With the advent of online trading and the massive advertising effort being foisted on the public by Internet firms like E*Trade, Charles Schwab, Waterhouse, and Suretrade, millions of Americans are trading stocks who had before only purchased one or two mutual funds. As a securities attorney, my phone has been ringing off the hook with claims that Internet firms have screwed up their trades. In a recent article, I addressed the problems beset by Internet trading firms; in this article I’ll address problems on the part of the end user. Too many people are rushing into the market without fully understanding some of the basics of entering orders. One article can’t make anyone a trading expert, but it may assist in avoiding some of the major pitfalls.

Market Orders

My client is a 21-year old young man who had $7,000 in his online account. He entered a market order to buy an over-the-counter (OTC) security on a stock that was being offered at 8 cents/share. He entered a 30,000-share market order that, in his young mind, would have resulted in a $2,400 purchase. Fifteen minutes later, his order was filled at a $1 per share. Needless to say, the $7,000 in his account fell woefully short in covering the $30,000 purchase price. The stock then plummeted, wiping out his account and leaving him with a $23,000 debt to the firm.

The above scenario is being played out all over the country. There is presumption that market orders are filled almost immediately. My client presumed that if his order were not filled at 8 cents, then it would fill at something reasonably close to 8 cents. A market order is an order to buy or sell a security at the security’s market price – not necessarily the market price when you decide to place your order, but rather the market price when your order hits the system. In today’s fast paced market, stock prices can jump up and down like a kid on a pogo stick.

Volatile Stocks and Volatile Markets
When dealing in volatile stocks and volatile securities markets, market orders can be dangerous. If you are considering entering a market order, you should first assess whether any of the following scenarios apply to you. First, if you are trading in OTC stocks, be aware that market orders tend to be less instant, because the order is first routed through one or more market makers (steps are being taken to adjust this process). Second, if you are dealing in a thinly traded security, that is, one where the average volume of shares traded on a given day is limited, your market order may not go through as you planned. Third, the securities markets are much more volatile than in the past. For numerous reasons, the up and down price of the entire market for the last several years has experienced large swings, so individual price movements on a give stock have increased. Fourth, the particular security my client was trying to buy was a volatile stock, that is, one that has large price swings on a percentage basis on any given day. A stock that goes from 8 cents to $1.00 in 15 minutes is by definition, about as volatile as you can get. The technical term for measuring a stock’s volatility is called its beta. If a stock has a high beta, then it has high volatility.

Volume Issues
The volume of trading can also be reason to pause before entering a market order. If there are other market orders in front of yours (orders entered at the same time as yours or before yours), then those orders will be filled before yours. If you are trying to buy 30,000 shares and the offer was 5,000 shares at 8 cents, then you should recognize that there are only 5,000 shares to be bought at 8 cents and the next set of shares could be at a significantly higher price. In addition, the offer may still only be a few thousand shares. Depending on the sophistication of the trading software or the firm you are trading with, you can get the size of the bid and ask, in addition to the price.
Another problem in entering a market order is if your order is for a large number of shares in relationship to the average daily trading volume. My client entered a trade for 30,000 shares when the average daily trading volume of that security was 15,000. In this scenario, a market order could be filled at a price vastly different than the then prevailing price. It is for this reason that when a person owns restricted securities, the selling shareholders are restricted from selling so many shares based on daily average volume. If the shareholders try and dump too many shares, they will depress the market.

Rumors
Hot news, a significant event, or a rumor related to the company whose stock you are considering buying or selling can greatly increase trading volume and thus generate a price swing in that security. Back to our example, the young man had gotten a hot tip about a big event happening at the company and was told that the stock would really go up. Well, it did. The hot tip was not wrong. The problem with any hot tip is that you are not the only one who gets it, much less the first one. What really happened to this stock, is that quite a few people got wind of this hot tip, they all rushed into the market to buy the security and in doing so, pushed the price up. It is probably safe to assume that the individual who spawned the hot tip had all of his shares bought at a price less than 8 cents. Think twice before acting on hot tips.

Limit Orders

If you decide to play in these fast markets and trade in volatile stocks, my suggestion is that once you’ve gotten a real time quote for the bid and the offer, put in a limit order, as opposed to a market order. A limit order is an order to buy or sell at a specified price or better. Your limit order should reflect the maximum you are willing to pay for the stock or the minimum for which you are willing to sell the stock. Most people don’t understand that if a stock is selling for a $1 and you put in a limit order of $1.20, you order should be filled at $1 (assuming that when your order hits the system, the offer is still $1 in the size that you are trying to buy). It is not true that if you put in a limit order of $1.20, that you will only get filled at $1.20. In the old days, this type of order was called “limit or better”. Anyone who is buying is always willing to buy it for less and anyone who is selling is willing to sell it for more. The “limit” is the most you will pay or the least you will accept. Most online firms do not have the words, “or better” after the word “limit” on their order screens. However, this is the way that firms should treat a limit order. If you need to clarify this with your particular brokerage firm, do so before entering a limit order.

Stop Orders and Stop Limit Orders

Stop orders and stop limit orders can be excellent tools with which to play the volatile markets. Like a limit order, they provide significant control over the price your order is executed. On the buy side, a stop order is an order to purchase a stock above the current prevailing price. You enter a specific price per share, and when the stock goes up and trades at your specific price, your order immediately changes to a market order and you are filled in line with other market orders at the then prevailing price. This means that your order could be filled at a price other than your stop price, just like when you enter a market order.

A stop limit order is also an order to buy above the then prevailing price. The difference is that when the stock trades to your limit price, your trade is executed – but only at the limit price. Remember – with a limit order you will get your limit or better, but with a stop limit, you will get your limit price or nothing at all.

These orders are best used on stocks that trade up to or down to certain prices. If IBM is trading at $100 and you believe that if it trades to $105, it’s on an up trend and will go to $120, you might put in a buy stop limit order at $105. Let’s say that IBM moves from $100 to $120 and that you got filled at $107 (your order converted to a market order). You are happy because you benefited from the up trend. For that, you were willing to take the risk of the price fluctuation. If you had instead put in a stop limit order at $105, then you can eliminate the risk of not knowing what price you will get filled. You know that either you will get filled at $105 or not at all. The risk of using the stop limit order is that you may not get filled at all. If, at the time your order goes through, there is not available the volume of shares you specified at the price you specified, your order will not go through and you will have missed the up trend.

If you have a job, the limit order, the stop order, and the stop limit order can be useful tools. You can enter trades and go to work without sneaking furtive glances at your online account all day. But market orders? Stay put and watch that monitor.

Tracy Pride Stoneman is a Colorado Springs attorney specializing in investment related complaints. 

Preparation of this article was assisted by Douglas J. Schulz, a registered investment advisor and former stockbroker residing in Westcliffe, Colorado.