When I say order, I mean the instruction for the broker to buy or sell on an exchange (such as NYSE [1]). Most people think of stocks when they reference orders but the same terminology is used in stocks, bonds [2] and commodity [3] markets as well.
Market Orders
A market order is simply a instruction to buy or sell at current market prices. Once the order is placed, the broker is supposed to find the best available price to execute the order. This type of orders are usually executed the quickest and some brokerage firms like E*Trade even have 2 second execution guarantee or your commission back. Market orders also have the best chances to get executed so brokers love these types of orders from clients but it may not be the best interest of customers to use these market orders.
The reason is simple. Time and time again, I see others taking advantage of people who use market orders to buy and sell. In a market where liquidity is low (buying and selling volume is low), the best available price may be very different than the current market price. For example, a person that puts in a market order for a stock with a price of $15 may end up getting the order executed at $15.50 if the volume is really low if there are no sellers between $15 and $15.49.
The problem was the worst when after-hours trading were first introduced because ignorant investors put in market orders in an environment where transaction volumes are much lower. These days with so many people getting burned and with the help of the media, the problem is less severe.
In the old days when retail investors isn’t as sophisticated as they are now, market orders were very common. Nowadays however, many people see the advantages of the alternative ordering method and have changed their preferences.
Limit Orders
An order type that gives investors much more control, a limit order [4] is an instruction to buy (or sell) at no more (or no less) than the specified price. These type of orders avoid the low liqudity problem mentioned with market orders all together as brokers are not allowed to execute the order without regard to prices.
For example, if I were to put in a buy limit order of $15 for a stock that is currently priced at $15, there will be no execution until there is a seller willing to sell the stock for $15 or lower. This reduces my exposure to surprises, but at the same time reduces the chance that my order will be executed.
Due to the lower chances of execution of a limit order, more conditions come into play. Brokerages generally allow you to specify whether you would like to execute the whole lot of shares at once. What I mean is that if I wanted to buy 500 shares, I can choose to allow my broker to execute whenever there are people selling at prices I’ve specified, or wait till the broker can execute in one transaction. For most of us, this sounds like a ridiculous options but for investors managing hundreds and thousands of transactions, this can be an efficient way to minimize book keeping.
Which One Should I Use
Whenever someone ask me that question, I always tell them to use limit orders because of the inherit danger of market orders that I mentioned earlier. If I really wanted to make sure that the order is executed, I can always put a limit order price that’s below (or above) the current price to make sure it gets executed. I’ve found that as stock prices fluctuate, using limit orders have always given me a better price for every transaction and while small, it certainly added up through the years!
For more, stay tuned to the extension of this explanation on condition orders next week!