Investors, who do not purchase their stocks and bonds directly from the issuer, must purchase them from another investor. Investor-to-investor transactions are known as secondary market transactions. In a secondary market transaction, the selling security owner receives the proceeds from the sale. Secondary market transactions may take place on a traditional exchange or in the over the counter market known as NASDAQ. While both facilitate the trading of securities, they operate in a very different manner. We will begin by looking at the types of orders that an investor may enter and the reasons for entering the various types of orders.
Investors can enter various types of orders to buy or sell securities. Some orders guarantee that the investor's order will be executed immediately. Other types of orders may state a specific price or condition under which the investor wants their order to be executed. All orders are considered "day" orders unless otherwise specified. All day orders will be canceled at the end of the trading day if they are not executed. An investor may also specify that their order remain active until canceled. This type of order is known as "Good Til Cancel" or "GTC".
A market order will guarantee that the investor's order is executed as soon as the order is presented to the market. A market order to either buy or sell guarantees the execution but not the price at which the order will be executed. When a market order is presented for execution, the market for the security may be very different from the market that was displayed when the order was entered. As a result, the investor does not know the exact price that their order will be executed at.
A buy limit order sets the maximum price that the investor will pay for the security. The order may never be executed at a price higher than the investor's limit price. While a buy limit order guarantees that the investor will not pay over a certain price, it does not guarantee them an execution. If the stock continues to trade higher away from the investor's limit price, the investor will not purchase the stock and may miss a chance to realize a profit.
A sell limit order sets the minimum price that the investor will accept for the security. The order may never be executed at a price lower than the investor's limit price. While a sell limit order guarantees that the investor will not receive less than a certain price, it does not guarantee them an execution. If the stock continues to trade lower away from the investor's limit price, the investor will not sell the stock and may miss a chance to realize a profit or may realize a loss as a result.
It's important to remember that even if an investor sees stock trading at their limit price, it does not mean that their order was executed because there could have been stock ahead of them at that limit price.
A stop order or stop loss order can be used by investors to limit or guard against a loss or to protect a profit. A stop order will be placed away from the market in case the stock starts to move against the investor. A stop order is not a "live" order; it has to be elected. A stop order is elected and becomes a live order when the stock trades at or through the stop price. The stop price is also known as the trigger price. Once the stock has traded at or though the stop price the order becomes a market order to either buy or sell the stock depending on the type of order that was placed.
A buy stop order is placed above the market and is used to protect against a loss or to protect a profit on a short sale of stock. A buy stop order could also be used by a technical analyst to get long the stock after the stock breaks through resistance.
An investor has sold 100 shares of ABC short at $40 per share. ABC has declined to $30 per share. The investor is concerned that if ABC goes past $32 it may return to $40. To protect their profit they enter an order to buy 100 ABC at 32 stop. If ABC trades at or through $32 the order will become a market order to buy 100 shares and the investor will cover their short at the next available price.
A sell stop order is placed below the market and is used to protect against a loss or to protect a profit on the purchase of a stock. A sell stop order could also be used by a technical analyst to get short the stock after the stock breaks through support.
An investor has purchased 100 shares of ABC at $30 per share. ABC has risen to $40 per share. The investor is concerned that if ABC falls past $38 it may return to $30. To protect their profit they enter an order to sell 100 ABC at 38 stop. If ABC trades at or through $38 the order will become a market order to sell 100 shares and the investor will sell their stock at the next available price.
If in the same example the order to sell 100 ABC at 38 stop was entered GTC. We could have a situation such as this:
ABC closes at 39.40. The following morning ABC announces that they lost a major contract and ABC opens at 35.30. The opening print of 35.30 elected the order and the stock would be sold on the opening or as close to the opening as practical.
An investor would enter a stop limit order for the same reasons they would enter a stop order. The only difference is that once the order has been elected the order becomes a limit order instead of a market order. The same risks that apply to traditional limit orders apply to stop limit orders. If the stock continues to trade away from the investor's limit, they could give back all of their profits or suffer large losses.