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Don’t Get Taken by the Trader: How to Get the Best Prices on Stocks and Options

By Dr. Steve Sjuggerud, President, Investment U
Thursday, April 17, 2003: Issue #233

I’ve learned a lot over the years about the CORRECT way to place a trade. Early in my career, I had no idea just how important the details could be when placing a trade. But I learned quickly.

Having been a broker, an institutional trader, and a hedge fund manager (among other things), I’ve traded every type of financial instrument and placed every type of order. Today, we’ll look at what types of orders you should use to trade smartly and how to avoid giving anything away to the trader, like I did trading options a long time ago.

The Trader Killed Me…

I knew I was going to make a mint that day it didn’t matter what price the trader gave me or so I thought.

I was just starting out. And I felt strongly that this particular option was worth $4 and that it could well close at $6 by the end of the day, for a 50% profit in a day. So I put in a “MARKET” order to make sure I got in that morning, at any price.

The trader killed me-he filled my trade at $7 and then moved the market to $4. The option closed at $6. But instead of making a 50% profit, I took a loss. All because I didn’t know what I was doing. I didn’t know how to properly place orders.

I don’t know about you, but losing money is a powerful teacher. Like touching a hot stove, you quickly learn you want to avoid that miserable experience if at all possible.

Knowing When To Fight The “Spread”

Before we get into “MARKET” orders and “LIMIT” orders, you’ve got to understand something called the “SPREAD.”

Let’s say you’ve got a 5-year-old car worth $12,500. You take it to a dealer to see if he’ll take it off your hands. He says he’ll give you $10,000 for it. But you say: “Hey that’s not fair. You’ve got the exact same car on your lot for $15,000!”

My friend, the difference between $10,000 and $15,000 is the spread.

If you sold your car, you’d like to get $12,500, not just $10,000. And if you were looking to buy, you’d much prefer to pay closer to $12,500 than the $15,000 the dealer is asking. So when you’re buying a car, in order to get the best deal, what you’re looking to do is ELIMINATE THE SPREAD.

In big stocks, like Microsoft, Intel and basically any other company you’ve already heard of, the spread is not a concern. There are so many buyers and sellers, you’re best off just putting in a MARKET ORDER, and you’ll own the shares immediately at the market price. (In fact, the spread on Microsoft, a $25 stock, is only 1.5 pennies as I write.)

Unless you are some kind of lightning-fast day trader, you should always use a MARKET order on major stocks. For a simple rule of thumb, we’ll define a major stock as one with a market cap (market value) of over $1 billion. That pretty much covers most stocks that you’d probably consider buying. And it covers nearly all of the stocks that are household names.

Now some may quibble with this $1 billion rule. Some people may try to save a little on the entry or the exit with another type of strategy. But for nearly all investors, a market order is fine. You’d hate to miss a huge great gain over a measly half of a percent.

How To Fight The Spread-And Avoid Getting Burned-In Small Stocks

However, in small stocks (less than $1 billion in size) and in options, you’re better off wheeling and dealing-fighting the spread. Options and small stocks can have a significant spread. Here it’s more risky to put in market orders, especially at the open (as I shared with you above). The lesson I learned above was this: Don’t use market orders on thinly traded positions-eespecially not at the open!
Let’s look at a real stock. Let’s take Qualcomm.

If you wanted to buy shares of Qualcomm right now, you’d find that there are two prices quoted – the BID PRICE ($33.09) and the ASK PRICE ($33.11)

The ASK PRICE (sometimes called the OFFER PRICE) is what you’d pay if you wanted to buy the shares right now, at any cost. Now take a look at that spread. It’s two pennies. Is it really worth haggling to get the trader to lower the price for you to $33.10? I don’t think so. It sure isn’t the $5,000 spread the car dealer has.

So to buy at the market price (to accept the trader’s price of $33.11), you would simply place a MARKET ORDER with your broker, which instructs him/her to buy the shares for you at the current market price, whatever it may be.

When it comes time to sell, you receive the BID PRICE instead of the ASK PRICE. So you would receive a price of $33.09.

If you were buying, and you didn’t want to pay the asking price of $33.11, but thought that $33.10 was a fairer price, you would enter a LIMIT ORDER to buy at $33.10. Since that price is below the current price, chances are your order won’t be filled right away. But it might. Again, I wouldn’t bother with this penny. But if I had put in a limit order on my options trade of $4 instead of a market order, I wouldn’t have been hammered by the trader.

Orders default to what’s called a “DAY ORDER,” which means it’s good for that day. Unless you specify “GOOD ‘TIL CANCELLED (GTC)” or “FILL OR KILL (FOK),” a DAY ORDER is what you’ve entered. These are all self-explanatory-a day order lasts all day. A GTC order is open for days and weeks until you cancel it. And a FOK order is a one-shot deal. I never use GTC orders (as I’ve seen people forget about them). And I’ve only rarely used FOK orders. Market orders and limit orders (both of which are day orders) should cover things.

You can also enter a STOP ORDER to limit your downside, but I don’t recommend these either. Imagine buying an option at $4 and then putting an order in that you want to sell at $3 if it falls there. That is a bad idea. That is like buying a house for $400,000 and telling everyone you’re willing to sell it for $300,000. As a general rule, don’t show your hand – use MENTAL stops (stops that you keep in your head) – not actual stop orders.

Well, that about covers the basics of placing an order. Summing up our rough guidelines:

Use MARKET orders on stocks that are valued at over $1 billion
Use LIMIT orders on options and stocks below $1 billion
Don’t bother with the rest of the types of orders

If you follow these three simple guidelines, you should avoid getting burned by a trader either on the “spread” or by inadvertently tipping your hand.

Good investing,

Steve

Today’s Investment U Crib Sheet

The goal today was to give you a simple set of rules that anyone can apply when it comes to trading. Now there are instances, of course, where I might use a limit order on a stock over $1 billion in size. And I may even use a market order on an option, if it is a Microsoft option, for example. Everyone trades differently. Everyone’s rules are different. But these rough guidelines make a complex topic very simple. You will not get hammered by following these simple rules.
For those of you who are new to the Investment U e-Letter (or anyone in need of some guidance) I would urge you to visit the IU e-Letter archives and check out IUEL #176: Timeless Rules of Investing. Here you’ll find 50 rules to help guide you through any market and to help you steer clear of trouble.