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Tips for the trade: Understanding market, stop-loss, and limit orders

March 13, 2017

Buying or selling investments such as stocks, bonds, and ETFs has a variety of ordering processes. And the type of order you use to buy or sell these investments can make a difference in the amount of risk you take on, as well as the price you ultimately receive.

Market order—A basic request

The most basic type of purchase or sale request is called a market order. It may be the first thing that comes to mind when you think of buying or selling a security or ETF.

First, you place an order with a broker or online brokerage service. A broker then sends your order to the market to execute as quickly as possible in order to complete the trade. This step happens even when you make a trade request online.

A very small amount of time passes between when you submit your order seeking a buyer or seller and the order is received by the stock market. Because of this lag, there could be differences in the price you see on your screen or hear during a conversation and the final execution price.

In most cases, this difference is small. However, on days with high market volatility, the span between the price you expect and the one you actually get can take you by surprise—especially if there aren't as many requests on the opposite side of the trade you want to perform.

A market order will execute your trade regardless of the final price. The order won't wait for market makers or other traders to refresh their screens to view prices for their buy or sell orders. In some cases, the price of a security or ETF may have changed—sometimes significantly— from the most recent trading levels.

Stop-loss orders—Setting trigger prices for market order

A stop-loss order combines multiple steps in one request. You set your stop price, also called a trigger price—that's the price at which you want the order to become active. The trigger creates a new market order should the stock, or ETF, move past the initial price you set. The market order then follows its standard execution steps, as noted previously.

This type of order has some benefits, as well as risks.

The benefit of having a stop-loss order in place for a security or ETF is that it can help prevent you from holding on to an investment that drops in value, especially when you're unaware of the price change. Let’s say you bought an ETF for $55. You've held it for a year and its price is now $70. To lock in your gain, you place a good-till-canceled (GTC) sell-stop order with a trigger price of $65. Should the ETF trade at or below $65, your brokerage firm will immediately send a market order to sell your entire position in the ETF.

Stop-loss orders also have some risks you should consider:

  • Securities don't open at the price at which they close the previous day. If your ETF closed at $65.50 on Thursday, but then opened on Friday at $62, your stop-loss order would automatically trigger a market order to sell that morning. A market order will execute as quickly as possible, regardless of price—even if it's lower than the price you set as the trigger.
  • You may experience wild price swings during a period of intense market volatility. The Flash Crash of May 2010 is an example of this type of situation. Securities prices plummeted within minutes, but then recovered and surged back to previous levels within the hour-and-a-half to market closing. Stop-loss orders converted to market orders at a time when the market had little-to-no liquidity. Sellers were abundant but buyers were scarce, so orders executed at prices substantially below previous-day values, as well as the fair value of the ETFs that had those securities in their basket of holdings. If you had a market or sell-stop order, you would have sold when prices dropped and then lost out on the rebound that quickly followed later in the day as securities and ETFs moved back in line with fair value.

Limit orders—Putting parameters on how much you'll pay or how little you'll take

Limit orders are a best practice for ETF investors

Vanguard research finds that using marketable limit orders is particularly prudent for ETF investors.

The white paper, 'Best practices' for ETF trading: Seven rules of the road, recommends this practice as one of several smart moves you can make when investing in ETFs.

Other best practices include avoiding trading at either the market open or close and considering calling your brokerage firm for additional sources of liquidity when placing large orders to reduce transaction costs.

Unlike a market order, a limit order ensures you get the price you set for a security, whether it's a maximum you're willing to pay to buy or a minimum you're willing to accept to sell. It doesn't ensure order execution.

The benefit of a limit order is that you can protect yourself from receiving a price that differs from your expected execution amount. The risk is that your order won't be filled if the price of the security or ETF is no longer within range.

So what can you do to protect yourself from the risk of a market order, but increase your limit order's success of executing?

A good option would be to use what's known as a "marketable" limit order. These order types can help improve the likelihood that your request will execute. In this case, you set your limit price either at or above the best "offer/ask" price when buying, or at or below the best "bid" when selling. This practice essentially accomplishes the same goal as a market order, but with added price protection.

Even if you choose a price several pennies away from the current "best bid/best ask," your order will still execute at the best available price. This executable limit ensures that your trade will execute at a price no worse than the limit you set. That makes marketable limit orders more likely to be fulfilled, while still allowing you to trade for prices you're more comfortable paying or receiving.

Let's say you have 50 shares of a security and you set a marketable limit order to sell them for a minimum price of $98.18. The security begins to drop in value and turns into a market order after hitting your trigger price. The price continues to fall, bottoming out at $72.

You may not be able to sell all the shares in your order, though. That's called a partial execution. Continuing our example, you sell 30 shares before the price falls below your minimum price, leaving you still holding 20 shares. If you'd have been able to sell your entire 50 shares at your limit price, you would have realized $4,909. Because you're only able to sell 30 shares, you receive $2,945.40—$1,963.60 less than you would have gotten if your full order had executed at your trigger price.

During times of high market volatility, as well as during the opening and closing of the markets, using marketable limit orders can provide price protection and security for your trades. Returning again to our example, you still have 20 shares of your holding. Those shares could regain value, perhaps quickly as in a situation such as the Flash Crash, or perhaps over a longer term.

Knowing the tools available to reduce risks—A best practice for all investors

Stop-loss and marketable limit orders may be new to you. But they're simply additional tools that can help you manage investing risks.

When used as part of a comprehensive investment strategy that includes a core of broadly diversified funds with the appropriate mix of stock and bond holdings for your time frame and goals, these orders can help you manage the inevitable market ups and downs that are part and parcel of investing.

Notes:

  • All investing is subject to risk, including the possible loss of the money you invest.
  • Vanguard ETF Shares are not redeemable with the issuing fund other than in very large aggregations worth millions of dollars. Instead, investors must buy or sell Vanguard ETF Shares in the secondary market with the assistance of a stockbroker. In doing so, the investor may incur brokerage commissions and may pay more than the net asset value when buying and receive less than the net asset value when selling.
  • Past performance is not a guarantee of future returns.
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