You sit down to begin negotiating with the car guy. But you have an edge. You know that the last customer paid $19,000 for the same car you’re planning to buy. The car guy knows you know this. So, the first thing you say is “the most I’ll pay for this car is $20,000.”
What!?
Why would you say that? The answer, of course, is that you wouldn’t say that. But in the world of limit orders for stock trading, this is perfectly reasonable behaviour as I’ll explain.
A sensible strategy for limit orders was explained clearly by Canadian Couch Potato. However, I’ve run into two people now who say they’ve read this article but say they just use market orders because they don’t want to dicker over small price differences. This comment makes it clear they’ve missed the point.
The point is to offer to pay more than the asking price for your shares. Yep, that’s right. Offer more. I assume that this point gets missed because it seems counterintuitive and readers get baffled by a jumble of numbers.
We all know that stock prices move around. Usually, they don’t move too much from minute to minute. So, if you see your stock with an asking price of $25 and you place a market order for 1000 shares, you’ll most likely get them for something very close to $25 each.
But sometimes stock prices swing wildly. What if the price suddenly jumps to $50 just after you place your order? You could end up paying $50,000 when you expected to pay about $25,000. This certainly won’t happen often, but even once is too often. How can you protect yourself against this?
Enter the limit order. Suppose you offer to buy your 1000 shares with a price limit of, say, $25.10 each. Does this mean you’ll pay an extra ten cents per share? In most cases the answer is no. If the asking price is below your limit, you’ll get the asking price. This means that in most cases your limit order with a price limit above the current asking price will work exactly the same as a market order.
So, why bother with limit orders? They protect you against wild market swings. When your price limit is initially above the asking price of a stock, it will only stop your trade if the stock price jumps sharply on you the instant after you enter your trade. If you’ve set a limit at the maximum price you’re willing to pay, then this works out perfectly. Either you get the shares for the best price available below your limit, or you don’t get them at all.
For selling shares, you can get the same effect by setting a limit below the current bid price for your stock.
It’s certainly true that you can use limit orders to dicker and try to save a few pennies per share by offering slightly less than the current asking price. But this doesn’t work well in the long run. Sometimes you’ll save a little, and other times your stock’s price will rise and you’ll have to pay more later. What we’re talking about here is choosing a limit price above the current ask price to protect yourself against wild markets.
So, it does make sense to offer more than the asking price when you’re buying stocks, but I don’t recommend it when buying a car. I seriously doubt that the car guy would listen to your bid and say, “That’s too high. I’ll give you the same price as the last customer.”
Ahhh... ok, I get that, I must admit at times I get confused between market and limit buys (as I don't do that much trading in shares and am forgetful in my old age), but a good point made.
ReplyDelete@Alan: I thought the car bit would make things more clear.
DeleteThe car example did help. Thank you.
ReplyDeleteI do the 'limit' thing but always wondered if I was paying too much and now I know it's okay.
RonB
For investors using ultra-discount brokerages, they should check for fees before doing this. Some of them charge what can add up to quite a hefty fee for "removing liquidity from the market." I've heard complaints of $40+ fees.
ReplyDelete(Big Bank Brokerages absorb that cost into the 6.95-9.99 regular trade fee.)
@BetCrooks: Market orders also remove liquidity from the market. So, you need to watch out for any such fees either way.
DeleteQuite right, Bet and Michael. I've been hit with those fees before for market orders and limit buys above the ask. They can be quite substantial on large orders, so it does tilt the scales in favour of the large banks that offer flat commissions and exclude ECN fees.
DeleteThis is a little overblown? To hit $40 in ECN fees at Questrade for example, you'd need an order worth well over $285,000 on a security trading at $25. Over the past year, I've paid about $6 in ECN fees buying ETFs (maybe 15 purchases over the year). That's less than the cost of a single purchase at a big bank brokerage.
DeleteGood explanation. It's a better explanation when you treat this like price insurance.
ReplyDeleteMark
@Mark: Thanks. You're right that it is like price insurance. Except that the premium (at my brokerage) is just the cost of typing in a price limit.
DeleteTimely, as I needed to do part of my rebalancing today.
ReplyDeleteIt's so unintuitive to me to "offer more than what someone is asking", it feels like the buyer will say, "hey, if you're offering me that much I'll take it!"
Didn't help that the brokerage web site actually WARNED me when I did this, required me to check a box acknowledging the message before proceeding:
[ ] "The limit price you have entered is above the current ask price"
... when I was doing it I had to keep telling myself "Michael James said this is the right way to do it!"
Sure enough, it worked great, got market price, not my 1-2 cents higher.
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[Aside]
In fact, in checking the real time quote, I wonder if I saw the price tricks I've only read about until now?
1) Bid: $28.22 / Ask $28.24 (lot size 284) / Last $28.24
2) Bid: $28.22 / Ask $28.24 (lot size 284) / Last $28.25 (!!)
1) Bid: $28.22 / Ask $28.24 (lot size 284) / Last $28.23
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Anyways, thanks for persisting in writing about this until I was convinced and gave it a shot!
@Daryn: I'm glad it worked out for you. The key is to enter a price limit you'd be content to pay. On your aside, I've seen things like that as well. It looks like some market activity happened between quotes, but I'm not a frequent trader. I see trading as just a necessary evil for owning equities.
DeleteThis is so true. One time I was trying to sell some shares at the close but I was too late, the market closed, so I figured "Ah, what the heck, I'll just put in a market sell for first thing in the morning, it'll fill near the close." Turns out it filled a good distance below the close, well over a percentage point (don't remember now, but it was shockingly bad). By the time I checked, the stock was back to trading near the previous close. Awful feeling.
ReplyDelete@Gene: As lessons go, this one sounds like it wasn't too expensive, but it's still not a good feeling.
DeleteAnother tip is to never buy a car from a car guy, alway buy a used one from an individual. This save me about 50% for each car I bought and the money I didn't spend is the money I use to proceed with limit buying orders on the markets!
ReplyDelete