Investor's Guide to placing stock orders (part 1)

Once an individual investor decides to buy or sell some stock, there are many more decisions that need to be made. Should the investor use a market order, a limit order, a stop order, or some other order type? Which brokerage firm should get the order? To what exchange should the order be routed? This article will help you make these decisions. 

The two common types of orders used when trading stocks are market orders and limit orders. A market order can be used to buy or sell stock at the best price that the brokerage firm can find at that moment, no matter how high or low that price is. A limit order tells the brokerage firm to purchase (or sell) the shares at a price not to exceed (or not less than) a certain amount, known as the limit price. 

Market Orders
One advantage of placing a market order is that the trade will be executed very quickly. Often a broker can confirm that a market order has been executed within just a few seconds of placing an order. 

The price at which a buy order is executed will usually be the current ask price, which is sometimes called the offer price, and the price at which a market sell would occur would be the current bid price. For example, if the current quotes are 1,000 shares bid at 10 1/8 and 1,700 offered at 10 3/8, that means that you can immediately sell up to 1,000 shares at a price of 10 1/8 or purchase up to 1,700 shares at 10 3/8. The difference between the bid price and the ask price is called the bid-ask spread. 

These market quotes can be obtained from your broker before you place an order, so that you will have a fairly good, but not necessarily exact, idea of the price at which your trade will be filled. During times of heavy trading activity, though, the market may change between the time you hear the quotes and the time your order reaches the exchange. 

There is a cost for the speedy execution of a market order, and that is that you may be paying a higher price for the stock than you might otherwise pay. In this example, a limit order to purchase 1,000 shares at 10 1/4 would have a good chance of being filled, so that the investor might have been able to save 1/8, or $125, on the trade. However, if no one were willing to sell at 10 1/4, the investor would have been unable to buy. 

Limit Orders
Most brokerage firms charge the same commission for limit orders as they do for market orders, but a few charge more for limit orders since they represent more work. Since a limit order often does not execute immediately, it means that the firm may have to call the customer back later to report that the order was executed. Furthermore, since the order may remain open a long time, the firm has to keep track of the open limit orders. Some firms allow a good-til-canceled limit order to remain active for up to 60 days. 

In order to get a feel for limit orders, it helps to understand what happens to a limit order after you place it with your broker. If the stock is listed on the New York Stock Exchange or the American Stock Exchange, your broker will send your limit order, usually via a computer, to one of the exchanges where the stock is listed or to a NASDAQ (National Association of Securities Dealers Automated Quotation system) market maker who trades the stock. Usually your brokerage firm will select the exchange to which it sends the order, although you can specify the exchange if you like. Since many stocks trade on several different stock exchanges, your limit order could end up in many different places, even if the stock is listed on the NYSE. 

At an exchange, limit orders are usually filled according to price and time priority. For example, the buy order with the highest limit buy price is filled first. For orders that come in with the same limit price, the order that arrives first is filled first. If there is no one willing to trade at the price given in the limit order, then it sits at the exchange until someone is willing to trade at that price, or the limit order expires,  whichever comes first. 

Generally, limit orders that are placed at a limit price in between the bid and ask quotes have a very good chance of being executed on the NYSE and Amex. Limit orders that are placed away from the current quotes have a very low chance of being executed, so this isn't recommended unless you do not really care if your order does not get filled.

Limit orders that are placed at the bid or ask quotes are another story. If the number of shares quoted at the bid (or offer, if you are selling) is large compared to the trading volume in the stock, then your order may be in the back of a long line. (There is an exception: If the quoted size represents only the position that the NYSE specialist is willing to trade, then a customer order takes precedence over the specialist under NYSE rules.) 

NASDAQ Stock Orders
Stocks that are not listed on a traditional exchange but trade via the NASDAQ system are handled with a very different mechanism. There is no centralized exchange, but there is a system of competing market makers who post quotes on NASDAQ stocks. The spreads between the bid and ask prices tend to be much larger for NASDAQ stocks than for comparable exchange-listed stocks, and the number of shares that the dealers quote are usually not representative of their willingness to trade. As with exchange-listed stocks,  your broker can tell you what the best quotes are at any moment. 

If you place a market order, you will probably get the order filled at the current bid or ask quote. Limit orders on NASDAQ are handled very differently from limit orders on the NYSE or Amex. Most likely, your limit order will stay with your brokerage firm and only be executed if the market makers' quotes change to meet your order. 

For example, suppose that you are interested in purchasing a NASDAQ-traded stock whose best displayed quotes are a bid of $8 and an offer of $8.75. If you place a limit buy order at $8.25, your order probably will not be filled until one of the market makers decreases their ask quote from $8.75 to $8.25. Your broker is under no obligation to show your order outside the firm. 

Many of the larger brokerage firms maintain their own internal limit order books, but there is no formal limit order book like the ones the exchanges maintain for exchange-listed stocks. Thus, your order to purchase at $8.25 may go unfilled even if there is an order at another brokerage firm to sell at $8.25. Unlike the NYSE, the market makers may trade ahead of your limit order even if you placed your order first. 

It is also important to think about what might happen if your limit order is not filled within a reasonable amount of time, and you still want to trade the stock. If you think that the stock is going to make a major move, then it may move before your limit order gets filled. On the other hand, if you are not expecting the stock to go anywhere soon, it may not run away from you. If you really want to get the trade done, you need to consider this risk that the stock may run away from you.