While every trade is ultimately about executing a buy or sell order, the order type helps execute the overall trading strategy. The right type of order can help minimize risk, limit losses and remove impulsive trading from the equation. In this article, we’ll examine each of the order types available and in which situations each of them makes the most sense.
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The Importance of Understanding Order Types
The common order types can handle most trading scenarios an investor can think of. Perhaps the most important aspect of the right order type is that it allows traders to think through their overall strategy and, ultimately, trigger the appropriate trade whenever specific criteria are met. These trades can occur automatically so that investors don’t need to stare at a screen all day waiting for a specific price to be hit. Understanding each type of order helps to identify which of the available trading strategies works best while minimizing trading costs. This will impact the cost associated with executing the trade, how profitable the trade becomes, and assessing if the trade achieves its desired result.
Technical analysis of ETFs is instrumental in understanding when exactly to buy an ETF. Read Introduction to Technical Analysis for an introductory look at technical analysis and find it out how it can be used in market timing when buying and selling ETFs.
Overview of Order Types
Here’s a brief overview of each order type that will be discussed in more detail.
|An order that executes as quickly as possible at the best available price.||Generally executes immediately at current price.||Best available price may be higher or lower than expected.|
|An order that executes once the security hits a specific trigger price.||Order only gets executed once an acceptable buy or sell price is achieved.||Order does not execute if limit price is not achieved.|
|An order that executes once the security trades through a specific trigger price.||Order gets executed automatically once the stop price is achieved.||Execution price may be significantly higher or lower than stop price if market moves quickly.|
|A stop order that triggers at trader's maximum allowable loss.||Order gets executed automatically once the stop price is achieved.||Execution price may be significantly higher or lower than stop price if market moves quickly.|
|A stop price that adjusts as the position becomes further in the money.||Allows in-the-money positions to continue to run with stop price adjusting automatically.||Trades could be executed too soon or too late depending on how far stop price is from current price.|
|A combination of stop and limit orders that gets executed at the limit price or better once the stop price is hit.||Order only gets executed at the limit price or better.||Order does not execute if stop or limit prices are not reached.|
The market order is the standard order used when a trader simply wants to buy or sell an ETF. The biggest advantage is that, in most cases, the trade gets executed in a matter of seconds at or near the latest available price. A market order is generally the most efficient way to get a trade completed quickly. On the downside, you don’t know exactly what price you’re getting with a market order. In a rapidly swinging market, the execution price could be different than the price expected, resulting in higher implicit transaction costs.
Read 6 Best Practices for Executing ETF Orders for tips on how to improve the quality of your ETF trading execution.
A limit order gets executed at a specific trigger price or better. A buy limit order gets executed at a price below the current market value. For example, if ABC ETF trades at $60, a trader may issue a buy limit order at $57. The trade only gets executed if the price dips down to $57. Conversely, a sell limit order gets executed at a price above current market value. Limit orders are ideal for traders who calculate a fair value target for a stock or ETF and only wish to enter or exit a position if that price is hit. A limit order, however, will never be executed if the price doesn’t reach the limit price.
The stop order works opposite to the limit order in that the trigger price for a buy stop order is above current market value, while the sell stop price is below. Sell stop orders are often used by investors as a way of locking in gains or cutting losses as an ETF begins moving downward. An investor who bought an ETF at $40 that currently trades at $50 may wish to place a sell stop order at $48 in order to lock in an $8 gain before the ETF declines further. A buy stop order may be entered by a trader once an uptrend in the ETF price is confirmed. A trader using technical analysis may place a buy stop order at a resistance level but wants to buy only if it breaks through that level.
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Stop Loss Order
The stop loss order is entered at the price that the trader would cut his or her losses and exit the position. Its strike price is generally set just below the original purchase price of the ETF. The risk of a stop loss order is that the trade may be executed well below the stop price. A trader may have a stop loss order at $60, but a negative news release may cause the price to immediately drop to $50. In this case, $50 is the next best available price and the stop loss order would not have provided the intended protection.
Trailing Stop Order
A trailing stop order is for someone who wants to sell once the price drops a specified percentage or dollar amount but wants to adjust the strike price higher as the fund’s price rises. For example, someone buys an ETF at $52 with a stop at $50. If the price rises to $60, the fund can still decline all the way back down to $50 before triggering a sell order. If this person were to place a trailing stop order with a $2 difference, the stop strike price would automatically adjust up to $58 when the ETF hit $60. A trailing stop helps a trader participate in a fund’s upside while automatically adjusting to protect from large losses.
Stop Limit Order
The stop limit order is simply a combination of a stop order and a limit order. A trader, for example, owns an ETF trading at $50 and issues a sell stop limit order at $45. Once the fund trades at or through the $45 price, the sell stop is triggered and the stop limit order becomes just a limit order. In order for the limit order to be executed, it needs to achieve the strike price or better. In this case, the price needs to move back above $45. In practice, the stop order and the stop limit order may achieve substantially similar results in heavily traded stocks but may have more difficulty getting executed with thinly traded issues or stocks that make sharp moves quickly.
The Bottom Line
The variety of different trading strategies available can be confusing at first, but they’re important to understand since they can help in developing and sticking to a strategy while protecting traders from losses. Choosing the right trade can also help limit potentially expensive trading costs.
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