With investing, sometimes how you buy is just as important as what you buy. There are many ways to buy into an investment, some riskier than others and some more expensive. Knowing how the market for buy and sell orders works can help you save money for investments.
You could already have a loss before you buy that stock!
All stocks are listed with a buy and a sell price called the bid and ask price. The bid price is how much another investor is offering to buy the shares while the ask price is that which is being asked for by another investor. The bid price is always lower than the ask price.
For very large companies with a lot of investor interest, the difference between these two prices could be less than a penny. That is due to the fact that there is more trading in the shares and buyers-sellers arrive quickly around a common price. For stocks with fewer buyers and sellers, the difference between the bid and ask could be greater.
For Instance, investors trade an average of 90,000 shares of Cascade Microtech (CSCD) a day and the bid price is often up to ten cents lower than the ask price. This might not seem like a lot but it represents a percentage point difference. Investors buying at the bid price would already be at a loss if they needed to sell at the ask price.
When you want to buy or sell a stock immediately, accepting the bid or ask price, you are making a ‘market’ order. You instruct your broker, or the broker that handles your online account trading to buy or sell the shares at the price demanded on the other side of the trade.
No one order for everyone
Fortunately, you do not have to accept the bid or ask order on a stock. In fact, the bid and the ask are established by investors not placing market orders. Another type of order is called a ‘limit’ order and sets a price at which you are willing to buy or sell. If your order price to buy shares is above the current bid, but below the ask price given by other investors, then your order becomes the new bid price and the bid/ask spread is reduced. If no other investor accepts your price then your order will not be filled.
Whereas a market order is to buy or sell the shares immediately, guaranteeing execution but at an unknown price, a limit order guarantees the price but execution is unknown.
Most market and limit orders can be made as good-til-cancelled or good-til-close, and will remain in the queue until cancelled or until the end of the trading day. Good-til-cancelled orders are a convenient way of automating your investing but can sit in the queue for a long time and then execute even after your opinion has changed on the shares. Make sure you regularly check your good-til-cancelled orders to make sure you still want the stock. Note, some accounts limit the good-til-cancelled order to a certain time period as seen below.
The important difference between a market and a limit order depends on your need for the shares. If you have analysed the company and think it is a good investment regardless of the spread, or if you think news will be released soon that will move the price significantly, then you would place an immediate market order. If you want to buy or sell the shares but only at a certain price or better, then you would enter a limit order.
Another important order type is a stop-loss order. This is an order you place to automatically sell a stock if the price falls below a certain point. The order remains effective until you cancel it or the stock falls below the price. Some investors use stop-loss orders to limit their losses in a stock, automatically selling if the value on the shares drops. Discussed in detail in another post, investors are prone to behavioral traps like holding on to poor investments even after large losses. A stop-loss order can be an effective tool to keep you from sticking with a losing stock. Unfortunately, stop-loss orders can also be triggered if the stock takes a sharp turn downward and the investor could miss out on any rebound.