investing

Try limit orders to tame stock trading risk

Highlights
  • Computer trading glitches have been blamed for wild market swings.
  • Brokers offer "limit orders," so investors can specify a price to buy or sell.
  • Limit orders can impose discipline on overeager investors.

If you took an item marked $5 from a supermarket shelf, and when you went to pay, the cashier said it's now priced $10, you'd probably demand to see the manager. But a similar scenario can occur when you're buying shares of stock.

The market moves with the buying and selling of many investors and trading firms. Within the minute it may take to check a stock price online and then call your broker with an order, the share cost could have moved up or down.

But more recently, incidents of wild market movements have been attributed to computer-driven trading glitches. The "flash crash" in May 2010 and the program-trading error involving Knight Capital Group, which disrupted pricing on some 140 stocks Aug. 1 this year, are two of the better-known anomalies.

These events only add to investors' fears, already stoked by the economic downturn. "People are wondering, 'What is going on here?'" says George Padula, a financial planning instructor at Boston University.

Outside of trading glitches, extreme volatility, whereby the Dow Jones industrial average swings more than 100 points in a day, has been on the rise, Padula says.

Fortunately, brokerage firms offer tools known as "limit orders," allowing investors to specify a price point to buy or sell. "In our investor education, we have talked about using limit orders, so you can control the situation more," says JJ Kinahan, chief derivatives strategist with TD Ameritrade.

Many firms don't charge any additional commission to use limit orders. They can be applied to transactions involving exchange-traded funds or stocks, but not mutual funds since the share price of mutual funds typically changes just once per day, Padula says. Investors can specify if they want the order to last just one day or are "good 'til canceled," meaning the brokerage firm will keep it open for a longer period such as 30 to 90 days.

Here's a primer on limit orders and related tools that give investors more price certainty.

Buy and sell stock with limit orders

How they work: Distinct from a "market order," whereby you ask a broker or go online through a discount brokerage to buy or sell shares at whatever the current price may be, a limit order allows you to specify the price at which you'll buy or sell. For instance, if you see that XYZ stock is trading at $40.20 a share and you'd like to sell at $43 per share, you'd enter that limit order.

Anytime a particular stock trades at a relatively low volume, setting a limit order guarantees you don't buy above or sell below your specified price, says Erika Safran, founder of Safran Wealth Advisors LLC in New York. And even with high-volume trading stocks, if you're determined to execute your order at a certain price, limit orders are essential.

The downsides and benefits: Anytime you place a limit order, there's no guarantee that the market price will move to that exact point and the transaction will actually go. Using limit orders means you are buying at the price you want. "They are good for (the stocks) you desire but don't feel you have to have," Kinahan says.

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