In This Chapter

Market orders are the tools that active traders use to help secure a profit or protect against a large loss. If you don’t know how to use these tools, you will have little chance of succeeding in active trading.

The two basic orders are, of course, buy and sell, but don’t think that’s where it ends. In fact, if you are new to trading, this is the place where you will see profits diminish and losses increase. The system of orders has not changed much in many years. Traders use many of the same orders their fathers used and the system works well for those who know how to use it.

Knowledgeable traders need precise entry and exit points to ensure profits and cut losses. As noted in earlier chapters, short-term traders make a living hitting small profits multiple times each trading day. To be successful, short-term traders need the precision of special market orders to get them in and out of a position at the price that’s right. Special trading orders aren’t foolproof, as we’ll see in a moment. Market conditions can conspire against a trader to make it difficult to enter or exit a trade at the precise moment and price she wants.

A market order to buy or sell goes to the top of all pending orders and is executed immediately, regardless of price. If you look a Nasdaq Level II pending orders for a stock during the trading day, you will see a number of orders to buy or sell arranged by price. The best ask price, which would be the highest price, is on the top of that column, while the lowest price, the bid price, is on top of that column. As orders come in, they are filled off these best prices. If an order with a better bid price comes in, it goes to the top of the list.

When a market order is received, it gets the highest or lowest price available. In other words, when you submit a market order to buy a stock, you pay the highest price on the market. If you submit a market sell order, you receive the lowest price on the market. Active traders love people, usually novices, or investors unconcerned about nickels and dimes of the price, who use market orders because they represent easy money.

In most cases, active traders avoid using market orders. Not only will you pay top dollar or get bottom price, but you will pay for a little mischief known as slippage. Slippage occurs when a market maker changes the spread to his advantage on market orders. This is a questionable practice, but beware that you may pay a small premium, which is the market maker’s extra profit, if you use market orders to buy and sell securities.

Is there ever a time when a market buy or sell order is okay? Absolutely. If you are caught in a short position and the market is moving against you, it’s time to bail out in a hurry and not worry about slippage. We’ll discuss short selling in detail later and you’ll see there are situations where escape from a position is more important than anything else.

There are other times when experienced active traders use market orders. Momentum traders may use market orders if they sense a fast-moving stock is taking off and they want to ensure a position. Using some of the limit orders discussed below may mean they would miss the move because the stock is climbing away from their price. When we look at momentum trading in Chapter 18, you’ll see the risky and fast-moving trades these active investors make to catch a stock on the move.

For most active traders, the use of a market order is a judgment call. Is it more important to buy the stock (or sell it) or to get in (or out) at a specific price? In most cases, active traders are very concerned with controlling entry and exit prices; however, as noted above, there will be times when buying or selling the stock is more important than price. The danger for active traders is convincing themselves that they have to own a “hot” stock at any cost and using market orders to grab shares. This was a tremendous problem during the dot.com boom when amateur traders assumed the price was always going up so it didn’t matter what they paid. The tech crash of 2000 was a rude awakening to many.

Placing a market order is saying you want to buy the stock regardless of price. If you were giving a verbal order to your stockbroker, it might go like this:

Assuming you are using an online broker or an advanced trading platform, the order is entered on the order screen. Most active traders have default trade parameters set up so they can quickly execute their typical trades. If a market order is not a typical order, some adjustment is made.

If the stock is actively traded, a market order will be filled almost instantly unless there is an unusually high volume in this particular stock. However, in a fast-moving market even almost instantly isn’t fast enough to ensure that the price you saw when you placed your order is the exact price you receive. If your trade isn’t filled at the price you thought it would be, you are the victim of slippage.

Slippage occurs when the price of an executed trade is different from the order you submitted. For example, you enter a market order to buy 100 shares of XYZ at $33.25 per share. When you get your confirmation of the trade, you notice you paid $33.30 per share. What happened? You are the victim of slippage.

Slippage comes in two forms. The naturally occurring slippage is when the stock is moving rapidly and even Level II quotes and order entry are not quite synched with executions. The ask price of the stock may have gone up, thanks to other orders arriving a fraction of a second before yours.

The other form of slippage is not so natural and happens when a market maker takes advantage of a market order in a slow-moving market and drops or raises his price to put a little extra commission in his pocket. (The difference between the bid and ask prices—the spread—is the market maker’s commission.)

A few cents per share doesn’t seem like a big deal, but if you are an active trader, especially a short-term trader, these few cents can add up to real money in a hurry. This is money out of your pocket. If you aren’t careful how you use orders when buying and selling stocks, slippage will slowly put you out of business.

Active traders protect against slippage by specifying a price at which they will buy and sell. With these types of orders, it makes no difference whether the stock’s price moves before the order hits the market. It also prevents market makers from taking advantage of market orders and inching the price up or down for a little extra profit at your expense.

The limit order limits the price you are willing to pay or the price at which you are willing to sell. You are telling the market you will sell (or buy) at this price. Unlike the market order, the limit order may or may not go to the top of the list. If the price on your limit order is the best ask or bid price, it will go to the top and may be filled very quickly. If it is not, it will slot in among the other orders that are away from the market. As other orders are filled, your order may work its way to the top. On the other hand, better orders may come in and push your order down the list.

