Know Your Limit Order

The country that has the highest posted speed limit is…Poland. The maximum speed limit is 140 kph. That is 87 mph.

The equity markets seem to be going about 90 miles an hour in either direction daily. Do the equity markets have speed limits?

In the equity markets there are speed bumps. If prices start to fall too fast in a short period of time trading can be halted. It rarely happens though. 

I look at falling prices as an opportunity. But how can I get on the autobahn and drive safely?

When you buy or sell stocks, there are different categories of orders. The most common is a market order.

A market order is an order to buy or sell a security immediately. This is another way of saying “at the next best price” .  A market order is about the speed of buying or selling. You could end up paying more than you thought you would.

In an environment like the one we are in today, with big swings in stock prices , using a market order could work against you. 

There is an alternative to using a market order. The alternative is  a LIMIT order.

A LIMIT order specifies the maximum price you are willing to pay for a stock. A LIMIT order can also be used to sell stock.

How do you decide if you should use a MARKET order or a LIMIT order?

The answer is to look at the current price where the stock is trading. 

If you are buying a stock you want to pay the lowest price. 

If you are selling a stock you want the highest price.

Of course this cannot be stated simply so here is the jargony jargon :

[1] “The bid price represents the maximum price that a buyer is willing to pay for a share of stock or other security. The ask price represents the minimum price that a seller is willing to take for that same security. A trade or transaction occurs after the buyer and seller agree on a price for the security which is no higher than the bid and no lower than the ask.”

The difference between the lowest price and the highest price is called the “bid ask spread”.  

You will see this terminology every time you buy or sell a stock.

I can’t change the terminology, but I can explain it to you.

A LIMIT order allows you to name your price. Unlike a market order, when the bid ask spread is wide, buying a stock using a limit order can prevent you from overpaying in a wild and crazy market.

In the middle of June there was one day when stocks prices lost all their meaning. Prices started to fall. Without using jargon let’s say it was ugly. 

When prices fall substantially in one trading session (one day) I am looking for opportunities to jump in. Not in a big way. I ask myself, is there a company I would like to own? Just a little bit.

This is where the use of a limit order can be fun. 

If I see a stock I would like to buy I can place a limit order. I can name my price. Naming my price does not mean I will automatically buy the stock. But what the heck? This isn’t a life changing moment. If I’m only planning to buy a few shares I am indifferent to whether I buy it or not.

If my limit does get “hit” I bought the stock at the price I wanted.

In the picture below we can see that the bid for the “redacted” stock is $104.25.

The ask is $104.45. The spread between the two is $0.20 cents. That is a narrow spread.

Now look at the orange bar. The stock price traded as low as $102.51 and as high as $107.84 in one trading session.

I like the stock at $104.00 but I do not want to risk paying $107.00.

I place a limit order at a price of  $104.25 for 10 shares.

I have no idea what is going to happen the next day. Stocks could end up trading higher or lower. 

I could pay $104.00 and watch the stock drop to $102.00. If I now own 10 shares , my loss is $20.00. 

I know I am never going to get the absolute lowest price. In fact, my maximum potential loss if I do buy the stock is $1040.00. 

This is when investing is fun. I didn’t see much risk of the stock going to zero, I am a long-term investor and I was able to set my “risk tolerance”. 

Investing is  not gambling. Gambling is more of an immediate gratification game ( or not). 

When you limit how much you are willing to spend by limiting the number of shares you buy and the price you are willing to pay you are not “over committing”. You are discovering ways to manage risk.

I would be more concerned driving in Poland than buying a few shares in a volatile market.

[1] https://www.investopedia.com/terms/b/bid-and-ask.asp
[2] Limit orders can be filled outside of regular trading hours.

This website is for informational purposes only and does not constitute an offer to sell, a solicitation to buy, or a recommendation for any security, nor does it constitute an offer to provide investment advisory or other services by The Modest Economist LLC.