Whenever it comes to entering or exiting a trade or investment, we get in a dilemma about choosing the right order type. Some traders even ignore the importance of selecting the right order type. Choosing the perfect order type can maximize your profits and minimize the losses. In this post, you will get to know the most basic stock market order types: Market Order, Limit Order, Stop Order, Stop-Loss Order and Trailing Stop-Loss Order.
So, why choosing the right order type is so important for a trader/investor?
As a stock market trader/investor, you will often face a variety of complicated situations where you won’t be able to decide where to enter and exit a trade/investment. Having a good knowledge of all the different order types can simplify this situation for you.
Some order types can also automate your decisions. You don’t have to torture your eyes by continuously looking at a trading screen. Buying and selling at a price of your choice and also the duration of holding the trade can be simplified just by choosing the perfect order type.
Before we start to look into different order types, we need to know how orders are classified. Orders are classified based on 3 factors:
There are some order types which are a combination of one or more of these three factors.
So, here is the list of all the order types that you may come across while trading/investing:
As you can see there are 18 order types that we have to know. To keep things simple, I will explain the different order types in 3 separate posts.
Your broker may or may not provide all the available order types. It depends on your broker. However, few orders like AON, MF are not available on the system as per SEBI directives.
In this post, we will focus on the order types based on price.
But before starting to learn any order type, there are three terms you must understand: Liquidity, Volatility, and Slippage. A clear understanding of these terms will help you to choose the correct order type in any situation.
It indicates the ease at which a stock can be bought or sold in the stock market without affecting the price of the stock to a large extent.
If there are more buyers and sellers, then the liquidity of a stock will be more. The effect of buying and selling on price change will be less in this case.
Volatility indicates the degree of uncertainty of a stock’s price change. It is inversely related to liquidity. In general, if the liquidity of a stock is more, then the volatility will be less.
If volatility is more, then the stock price will fluctuate by a large amount.
Slippage is the difference in the price you want to pay for a stock and the price you actually end up paying for the stock.
Suppose you want to buy a stock when it was trading at Rs.40. So, you place a buy order. But, by the time your order gets executed on the stock exchange, the price has reached Rs.45.
So you have to pay Rs.45 instead of Rs.40.
So, slippage = Rs(45-40) =Rs.5
If liquidity is less and volatility is more, then slippage will be more.
Now that you know the 3 necessary terms, we will start with the different order types based on price
To simplify your understanding of the basic stock market orders I will use simple chart diagrams.
When you place a market order to buy, it tells your broker to buy the shares at the price available in the market currently for that stock. This order type guarantees the execution of the order. But it does not guarantee the execution price.
Suppose, when the stock price is at price level-1, you decide to buy 100 shares of the stock. So, you place a market order to buy. This order will ensure that all the 100 shares are purchased. But all the 100 shares may not be purchased exactly at price level-1. It may also happen that none of the shares is purchased at price level-1.
It happens because a market order gets executed at the current price. By the time your order enters into the system, the price may have already changed.
If the stock is very volatile, and there are fewer sellers, your order may take some time to get filled. In such conditions, the slippage increases and this may lead to an unprofitable trade.
As a practical example, let us consider there are only 3 sellers. The first one is willing to sell 20 shares at price level-1, the second seller is willing to sell 50 shares at price level-2 and the third seller is willing to sell 30 shares at price level-3.
Now, you have placed a buy market order for 100 shares at price level-1. At first, only 20 shares will be purchased at price level-1. Then the next 50 shares will be purchased at price level-2 and the remaining 30 shares will be purchased at price level-3.
As you can see, purchase of all the 100 shares is guaranteed, but the exact price is not guaranteed. If you are price sensitive, a market order may not be your choice.
A Limit Order is an order to buy or sell at a specified price or at a price better than that. For a buy limit order, the specified price is below the current market price. For a sell limit order, the specified price is above the current market price.
A limit order does not guarantee the fulfillment of the entire order quantity. But it guarantees the price that you want or even better.
Let us now follow the chart above for better understanding.
Suppose, the stock price is at level-1 when you decide to buy 100 shares. But you do not want to pay the current price. You want to buy the shares at a lower price. Let’s say that you want to pay the price at level-2.
If you place a buy market order when the price is at level-1, it will get executed immediately, and you may not get the lower price you want.
This is the situation where you can use a limit order. Limit orders are particularly helpful when you are touchy about the price.
If you place a buy limit order with the limit price at price level-2, then your order will get executed only when the price will drop to or lower than price level-2.
But, what’s the disadvantage of limit order?
As you can see the stock price has reversed direction from price level-2. If the stock price rises above your limit price level-2 before all the 100 shares are purchased, then your order will remain partially filled. This ensures that you do not end up paying more than you want.
To understand this scenario better, let us consider another trade. Suppose, the stock is currently trading at price level-3 and you want to buy 50 shares when the price falls to level-4. So you place a limit order at level-4. But the stock price reversed its direction before reaching price level-4.
What do you think will happen to your order?
It won’t get executed at all.
Now that we have a clear understanding of limit orders, let us look into another order type which is mainly used for minimizing losses. It’s the Stop Order.