The important point for active traders is that your order will only be filled at your price or better. Active traders learn quickly that the potential for profits is greater at certain price points, but not less at others. If they can capture a security at the price they want, it is usually because the stock is moving in a direction that the trader believes offers a quick profit. Many active traders use limit orders or some variation (see below) almost exclusively.

A limit order, whether given to a stockbroker or entered into your advanced trading platform, has the same five components:

For example, if you wanted to buy 100 shares of XYZ using a limit order, here’s how you would express it:

This order tells the market you will buy 100 shares of XYZ, but under no circumstances will you pay more than $33.45 per share.

An important point to remember about limit orders is they are not absolute orders. Your limit order to buy XYZ at $33.45 per share can’t be filled above that price, but it can be filled below that price. If the stock’s price drops past your limit before it is filled you could pay less than $33.45 per share. It works the same way on the limit sell order. If you enter a limit sell order for $33.45, it can’t be filled for less than that amount. However, if the stock rises above that price before your order is filled, you could receive more than your limit price.

The simple limit order could be a problem for traders or investors not paying attention to the market. For example, you enter a sell limit order on a stock that is a few dollars per share over the market price and a buy limit order a few dollars per share under the market. This way you will make a profit if the stock rises and add to your holdings if the stock dips. Not a particularly inspired trading strategy, but one that seems to have your bases covered. You take off for a long weekend and return on Monday to find your sell limit order has been filled. You are happy with your small profit until you notice that the company is a merger target and the stock has jumped $15 per share. Unfortunately, your limit sell order got you out of the stock with a $2 per share profit, leaving $13 per share on the table. You can imagine the reverse of this scenario if the stock dropped like a rock and your buy limit order filled as the stock was in a free fall.

The point is simple limit orders are excellent tools, but they are not foolproof. Active traders can use more sophisticated orders when the need arises.

Using limit orders has a price, at least with some brokers and direct access providers. In many cases, market orders carry a much lower commission than limit orders. Added commissions mean extra profits will be needed to cover that overhead. Now that stocks are traded in decimals, the bid-ask spread on actively traded stocks may be just a penny. For an actively traded stock, you may not see any slippage for a market order. Active traders may find that the lower commissions for market orders (compared to commissions charged for limit orders) make up for any penny slippage that may occur. Experience will teach you when a market order placed in a fast-moving market may make more sense than a higher cost limit order. Be sure you understand any extra charges for limit orders or the other orders, which follow to avoid nasty surprises on your account statement.

A hybrid order that many active traders use extensively is a stop order—also known as a stop loss order. The stop loss order combines attributes of market and limit orders. It can be used to sell or buy, but is most often used to sell (thus the stop loss name).

Limit orders are executed when the price is hit and market orders are executed as soon as they are entered into the market. The comparison is a limit order guarantees price, but not a fill and a market order guarantees a fill, but not a price. The stop loss order does nothing until the stock hits the stop loss price and then it becomes a market order and is filled at the best available price.

Active traders use stop loss orders to protect a position. Here’s how they would enter a stop loss order:

This tells the market that when the price of XYZ drops to $33.45, this becomes a market order to sell 100 shares at the best available price. Unless the stock is in a free fall, the active trader should get close to $33.45 on the order fill. Frequently, traders will use this order to protect a profit in a stock. Rather than constantly watch the price, the trader can set a stop loss order and be confident she will get a good fill if the stock retreats to the point she designates.

Better than a simple stop loss order is the trailing stop. Swing and position traders can use trailing stops to protect profits of rising stocks without having to watch the securities on a daily basis. Most advanced trading platforms can set up trailing stop orders.

A trailing stop order is like a stop loss order except it moves with a stock that is increasing in price. The stop loss order follows the stock price up by a specified amount or percentage of the price. The idea is to let a rising stock keep going and accommodate typical fluctuations in price while protecting most of your profit.

For example, you could set a trailing stop order on a stock that would be triggered if the stock dipped by 10 percent. If you put such a trailing stop on XYZ and the price climbed to $40 per share, the stop loss order would not be triggered unless the price dropped to $36 per share ($40 × 10% = $4; $40-$4 = $36). If the stock rose to $42 per share, the stop loss would not be triggered until the stock price dropped to $37.80 (90% of $42). As long as the price does not back up 10 percent, nothing happens. If the price does back up to the trigger, the stop loss becomes a market order and is filled at the best available price.

Some traders use stop orders on the buy side. They may be interested in a stock, but only if it makes a move up. They may believe the stock is due for an upward swing, but rather than buy and hold for something that may happen in the future, they will enter a buy stop order.

Like the sell stop order, the buy stop order doesn’t do anything until the trigger price is hit. For example, if a trader feels a stock will move upward she would enter a buy stop order above the current market price by some amount—usually not a lot, but enough to confirm an upward trend and not just a typical intraday price fluctuation. If the stock hits the trigger price, the stop buy order becomes a market order and is filled at the best available price.

