Intro to Stock Trading

We’ve covered financial statement analysis, financial ratios, ways to identify excellent businesses, and alternative investments such as REITs and foreign bonds; all designed to help you learn what to look for in an investment. Few people realize that how you acquire (or sell) those same investments can affect your returns, sometimes in a substantial way. In this beginner’s stock trading tutorial, you’ll be empowered with the knowledge necessary to place the types of trades that meet your personal requirements and objectives. From the basic market order to more advanced orders such as trailing stop losses and brackets, you’re sure to add a few tricks to your arsenal of investing wisdom. (Please note that these trades are meant to be used in the context of a disciplined, long-term investment strategy, not for the purposes of short-term or day trading.)

Market Orders

The simplest and most common type, market orders simply tell your broker that you are willing to take whatever price is presented to you when your order is executed. These orders are often subject to the lowest commission since they are the easiest to execute. Imagine you want to buy 100 shares of Apple Computer, Inc. (Symbol: AAPL). The current market price is $53.95. You log into your brokerage account or call your broker directly on the phone and tell him, “Place a market order for 100 shares of Apple Computer, ticker symbol AAPL”. By the time the order is actually executed a few seconds later, the market price may be higher or lower; $54.10 or $53.75 for example. Your cost before commissions will vary accordingly; in our example, the difference between $5,410 for the round lot and $5,375, or $35. That may not seem like much, but thanks to the time value of money, those savings can result in a substantially larger nest egg.

Limit Orders

A limit order allows you to limit either the maximum price you pay or the minimum price you are willing to accept when buying or selling a stock. The primary difference between a market order and a limit order is that your broker cannot guarantee that the latter will be executed.

Imagine you want to buy 300 shares of U.S. Bank stock. The current price is $29 per share. You do not want to pay more than $27.50, so you place a limit order set to execute at $27.50 or less. If the stock falls to that price, your order should be executed.

There are three considerations you should take into account before placing a limit order:

1. The stock price may never fall (or rise) to the limit you’ve established. As a result, your order may never be executed.
2. Limit orders are executed by your broker in the order they are received. It is possible that the stock you are interested in buying (selling) will reach your limit price yet your trade will not be filled because the price fluctuated above (below) your limit before the broker could get to your order.
3. If there is a sudden drop in the stock price, your order will be executed at your limit price. In other words, imagine the stock you want is trading at $50 per share. You have a limit order placed at $48 per share. The CEO resigns, and in a single session, the stock plummets to $40 per share. As the security was falling in price, your order was executed. You are now sitting on a loss of $8 per share.

All-or-None Orders

Normally, when you purchase a substantial amount of a company’s common stock, your broker will fill your order over the course of several hours, days, or even weeks, as opportunity arises. This will prevent you from “moving the market” – or drastically increasing (decreasing) the price of the stock by flooding the market with a single, huge order.

At times, however, you may want to place an order at a single price. This can be an efficient way to place your order while ensuring a minimum amount of bookkeeping; always a consideration if you are managing a larger portfolio with several hundreds of thousands, or millions, of dollars in equities. The solution is to place an all-or-none trade. All-or-none trades essentially tell your broker that you do not want your trade executed unless he can do so in a single transaction. The minimum qualification for an all-or-none trade is three round lots or more (300 shares).

Besides the usual caveats, there are some additional considerations before placing an all-or-none order:

• Your all-or-none order will not be executed if there are not enough shares available in a single transaction to cover it.
• All-or-none orders are not placed until all of the orders ahead of it with no special conditions are executed.
• All-or-none orders can only be applied in conjunction with a limit order; market orders are not eligible. (You can get the same result by simply placing a limit order 10 cents above or below the current market price.)

Stop Order and Stop Limit Orders

In common parlance, stop and stop limit orders are known as “stop loss” orders because speculators use them to lock in profits from profitable trades.

A stop order automatically converts into a market order when a predetermined price is reached (this is referred to as the “stop price”). At that point, the ordinary rules of market orders apply; the order is guaranteed to be executed, you simply don’t know the price – it may be higher or lower than the current price reported on the ticker symbol.

Contrast that to a stop limit order, which automatically converts into a limit order (not a market order) when the stop price is reached. As discussed earlier in this tutorial, your order may or may not be executed depending upon the price movement of the underlying security.

Sell Short and Buy to Cover Orders

As you learnt in The Basics of Shorting Stock, selling short is an extremely speculative practice that can, theoretically, lead to unlimited losses.

Here’s how it works: You think that Company ABC is grossly overvalued. Management is terrible, financial condition is deteriorating, the sales outlook is pitiful, and, you believe, the stock price does not fully reflect these apparent realities. You are convinced the stock is going to fall substantially from its current price of $10 per share.

To take advantage of the situation, you enter a short sell order for 1,000 shares, borrowing the $10,000 worth of ABC shares (1,000 shares x $10 each) from your broker, selling them on the open market, and pocketing the cash. You hope that the price of ABC common stock will fall, you'll be able to purchase the shares at a lower price and return them to your broker, pocketing the difference. If, for example, ABC fell to $7 per share, you could repurchase the 1,000 shares for $7K by placing a buy to cover order, return them to your broker and pocket the $3K profit. (The buy to cover order is not the same as a regular market order; it effectively returns the borrowed shares to your broker and must be used to close your short position.)

