In order to invest in the market, an individual needs to go
through a broker who will charge a fee or commission for execution of trades
ordered by its clients. Whereas before, only the wealthy could afford a broker
and therefore access the stock market, the birth of the internet allowed for
the subsequent birth of discount brokers on the internet. These brokers allow
investors to trade at a lower cost, but they don't provide investors with
personalized advice. Many brokers will charge under $10 per trade and some will
go even lower. Thanks to discount brokers, almost anyone can trade in the stock
market.
Brokers
Brokers come in two different flavors. The first kind is the
full service brokerage firm. These are the largest and most known brokers in
the country and they spend millions of dollars a year on advertising to make
sure of that. The problem with these brokerages is that they are expensive and
they are biased. Such large firms usually have an investment banking division
that helps companies make IPOs. It's not hard to see that it may pose a
conflict of interest when the other part of the company is dedicated to
advising people on what to invest in. Therefore, they may guide the investor to
buy shares of a company that they put to market just to keep a good banking
relationship with that company. Furthermore, they are very expensive with fees
upwards of a $100 per trade. A trade may cost a lot of money and their advice
is usually misleading.
The second kind of brokerage firm, and the most appealing one
to use, is the discount brokerage firm. They do not have investment banking
divisions, but even if they did it would not matter anyways because they don't
give their investors any advice. They provide a trading platform to stay
competitive and may help the investor by giving them reports from third
parties, but the only reason they really exist (in the mind of the investor) is
to execute his or her orders to buy or sell. Here, a trade may cost around $7
to $10, so it's more affordable. In addition, they make commission the same no
matter what stock gets traded, so they are not interested in giving the
investor any recommendations.
Types of orders
In order to invest intelligently and successfully, the
investor needs to put all the tools available to him or her to use. Different
orders that the brokerage performs are some of those tools and are instrumental
in executing trades under specific conditions.
Market Orders
When a market order is placed, it is an order to purchase
shares of stock immediately at the next available current price. It guarantees
execution, and also carries with it a lower commission, because all the broker
has to do is buy or sell. However, placing a market order with a stock that has
low average daily volume can be dangerous. In such a situation, the ask price
can be a lot higher than the bid, causing a larger spread, and therefore making
the shares cost a lot more than originally quoted.
Above the market Orders
An order to buy or sell at a price that's higher than price
the security is currently trading. An example of such an order can be a limit
order to sell, a stop order to buy, or a stop-limit-order to buy. Momentum
traders will often place such traders above the resistance level in the hopes
that once a price breaks through the resistance level, it will continue in an
upward trend.
Below the market Orders
An order to buy or sell the security at a price that's lower
than the current price. An example would be a limit order to buy, a stop order
to sell, or a stop-limit order to sell. This can be used to limit losses by
some investors who will want to sell a security after it has hit a certain low
price point.
Trade execution
Limit Order
An order that instructs the broker to buy or sell a number of
shares at specific price or better. The investor can also limit the length of
time the order can be outstanding before it's no good. These can often cost
more than market orders, but are sometimes worth the higher price if used to
limit losses, or purchase shares at a low price the stock hits for only a few
minutes.
Example: Tony has decided he wants to buy 100 shares of
Coca-Cola but he is willing to pay no more than $30 per share. He sets a Buy
Limit order at $30 for 100 shares. If the price of the stock drops to $30 or
below, the order will become a market order and execute but only a price of $30
or below. If the price never reaches that point, the order will not execute.
Stop Order
An order to buy or sell a security when its price passes a
certain point. This gives the investor a larger probability of hitting an entry
or exit price that he or she wants. Once the price passes that point, the order
becomes a market order. Investors usually use this when they know they will be
unable to monitor their portfolio for a certain period. However, they are not a
guaranteed the transaction will happen at the price the trader wants. If the
stock drops down really quickly or jumps, the investor's stock will be sold or
bought at a very different price than what the investor expected.
Example: Tony has bought a stock for $20 that is now trading
for $70. He wants to sell it at $60, therefore locking in a 200% gain. He
places a stop order to sell at $60. The order will execute at the best price it
can after the price hits $60 or lower.
Stop Limit Order
This order combines the features of a stop order with those
of a limit order. This order will be executed at a specified price or better
after a given stop price has been reached. In other words, once the stop price
has been reached, the order becomes a limit order instead of a market order,
therefore giving greater assurance that the order will be filled at the price
desired by the investor.
However, the downside is that the trade may not be executed
if the stock reaches the stop but does not hit the limit.
Example: Going back to Tony and his stock that he wants to
lock in a 200% gain on. If he places a stop limit order to sell at $60, and the
price hits $60, the order will only execute at a price that is $60 or higher,
unlike the stop order which will execute at any price after the price point has
been hit.