Traders use buy stop orders to protect themselves against a short position gone bad. Selling short can leave a trader in a dangerous position if the stock begins rising sharply. A buy stop order will close the trader’s short position out on a rising stock. More about short selling below.

Stop orders convert to market orders when the trigger price is hit. A variation of stop orders converts to a limit order when the trigger price is hit. This order gives the trader more price control than a market order, but risks not being filled because of the limit price. Here’s how a stop limit order might be entered:

This order becomes active when the price of XYZ hits $33.45, but says the trader will buy 100 shares at $33.39. The trader is hoping XYZ is on the way to a big move and is counting on grabbing shares when the stock dips slightly. There is a risk the stock will keep going up and your order won’t be filled. Active traders who watch the market closely probably won’t find much benefit in these orders.

Most advanced platforms allow you to set up a default margin trade. You can choose or change the percent (up to 50 percent) of the amount you want to borrow. Margin trades are instantly checked against your equity to confirm you have enough for the trade. Active traders who make multiple trades during a day will keep their account management window open on the desktop of their computer. Real time updates show traders exactly where they are with their margin and cash positions. They can also see what margin is available to them. If an attractive opportunity presents itself, but equity is low, the trader may choose to liquidate a position that has less appeal to increase equity in the account.

Active traders want to keep an eye on the minimum maintenance requirement to avoid a margin call, but also to avoid having the broker freeze the account to any further margin trading. Fortunately, advanced trading platforms will keep track of this requirement based on the broker’s requirements and regulations. This is helpful to traders in a fast-moving market who don’t have to do the calculations manually.

Even though most active traders will use systems that calculate the minimum maintenance requirement for them, it is helpful to know how the calculation works. If you want to buy 100 shares at $50 per share and use 50 percent margin, you will put in $2,500 cash and borrow $2,500 from your broker, which requires a 35 percent minimum maintenance margin. Of the $5,000 account value, $2,500 is equity. If the stock drops to $40 per share, the account is now worth $4,000. However, you still owe your broker $2,500, so the equity is only $1,500. That leaves your equity at 37.5 percent ($1,500 ÷ $2,500 = 0.375). You are still within the minimum maintenance requirement, but just barely.

If the stock’s price drops to $36 per share, the account is now worth $3,600. When you deduct the debt to your broker of $2,500, you are left with $1,100 in equity or 30.5 percent, which is below the minimum maintenance requirement. You will get a margin call to bring up the equity in your account to the minimum maintenance amount. Some brokers may not give you the courtesy of a call, but will liquidate all or part of your holdings to pay themselves back.

If your brokerage system does not automatically calculate and update minimum maintenance margin for you, be very careful how you use margin. Unlike a cash investment in securities, it is possible to lose more than you have invested with a margin account. This is an important point and should be carefully considered before you jump into heavy reliance on margin to support your trading needs.

Using margin in your trading is a way to extend your purchasing power. When trading tiny profits, as short-term traders do, you’ll need to trade big lots to earn enough on each trade to make it profitable (after commissions). Margin makes it possible to do this, but it can also amplify your losses if the trade goes bad.

Not all stocks are marginable. Your broker maintains a list of stocks that can’t be bought on margin. Regulations prevent you from buying new issues, penny stocks, and others on margin. Check with your broker for these rules.

It is also important to remember that margin isn’t free. If you hold a margin trade overnight, your broker will charge you interest on the amount you borrowed. That interest is another expense that will eat into your profits. Unless a stock is on a steady climb, interest charges on a margin loan along with commissions will consume any profits.

Selling short, another margin transaction, is an order that puts you in position to profit when a stock falls in price.

Short selling is a popular tool for active traders because it gives them the opportunity to profit on both sides of a stock’s price cycle. Traders can grab profits as the price goes up and then reverse their strategy and take profits as it reverses. Of course, it sounds easy reading about it in a book, but the reality of making it happen is possible, although profits are not a given and traders lose money attempting this strategy.

Because short-selling is a margin transaction, the broker will charge interest on the value of the borrowed shares. If the price of the stock rises instead of falls, traders are faced with buying higher priced shares to replace the lower priced shares they borrowed and will suffer a loss. If the difference between the price of the borrowed shares and the market price is great enough, traders may experience a margin call.

Traders exit a short sale position by buying an equal number of shares to replace the borrowed shares. On many trading platforms, you may find a buy to cover option. This lets the system know you are covering a short sale with this order.

For traders who hold positions more than one day, there are some risks in selling short. Of course, the price of the stock could rise, forcing you to buy back shares at a higher price and creating a losing trade. This can get out of hand when a company that has been the target of short sellers turns in some good news and the stock blips upward. The short sellers begin covering their positions by buying shares. The more short sellers that cover, the higher it drives the price. The higher the price, the more short sellers are driven to cover. The feeding frenzy pushes the stock’s price up in a hurry. This is known as a short squeeze and the folks on Wall Street who don’t like short sellers enjoy seeing them squirm.

The stock market is geared to growth and profits. The focus is on the positive and, in general, the market favors growth over time. So short-selling is against the general market trend. As such, it is probably a difficult standalone strategy, however most active traders take advantage of it during their trading.

The Least You Need to Know