Taking Your Trade To The Limit
So you're ready to trade some XYZ stock. How are you going to place the order? You have two basic choices: a market order or a limit order. Buy or sell "at the market" and you'll get the price that's available when your order hits the bourse. But with volatile stocks in thin markets--such as many of today's tech issues--that can be a risky proposition. A limit order limits your risk by letting you name your own price for a stock. No less an authority than Securities & Exchange Commission Chairman Arthur Levitt thinks limit orders, which now make up two-thirds of orders on the New York Stock Exchange, are the small investor's best friend.
Are you missing out on something if you're not using limit orders in your trading? Yes. Limit orders can help you squeeze every penny out of an order, especially when a stock's spread--the gap between dealers' buy and sell prices--is wide.
Take the slow-moving shares of Federal Screw Works, an auto-industry supplier that Georgetown University finance professor James Angel likes to cite to his students. Dealers who make a market in this issue were recently bidding $40 to buy shares but asking $42 to sell to you. That $2 is an exceptionally wide spread, compared with the 6.25 cents spread for, say, Microsoft. It means that an investor who buys Federal Screw Works at the market won't see a profit unless the stock climbs more than 5%. But you don't have to put in a market order. Instead, says Angel, you could place a limit order "inside the spread" at, say, $41 a share, "just to see if anyone out there will give you a break."
You don't need a $2 spread to profit from limit orders, though. You might catch a price break any time the spread is more than your target stock's "tick," or smallest price move allowed. For most stocks, that means you should consider a limit order when the spread is one-eighth (12.5 cents) or more--like, say, Intuit, quoted recently at $51.06 bid, $51.19 ask.
Limit orders run a risk, too: Roughly 40% of them never get filled. "Limit orders guarantee you a price, but they don't guarantee that your trade will get executed," warns John Mullin, president of Datek Online Brokerage Services. Set a limit order to buy at too low a price and you might miss the chance to ride a stock's surge. Even worse, put too high a price on a sell order and you might get stuck with a stock that's tumbling. In those cases, a market order might be better. With a market order, you can't be sure of the price, but you're assured that your order will be filled.
Datek's active traders, who want to exploit every 16th of a point, are heavy users of limit orders. Traditional brokers catering to buy-and-hold investors handle fewer limit orders. That's fine with them, because an unfilled limit order doesn't pay a commission. "A market order rings the broker's cash register immediately, but a limit order may just sit there," says Steve Bradley, a former Salomon Smith Barney executive who is co-author, with Richard J. Teweles, of The Stock Market (John Wiley & Sons, $39.95). For that reason, brokers used to charge more for limit orders. But now, major online brokers such as Datek, Charles Schwab, and E*Trade no longer surcharge limit orders. Traditional brokers increasingly use flat-rate or percentage-of-assets fees that treat limit and market orders the same.
Limit orders involve one extra wrinkle: You have to set a deadline for filling the order. Most investors use day orders, which expire at the traditional 4 p.m. (ET) market close. If you specify "good till cancelled," most brokers will carry the order for 60 days. One especially useful form of good-till-cancelled order is the "stop-loss" order, which instructs your broker to sell shares you own if the price falls to a level you specify. With any open-ended order, you've got to monitor the market to be sure the price you've set reflects up-to-date conditions.
When should you use a limit order? That depends on everything from your time horizon for the investment to the market where the stock trades. Here's what the experts advise:
-- INVESTOR VS. TRADER: If you're buying a company you'll want to own for the next decade, 16ths don't matter. Place a market order. But if you're just hoping to catch a $2 move over the next few days, a limit order that squeezes a few cents out of the spread could boost your profit by a significant amount.
-- MUST-HAVE STOCKS: Say your target stock is selling for $50. You're convinced that it's about to go to $60. If you try to grab shares on the cheap, with, say, a $49.93 limit order, your order may never be filled--and you'll miss out on the big move. "If the stock is about to run away from you, place a market order so you're sure to be on board," says Angel. That advice goes double for unloading a stock that you suspect is poised to fall: If you're like most people, you feel much worse about actual losses than you do about mere missed opportunities.
-- UNRULY MARKETS: A limit order guarantees that you won't pay $40 for a stock you thought you would get for $15. That can happen when you're trying to buy shares in the market in a company that just had an initial public offering. Those stocks can double or triple on the first day of trading but usually lose most of their gains in the next week. Schwab, the biggest online broker, requires its customers to use limit orders for IPO shares so they won't get a rude price shock. Overnight orders to be filled when the market opens also should be limit orders. Trading, especially in Nasdaq, can be crazy at the opening. "This morning's price can be a long way from yesterday's close," says Bradley.
-- THIN VS. THICK: If your order will buy up a major chunk of the day's trading in your target stock, you'll want to consider a limit order. In thinly traded Nasdaq stocks, compare your order to the market makers' "size"--the number of shares brokers are quoting at the best ask price. If you want 1,000 shares and they're offering only 100, a market order will net you the best price on just 100 shares. The price is likely to tick higher for every extra 100 shares you get.
How can you gauge the market's depth? Ask your broker to see what orders are queued behind the best bid and offer. For Nasdaq stocks, check Island ECN (www.isld.com) or Archipelago (www.tradearca.com), alternative trading systems that post their entire order books online. They won't show other dealers' orders, but they'll give you a feel for the market. Thinly traded stocks often have wide spreads--another good reason to try a limit order inside the spread.
-- WHICH MARKET: Limit orders get better treatment on the New York Stock Exchange than on Nasdaq. Specialists on the NYSE floor are required to give limit orders priority over their own trades at the same price. In Nasdaq, where several dealers make a market in the same stock, market makers must honor only their own customers' limit orders. That's an improvement from the early 1990s, when Nasdaq dealers routinely ignored less-profitable limit orders. Now, when a Nasdaq dealer receives a limit order better than his own bid or ask price, he must either fill the order or route it to one of nine electronic markets, such as Instinet, Island, or Archipelago, for display to other dealers and investors.
Those rules for handling limit orders, imposed on Nasdaq in 1997, have boosted the growth of electronic markets. Now, the SEC is debating whether to impose even stricter rules requiring all markets to give priority to limit orders. "Individuals with limit orders are price-setters, not price-takers, and that's good for competition," says Robert Colby, deputy director of the SEC's Market Regulation Div. Just think: That limit order you place might change the face of America's stock markets. It might also get you a better deal--and that's what investing is all about.