A Stop Order is an order to buy or sell only after a specific price level is reached. For a buy stop order, the specified price is above the current market price. For a sell stop order, the specified price is below the current market price. This order does not enter the system as long as the specified price is not reached.
This specified price level is called the ‘trigger price’. As long as this trigger price is not hit, your order remains in your broker’s system.and does not enter the system of the stock exchange.
Once the stock price hits the trigger price, the stop order enters the stock exchange’s system in the form of either a ‘Stop-Market Order’ or a ‘Stop-Limit Order’.
Let’s simplify the stop order using the above diagram.
When the share price is at level-1 you decide to purchase the share. But before that, you want to make sure that the share price is actually going up. So instead of placing a market order or a limit order, you place a buy stop-market order with trigger price at price level-2.
This order will enter the market only after the share price hits price level-2. So, at price level-2, the stop-market order gets executed as a normal market order.
But, if you place a buy stop-limit order with trigger price at price level-2 and limit price at price level-3, then the situation will be a little bit different. Your order will enter the market at price level-2 but will be executed only if the share price becomes equal or higher than price level-3.
Have ever heard the term ‘stop-loss’ (for exiting a trade)?
The stop loss in share market actually a ‘stop-market order’. Sometimes it’s also called the ‘Stop-Loss Market Order’ (SL-M). As soon as the trigger price is hit, the stop-market order enters the system as a normal market order and gets executed immediately. This protects you from suffering more losses.
As the stop-loss order is the most commonly used stop order, let’s discuss it in more detail.
The Stop loss in share market is one order type that you can not neglect. Out of the numerous order types, the stop-loss order alone has the capacity to decide your success or failure as a trader. So, let us understand the importance of the stop-loss order in the stock market using a simple diagram.
Let us take a look at the chart above.
Suppose, you have already bought a share at limit price level-1. Now you want to sell it at a profit. So, you have set the target price at price level-2.
It feels really good to think of profits. But what if the price starts to fall instead of going up?
That’s what has happened to the share you purchased. The share price goes up for some time. But before reaching the target price level it starts to fall back.
Always remember one fact about the stock market, esp. if you are trading for the short term: It’s Mad!
Let us assume something even worse! What if the price falls below the price at which you bought the share?
If you don’t want to lose a huge chunk of your money in case the share price keeps falling further, you better know how to use a stop-loss.
You usually place the stop-loss while entering a trade in the share market. Suppose you have placed the stop-loss at price level-3. Remember, that the stop-loss price you mention is actually the trigger price. In this case, the trigger price is at price level-3.
Once the share price hits this trigger price, your stop-loss order would enter the system as a sell market order and your shares will be sold at the current market price. This will prevent you from suffering further losses.
A trailing stop-loss is a dynamic form of a simple stop-loss.
When you place a simple stop-loss, it is fixed at a particular price. But when you place a trailing stop-loss your stop-loss is not fixed. It keeps following the share price as long as the price goes in your favor.
But when the price changes its direction against you, the trailing SL doesn’t come back in the opposite direction. This is the advantage of a trailing stop-loss.
For a better understanding let us have a look at the chart above.
You have already bought the share at price level-1. To keep your loss under control you have also placed a stop-loss at price level-2.
So, how is a trailing stop-loss going to help you now?
Initially, when you place the trailing stop-loss, its value is kept slightly more than the simple stop-loss. So, you place a trailing stop-loss at price level-3.
Notice the yellow vertical arrow that represents the ‘maximum’ gap which the trailing SL has to maintain with the share price. Whenever the share price increases, the trailing SL also rises to maintain this gap.
You can see that after a certain increase in price the trailing SL will rise above the simple stop-loss. If your brokerage is advanced, it will automatically cancel the simple stop-loss as it will be of no use then. Only the trailing stop-loss will exist after that.
Now, assume that the share price increases till price level-4. At this point of time, the trailing SL also rises and adjusts itself at price level-5 to maintain the same ‘maximum’ gap.
Now, suppose the price falls from price level-4 to price level-6. What will the trailing stop-loss do now??
This is the situation where a trailing SL comes in handy!
It stays at price level-5. It doesn’t move down along with the price. So, if the price falls further, the stop-loss will get triggered at price level- 5. This means you have already locked-in profits from price level-1 to price level-5. This is not possible if you use only a simple stop-loss.
Now, the share price starts increasing from price level-6 till price level-7. The trailing SL also starts rising to maintain the maximum gap and adjusts at price level-8.
Now here comes the interesting part!
The share price starts falling from price level-7 all the way down to price level-2 (where you had placed your simple stop-loss initially). If you had only a simple stop-loss and no trailing SL, this is the price where your shares would have been sold!!!
But you have a trailing SL already adjusted at price level-8. When the share hits the price level-8, a sell stop market order is triggered and the shares are sold. So you have actually made a profit instead of suffering a loss!
I have explained the order types using ‘buy’ scenarios only. In case, you want to short sell, you can just look at the charts upside-down. Rest everything will be similar.
This post should have cleared your doubts about the most basic order types. In case you have any queries, you can ask in the comment section below.
I will cover the remaining order types in the next two posts.
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Also read: Stock Market Order Types: Part-2