By Richard L. Muehlberg*
Posted: February 22, 2008
If you put 10 different day, swing and trend traders on a panel, then ask them, one by one, about the advantages of using limit, market and stop loss orders, you would probably end up with a lively discussion. If I were on this hypothetical panel, I would add to the liveliness!
I am a day trader by orientation. In a day trading context, the best time to enter a trade can be measured in seconds.
Limit Orders
Limit orders are precise. You enter at the price you specify or better or you do not enter. One disadvantage of a limit order over a market order is that a limit order takes extra seconds to prepare. These extra seconds can cause you to miss a sharp run. If you miss a sharp run, you can mentally zone out. You can peevishly feel that if the run "won't let you enter" then "to heck with it". You can end up standing on the sidelines. (This has happened to me…I do not think I am the only trader who has sidelined him or herself this way.)
Suppose you are in a position and the price runs against you. If you try to use a limit order to exit, you can end up chasing the price and deepening your loss. If you fail to "catch the price", you can peevishly lose interest in exiting and ignore your deepening loss. (I have experienced this.)
Market Orders
Market orders are quick. If you see a good trade, according to your trading system, do not over-think your order. Do not second-guess or doubt yourself. Place a market order! The moment you place the order, it will usually be executed immediately. What are your objections? Are you thinking, "Market buy orders get filled on the ask. Market sell orders get filled on the bid. I leave myself open to getting hammered by the spread."
Think on this: When you place a limit order, your order will only be filled when the ask hits your buy price or the bid hits your sell price. You do not escape the spread by choosing a limit over a market order. I will talk more about limit orders later.
Stop Loss Orders
What about stop loss orders? Again, I bring a day trader's bias. One disadvantage with a stop loss is that you can fixate on the price you set. You can develop "tunnel vision". This is the phenomenon of ignoring all other price activity in related markets. All you can see is the market you are in and the price at which you have set your stop loss. (I have experienced this, too.) I will talk more about stop loss orders later.
Limit Order or Market Order…When Is a Good Time to Use Them?
Here is an example of a well-timed market order: The clock shows 3:50 p.m. Eastern. The New York Stock Exchange will close in 10 minutes. Earlier in the afternoon, during the 1:00 to 3:00 p.m. time period, the S&P 500 attempted a weak rally, then broke.
Let's say you went short on that break. (You sold the futures and / or the S&P 500 exchange-traded fund SPY.) You used a market order. You were filled immediately. The ride down was rough. The price staged micro rallies but worked lower. After the close of bond futures floor trading at 3:00 p.m. Eastern, the S&P 500 rallied sharply.
At approximately 3:50 p.m., the price broke again. So, there you were… you had a choice to make…hold your short or exit. You had to think fast. You decided that a disciplined exit was a good idea. The price was jumpy. Here was your dilemma: If you set a limit buy order, the market might run away from you. If you opted for a market buy order, you knew you would catch an ask. You opted for a market buy order. Good move!
The price action I just described really happened. The day was November 30, 2007. Just seconds after your exit, the S&P 500 spiked higher. You pocketed a decent profit that otherwise would have turned into a painful loss.
Here is an example of a well-paced limit order: Say you have your eye on crude oil futures. Crude oil is in a four-day downtrend. The price has been setting lower highs for four days in a row. Today, the price broke sharply during the early morning hours. Now, you see the price hit support at a low that was established earlier in the month. You see the price rally off that support.
The price is working higher now. It may test resistance at yesterday's low. You plan an ambush. You place a limit sell order just above yesterday's low. The price is hit. You are now short crude oil. Within minutes, the price begins to break sharply. Just before the close of crude oil futures floor trading, you take your profit.
Of course, the price action I just described also just really happened. The day was November 30, 2007.
Limit orders and market orders are tools. Each tool has its strengths and weaknesses. In the right situation, one is better than the other. In a fast-moving situation, use a market order. In a situation where you can see "obvious" support or resistance, use a limit order. Another occasion to use a limit order is in a slow-moving market. Get the price you want or walk away.
Limit order or market order? Let your training and the situation be your guides. Stop loss orders? Yeah, you're supposed to use a stop loss order to protect yourself from yourself. Because I'm primarily a day trader, I find that placing stop loss orders, then moving and cancelling them, creates an administrative burden for me. The burden can slow my reaction time, and I can easily leave a forgotten stop loss order in effect. Forgotten orders can bite.
However, if you are a swing trader or a trend trader, then, yes, use stop loss orders. Your need to act fast is diminished. But, if you're a day trader, my vote is to steer clear of stop loss orders. Stay alert! Trade liquid markets. Avoid wide spreads. Study how orders work. Study how markets work. And, always appreciate how your own mind works. Do what is right for you and for the situation.
*Reprinted (and modified) with permission from Richard L. Muehlberg (richardmue@yahoo.com), full-time trader and online publisher, www.DayTradingWithLinesInTheSky.com
