Trading Mechanisms and types of orders
In our previous post, we discussed how exchanges facilitate buying and selling of shares between market participants and the role of brokers in the process. In this article let’s discuss how orders to buy/sell shares are placed on an exchange.
Let’s assume you decide to buy 1 kg of tomatoes from the nearby vegetable market at not more than Rs.10/kg. You go to the market and see that there are five vendors, all selling tomatoes at Rs 15/Kg. You start negotiating with each one of them and realize that there can be two outcomes:
Outcome 1: Just like you other customers are also demanding lower price. Seeing this vendors will start reducing the price, as nobody is willing to buy tomatoes at Rs 15/kg. It might happen that the price comes down to Rs 10/kg and after buying 1 kg tomato you go home happily,
Outcome 2: Unlike you, others are willing to pay the price of Rs.15/kg demanded by vendors. As vendors will be able to clear their stock at higher price, prices will never come down. In this case you won’t be able to buy tomatoes at Rs.10/kg and will return empty handed.
In the above example, you are the buyer, tomato vendors are the sellers and tomatoes are the commodities (underlying). Similarly on the exchange, there are many buyers and sellers and the underlying could be anything: stock, bond etc. The entire trading process takes place on an electronic system where buy and sell orders are matched. Just like in our example, suppose now you want to buy 1 share of a company A at Rs 100, currently trading at a price of Rs 108. Lets us discuss the different types of orders that can be placed to execute the above order.
Types of orders
Limit Order: You can key in an order into your computer to buy 1 share of company A at Rs.100. Just as in our earlier example there are 2 possibilities. If lot of people are demanding shares of company A, at Rs.100 and nobody is willing to pay the current market price of Rs.108, prices will automatically come down to match demand and you might be able to buy at Rs.100 or even lower than that. However if other buyers are comfortable paying Rs.108, then prices will not come down to your desired level and you will not be able to buy the shares. In a limit order, the order will get executed at your desired price or at a better price – i.e. at the limit price or a lower price in case of a buy order, and conversely, at the limit price or a higher price in case of a sell order. This order type is advantageous when the investor wants to buy/sell at a particular price and does not mind waiting for that price.
Market Order: In this case you key in an order to buy/sell the shares immediately at the current market price. Your priority is speed of order execution and you do not care about the direction of price movement. In this case you might end up buying at a higher price or selling at a lower price, as price might increase/decrease by the time order is executed.
Stop Loss order: This is a risk averse investors favorite. Suppose after buying the shares at Rs.100 you are now concerned that the price might fall further and do not want to make a huge loss. So you can enter a stop loss order at a price lower than your purchase price. Let’s assume you do not want to lose more than Rs.5 on your purchase, a stop loss order can be put in at Rs.95. If the price starts to trend down and hits Rs.95 shares will be sold and your loss will be minimised to Rs.5.
Duration order: This order variety allows you to specify the time till when the order you placed stays open. Let’s suppose you enter a limit order and make it “Good for the day”. In this case, if the order is not executed by the end of the day then it will automatically get cancelled. However if you place “Good until cancelled” order, then the order will remain open/active until the price comes down to your desired level and you are able to buy the share.