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Limit Orders: Here's the How and When

April 28, 1998|WALTER HAMILTON

Here's the way you should think of limit orders for stocks: They're of limited use in limited situations.

Much has been made about limit orders in the 15 months since Nasdaq changed its trading rules. And, indeed, limit orders can help investors buy and sell some stocks at desired prices.

But limit orders are far from being a panacea for small investors, primarily because they involve a basic trade-off: Is it more important to buy or sell a stock at an exact price but run the risk that it gets away from you without ever hitting that level? Or is it better to give up a little in price in exchange for the certainty of having bought or sold the stock?

There's no right or wrong answer. What's important is understanding how limit orders work and under what general conditions they should be used.

"They're useful in certain situations," said Amy Robinson, managing director of equity trading for the Phoenix, Duff & Phelps mutual fund group. "I wouldn't say you use them 100% of the time. Nor would I say you never use them."

First, some order terminology: Small investors can place two basic types of orders--market orders and limit orders.

A market order is just that, an order to buy or sell a stock at whatever price it currently trades in the market. It's a bit like writing a check but leaving out the amount. You send in an order and aren't sure of the price you're going to get.

A limit order, by contrast, instructs a broker to complete the transaction at a specific price.


The Nasdaq reform plan came about because some Nasdaq stocks had extraordinarily wide spreads between the "bid" price, at which a broker buys from an investor, and the higher "asked" price, at which the broker sells.

Individuals who filed limit orders within the spread often were ignored. Or worse yet, a limit buy order was disregarded when a stock was going up but filled when it was going down as dealers tried to blunt the slide in stocks they owned.

The new Nasdaq system, therefore, is helpful because it puts some teeth in small investors' limit orders by giving them a real chance at "price improvement"--getting a better price than dealers are offering at any given moment.

Naturally, then, limit orders might be most useful in trading smaller and less-liquid stocks in which spreads are very wide. In such cases, placing an order in between the dealers' bid-asked spread may help a small investor who wants to buy match up at a specific price with another investor who's trying to sell at that price.

Limit orders might be less useful in the case of larger Nasdaq stocks whose spreads are already very narrow--often just a sixteenth of a dollar between the bid and asked.

What's the downside of using limit orders? They aren't advisable in every market or with every stock.

Consider a stock with a $20 bid price and $20.25 asked price. In other words, the broker will buy from you at $20 and sell to you at $20.25. You put in a limit order to buy at $20.125 (20 1/8). But the stock moves up and by day's end trades at, say, $20.75 bid/$21 asked.

You've missed the stock. Now you must make another decision. You can either put in a limit order or a market order at higher prices. Or you can sit tight and hope the stock falls back to $20.125. The problem is the stock may never come back to you--a common occurrence in a strong market.

"It doesn't suit our needs a lot of the time to sit back and passively let a stock come to us," said Kevin Cronin, head of listed equity trading at Aim Management Group Inc.

Some professionals say the use of limit orders hinges on how much faith an investor has in a stock's near-term potential. If you have high hopes for it, it might be better to jump aboard with a market order. If you're less certain about the stock, use a limit order to guarantee a target price.

But other pros say that if you're unsure of a stock's prospects, forget about a limit order. Don't buy the stock, period.

If you believe in the stock and are investing for the longer term, it's often better to just get in at the market price rather than try to split the bid-asked or set a limit price below the bid. In either case, the risk is that no dealer or other investor will trade at your price. (Remember, dealers aren't obligated to meet you at your price.)

Kurt Schroeder, 42, an individual investor in West Los Angeles, usually eschews limit orders in favor of market orders, especially when he's spying fast-moving stocks, even though he sometimes pays rising prices.

In some cases, he ends up shelling out 25 cents or more over the quoted price on his screen, as market makers raise their bid-asked ranges.

"I make myself mentally eat the quarter and not get hosed off, but you know it's been stuck to you," Schroeder said. "You could use a limit order to make sure that doesn't happen, but you may not get the fill."

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