Corporate Finance For Dummies
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After you decide that you want to buy or sell stock, you have to decide the type of buy or sell order you want to place, the price at which you want the transaction to take place, and the timing of the transaction. These factors can all be controlled by managing your transaction order.

Say that you want to buy 10 shares of Ford stock for $10 per share, and you want the transaction to take place as soon as a seller of that many shares at that price becomes available. Basically, all you do is give that order to your broker or set it up online using your brokerage account.

Whether your order is fulfilled or not depends on whether a seller can be found who’s willing to sell 10 shares for $10 per share.

That brings up a very quick point: the mechanism by which the price of equities is set. Pricing is actually performed in a sort of dual-auction system, where potential buyers and sellers negotiate back and forth on price until a price is established that allows a transaction to take place. This compromise is found through fluctuations in the bid and ask prices of the stock:

  • The ask price of a stock is the price that the people who own the stock are willing to sell it for. When the owner of a stock wants to sell his shares, he must ask for a price that buyers are willing to pay, or he won’t be able to sell his shares.

  • The bid price is the price that buyers are willing to pay to purchase shares of a stock. The buyer must pay a price that sellers are willing to sell their shares for, or he won’t be able to buy those shares.

  • The spread is the difference between the ask and bid prices.

The price of a stock is established when two people find a compromise in the spread whereby the buyer is willing to pay a particular price and the seller is willing to accept that price.

The price of a stock increases when buyers are willing to compromise more, paying the ask price or even more. The price of a stock decreases when the sellers are willing to compromise more, accepting the bid price or even less.

The different types of orders available are meant to manage the interaction between the bid price, the ask price, and the spread. They do this by allowing the investor to determine when and at what price the transactions will take place, if at all.

Market order

Easily the simplest type of order for the purchase or sale of equity is the market order. In a market order, the investor simply accepts the price set by the other side of the transaction. If the person setting the market order is a buyer, the price established automatically becomes the ask price, and the exchange happens nearly instantly because the buyer isn’t waiting for the seller to come down in price.

If the person setting the market order is the seller, the price automatically becomes the bid price, and that exchange, too, occurs almost instantly.

Stop and limit orders

That stop and limit orders are even differentiated from each other is really just silly, because the distinction has more to do with the motivation of the traders rather than the actual mechanism of the order.

Stop and limit orders are used to manage the price at which a transaction takes place. For instance, an investor may want to place an order whereby shares are not purchased until prices either drop below or rise above a certain level.

Once the trigger that the order is dependent on occurs, it automatically takes place assuming a partner to the exchange is available at a given price. The same can apply to selling shares: Someone may place an order to sell a specified number of shares only if and when the price of the stock increases or decreases by a predetermined amount.

The motivation behind this strategy depends on the order and the price. If someone sets an order to sell shares once they drop below a certain price, she’s likely attempting to limit her potential losses from the price going too low. If someone wants to sell shares after the price increases, she likely has a strategy in mind that involves walking away with the revenues from the sale.

If an investor wants to purchase shares after they drop below a specified price, she likely believes that this particular price would be a good deal and that the price will rebound upward. If she wants to purchase shares after the price increases past a certain point, she may be waiting for the rebound on the stock price to have already begun, to ensure that the company isn’t simply performing poorly in the market.

The price that the order is set at isn’t necessarily the price at which the transaction takes place. Because these types of orders are typically “at price or higher” or “at price or lower,” market gaps can occur that cause the transaction to occur at a price that surpasses the milestone price.

If these orders are all basically the same thing anyway, why do we differentiate between stop orders and limit orders? Really, it’s all about motivation. A stop order is an order to sell shares once they drop below a certain price, stopping the amount of potential loss that may be experienced.

Limit orders are orders to purchase shares once they drop below a certain price or to sell shares once they exceed the trigger price. Stop and loss orders are really all the same thing, though, and are treated as such in computer-automated trading.

Pegged order

A pegged order is a bit like a stop or limit order in that the exchange doesn’t take place until the trigger price is reached, but that trigger price changes along with the value of some other variable, such as an index or economic metric. Once that variable reaches a particular value, the peg fluctuations stop, and the order is set.

Time-contingent order

An order may be contingent on time. Some orders are delayed for a predetermined period of time before they’re entered into the market. Other orders are cancelled if they’re not fulfilled before a certain period of time.

For example, day orders are time-contingent orders because they’re cancelled at the end of the trading day if they’re not filled by then.

About This Article

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About the book author:

Kenneth W. Boyd has 30 years of experience in accounting and financial services. He is a four-time Dummies book author, a blogger, and a video host on accounting and finance topics.

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