Types of Orders

Market Orders Market orders are simply buy or sell orders that are to be executed immediately at current market prices. For example, an investor might call his broker and ask for the market price of Exxon. The retail broker will wire this request to the commission broker on the floor of the exchange, who will approach the specialist's post and ask the specialist for best current quotes. Finding that the current quotes are $68 per share bid and $68.15 asked, the investor might direct the broker to buy 100 shares "at market," meaning that he is willing to pay $68.15 per share for an immediate transaction. Similarly, an order to "sell at market" will result in stock sales at $68 per share. When a trade is executed, the specialist's clerk will fill out an order card that reports the time, price, and quantity of shares traded, and the transaction is reported on the exchange's ticker tape.

There are two potential complications to this simple scenario, however. First, as noted earlier, the posted quotes of $68 and $68.15 actually represent commitments to trade up to a specified number of shares. If the market order is for more than this number of shares, the order may be filled at multiple prices. For example, if the asked price is good for orders of up to 600 shares, and the investor wishes to purchase 1,000 shares, it may be necessary to pay a slightly higher price for the last 400 shares than the quoted asked price.

The second complication arises from the possibility of trading "inside the quoted spread." If the broker who has received a market buy order for Exxon meets another broker who has received a market sell order for Exxon, they can agree to trade with each other at a price of $68.10 per share. By meeting inside the quoted spread, both the buyer and the seller obtain "price improvement," that is, transaction prices better than the best quoted prices. Such "meetings" of brokers are more than accidental. Because all trading takes place at the specialist's post, floor brokers know where to look for counterparties to take the other side of a trade.

Limit Orders Investors may also place limit orders, whereby they specify prices at which they are willing to buy or sell a security. If the stock falls below the limit on a limit-buy order then the trade is to be executed. If Exxon is selling at $68 bid, $68.15 asked, for example, a limit-buy order may instruct the broker to buy the stock if and when the share price falls below $65. Correspondingly, a limit-sell order instructs the broker to sell as soon as the stock price goes above the specified limit.

What happens if a limit order is placed between the quoted bid and ask prices? For example, suppose you have instructed your broker to buy Exxon at a price of $68.10 or better. The order may not be executed immediately, since the quoted asked price for the shares is $68.15, which is more than you are willing to pay. However, your willingness to buy at

CHAPTER 3 How Securities Are Traded

Figure 3.4 Limit orders.

Sell

Condition Price below Price above the limit the limit

Condition Price below Price above the limit the limit

Sell

Limit-buy order

Stop-buy order

Stop-loss order

Limit-sell order

$68.10 is better than the quoted bid price of $68 per share. Therefore, you may find that there are traders who were unwilling to sell their shares at the $68 bid price but are happy to sell shares to you at your higher bid price of $68.10.

Until 1997, the minimum tick size on the New York Stock Exchange was $V8. In 1997 the NYSE and all other exchanges began allowing price quotes in $Vi6 increments. In 2001, the NYSE began to price stocks in decimals (i.e., in dollars and cents) rather than dollars and sixteenths. By April 2001, the other U.S. exchanges are scheduled to adopt decimal pricing as well. In principle, this could reduce the bid-asked spread to as little as one penny, but it is possible that even with decimal pricing, some exchanges could mandate a minimum tick size, for example, of 5 cents. Moreover, even with decimal pricing, the typical bid-asked spread on smaller, less actively traded firms (which already exceeds $V8 and therefore is not constrained by tick size requirements) would not be expected to fall dramatically.

Stop-loss orders are similar to limit orders in that the trade is not to be executed unless the stock hits a price limit. In this case, however, the stock is to be sold if its price falls below a stipulated level. As the name suggests, the order lets the stock be sold to stop further losses from accumulating. Symmetrically, stop-buy orders specify that the stock should be bought when its price rises above a given limit. These trades often accompany short sales, and they are used to limit potential losses from the short position. Short sales are discussed in greater detail in Section 3.7. Figure 3.4 organizes these four types of trades in a simple matrix.

Orders also can be limited by a time period. Day orders, for example, expire at the close of the trading day. If it is not executed on that day, the order is canceled. Open or good-till-canceled orders, in contrast, remain in force for up to six months unless canceled by the customer. At the other extreme, fill or kill orders expire if the broker cannot fill them immediately.

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