There are a few rules regarding short selling that are important:

• In order to sell short, you must have margin privileges on your brokerage account.
• You cannot short a stock as it is falling in price. For exchange-traded securities, short sales can only be placed if the most recent trade is higher than the previous one (known as an “up-tick”) or equal to the previous trade (known as a “zero-tick”). Over-the-counter securities can only be shorted on up-ticks.
• You must maintain enough purchasing power in your account to place a buy to cover order on your short sale. If the stock price increases on your shorted security, you may face a margin call to ensure you have to capital necessary to repurchase the stock and return it to your broker.

Day and GTC Orders and Extended Hours Trading

When you place an order, you must give it an expiration date. Day orders are good until the end of the trading day, at which point they are cancelled; all market orders are placed as day orders. Good-till-Cancelled (GTC) orders, however, remain open until one of three things occurs:

1. They are completely filled
2. You cancel the order
3. Sixty calendar days pass

There risks in using Good-till-Cancelled orders:

• You may forget you placed the order; a lot can change in 60 days!
• If you place a large trade with Good-till-Cancelled status, you will pay a commission each day your order is partially filled. If, on the other hand, your order is filled by multiple transactions in a single day, your broker should only charge you a single commission.

Extended Hours Orders

The extended hours market allows you to place trades between 8 p.m. and 8 a.m.; times when the market is traditionally closed. This system permits investors to react to corporate announcements and news prior to the next session. There are a number of risks associated with extended hours orders; primarily an increase in volatility as a result of decreased liquidity. Any time there are fewer shares trading hands, stock price movements larger because buy and sell orders have a disproportional influence upon the quoted value. As a result, the price you pay for an extended hours trade can differ substantially from what you would pay (or receive) during regular market hours.

Trailing Stop Orders

One way to protect gains and limit losses automatically is by placing a trailing stop order. With a trailing stop order, you set a stop price as either a spread in points or a percentage of current market value.

Imagine you purchased 500 shares of Hershey Chocolate at $50 per share; the current price is $57. You want to lock-in at least $5 of the per share profit you’ve made but wish to continue holding the stock, hoping to benefit from any further increases. To meet your objective, you could place a trailing stop order with a stop value of $2 per share.

In practical terms, here’s what happens: Your order will sit on your broker’s books and automatically adjust upwards as the price of Hershey’s common stock increases. At the time your trailing stop order was placed, your broker knows to sell HSY if the price falls below $55 ($57 current market price - $2 trailing stop loss = $55 sale price). Imagine Hershey increases steadily to $62 per share; now, your trailing stop order has automatically kept pace and will guarantee at least a $60 sale price ($62 current stock price - $2 trailing stop value = $60 per share sale price). In other words, the trailing stop order will increase in your favor and lock in any gains you’ve made in the interim. If Hershey were to fall to $60, your trailing stop order would convert to a market order for execution, your shares would be sold, and should result in a capital gain of $10 per share.

Bracketed Orders

One thing to consider: If you're planning on holding a particular investment for an extended period of time because you believe its long-term potential is substantial or that it is undervalued, placing a trailing stop order may not be a sensible course of action. As an asset class, stocks are notorious for their collective and individual volatility; the road is certainly bumpy. Yet, you may not be able to profit from your convictions because your trailing stop orders could be triggered as a result of ordinary volatility. If you have any doubts or questions, consult your financial advisor.

Bracketed Orders

Bracketed orders go one step further than trailing stop orders. Just like the latter, you set a trailing stop as either a percentage or fixed spread (recall that on the previous page, our trailing stop was $2 for Hershey). In addition, however, you can establish an upper limit that, when reached, will result in the stock being sold. Going back to our Hershey Chocolate example, let’s now assume you placed a bracketed order with a trailing stop level of $2 per share and an upper limit of $65 per share. The bracketed order will behave exactly the same as the trailing stop order, with the $2 trailing stop automatically ratcheting up as the price increases. The difference? When and if Hershey hits $65, the bracketed order will automatically convert into a market order and should be immediately executed by your broker.

Summary

Congratulations! You've reached the end of the stock trading tutorial. You now have the basic building blocks to help you make better decisions for your portfolio. This handy summary will serve as a cheat sheet in the future:

• Market orders guarantee execution but not price.
• Limit orders guarantee price but not execution.
• All-or-none orders are only executed if the broker has enough shares, as a block, to fill your order in a single transaction.
• A stop order automatically converts to a market order when a predetermined price (the stop price) is reached. A stop loss order, on the other hand, automatically converts to a limit order when the stop price is reached.
• When you sell short, your potential losses are theoretically unlimited.
• Day orders expire at the end of a trading day. Good-till-cancelled orders stay on the books until they are completely filled, cancelled, or sixty calendar days have passed.
• Due to the lower level of liquidity, extended hours orders are subject to far greater volatility than those placed during the regular market day.
• Trailing stop orders can be used to lock-in profits while potentially benefiting from the increased rise in stock price.
• Bracketed orders are the same as trailing stop orders, except that they require an upper limit trigger price which, when reached, results in the stock being sold.