your firm may not allow stop or limit orders on some securities, or could charge higher commissions and other fees for processing them. Before building a buy or sell strategy on certain types of orders, ask your broker what types of orders you can place and what they cost. The tables below outline some of the other order types commonly available to investors.
Stop-Limit: A combination of a stop and limit order–an order to buy or sell at or better than a specified limit price only after the stop price has been reached. You run the risk that your order may not be executed because it will be treated as a limit order once the stop price is reached.
Trailing Stop-Limit: An order in which the stop price trails the current price by either a number of points or a percentage the investor specifies. For example, you could put a trailing stop-limit order to sell your shares if they drop 10 percent from their current price. The benefit is that you wouldn't need to keep resetting the order if the value of the shares rises or falls over time.
Fill-or-Kill: An order that must be immediately executed in full or it will be automatically canceled.
Immediate or Cancel: A market or limit order that trades immediately and automatically cancels any unfilled portion.
All or None (AON): A buy or sell limit order in which the broker is directed to fill the entire amount of the order or none of it. Immediate execution is not required, which makes this different than a fill-or-kill order.
Day: A market or limit order that expires at the end of the trading day it was placed if it isn't executed.
Good Till Canceled (GTC): A limit order that remains in effect until it's executed by the broker or canceled by the customer.
On Open: A market or limit order that must be executed when the market opens or re-opens. Any balance not executed as part of the opening trade is canceled.
On Close: A market or limit order that is either entered in its entirety at the closing price or canceled.
Things to Consider
Keep in mind that all orders are not handled the same way by your financial firm. Ask about your firm's procedures for executing securities transactions and different order types, particularly during volatile market conditions. Market orders typically receive the highest priority, followed by limit orders.
When you use order types with automatic triggers, consider that these transactions may have unintended tax consequences. For example, you could end up paying a higher tax rate on your capital gains. The federal taxes you pay on long-term capital gains–those realized from assets held for more than one year–are generally lower than your individual tax rate. However, if a stop order triggers a sale on an investment you've held for less than a year, the capital gains would be taxed at your nominal federal income tax rate–which could be as high as 39 percent–plus a Net Investment Income Tax of 3.8 percent if your income exceeds thresholds set by the IRS.
No matter what type of order you choose, you cannot completely eliminate market and investment risks. You cannot predict when periods of market volatility will hit, so it's often best to decide what is most important to you based on your investment goals and objectives, whether it be price or making a trade at a specified time. In general, understanding order types can help you prioritize your needs, manage risk, speed execution and provide price improvement. For all your securities transactions, check the trade confirmation you receive from your financial institution to make sure the price, fees and order information are accurate.
This article is intended to provide general information and shouldn't be considered legal, tax or financial advice. It's always a good idea to consult a tax or financial advisor for specific information on how certain laws apply to your situation and about your individual financial situation.