Swing Trading - How to Use Limit Orders to Boost Returns

Buy Limit

A buy limit order is an order to buy a stock at a pre-determined price that is below the market. For example, if a stock is currently trading at $24.00, a buy limit may be entered at $23.00. It will be executed at $23.00 or better (i.e. lower) - if/when the stock trades down to that level.

A typical amateur mistake is to use limit orders where a market one will do. Amateurs use limit orders presumably to get a better price. But since most limits are calculated arbitrarily (just to get an instant "bargain"), the execution price does not matter much in the big scheme of things. It is much more important to buy stocks at the right time - i.e. close to pivots during breakouts. My experience has been that if you buy a stock within 2 days of a breakout and keep it for the duration of advance, your return will be more or less the same over time.

The risk of placing buy limit orders in a fast moving stock is that the stock may run away from you - your order will never get filled, forcing you to buy higher or abandon a profitable trade. The flip side is that the stock trades right through your limit and continues to slide, leaving you with a loss. So if you buy, just buy at the market.

One notable exception is buying thinly traded stocks. If you place a market order for 1,000 shares in a stock quoted at, say, $7.46 that trades less than 100,000 shares a day, chances are you will only get the first 100 shares at that price. The rest may get filled as follows: 100 - at $7.50, 200 - at $7.60, 173 - at $7.75, 400 - at $7.98, 27 - at $7.87. The worst part: once your order is filled, the stock comes right back down to around $7.40 and stays there. In a situation like that it is better to use a buy limit order. But, again, if you place your order below the market, the stock may run away from you or simply never go there. Instead, if it is quoted at $7.46, enter a buy limit for 1,000 shares at $7.46.

The risk here is that you may only get 100 shares at $7.46 and the price will move up, leaving the balance of your order (900 shares) unfilled. If you chase the stock by adjusting your buy limit upward to get the remaining 900 shares, your broker will charge you another commission. Your order may cost you. The best thing is to place a buy limit AON (all or none) order. It will only get executed if the entire amount, 1,000 shares in our example, is available at that price.

Using AON buy limits in thinsters is a good way to gauge share availability. If only 100 shares are quoted at $7.46 but your buy limit for 1,000 shares is filled instantly - chances are there is plenty of stock for sale, the seller just does not want to show his hand. If, on the other hand, your AON buy limit order for 1,000 shares does not get filled and the price moves away from you - the stock is scarce and difficult to buy - you'd better hurry to get it while the price is still low.

There is a simple explanation behind these phenomena: behind each stock there is a specialist or a market maker. They have a much better feel for the stock (and your intentions), and more resources and patience to outsmart you. If they sense you are anxious to buy, they will yank the offer(s) and make you chase the price upwards. They may even sell you shares they don't own by going short and covering later at a lower price (sometimes even buying back from you, if you sell in frustration on a pullback). The bottom line is: don't try to beat these guys at their game, just buy.

Sell Limit

A sell limit order is an order to sell a stock at a predetermined price that is above the market. For example, if a stock is currently trading at $45.00, a sell limit order may be entered at $46.00. It will be executed at $46.00 or better (i.e. higher) if/when the stock trades up to that level. Amateurs use sell limit orders to lock in profits after they buy a stock. Again, most sell limits are calculated arbitrarily: it's either a nice round number or a percentage gain - say 10 or 20% from the buy point.

There are several problems with this approach:

1) Your number one concern after you buy a stock should be protection of principal. Before counting profits you don't yet have, it is more important to place a sell stop order below your purchase price to limit your downside (stop orders are covered in a separate article that follows).

2) The number one complaint about poor returns that I hear from newbies and oldtimers alike is that "I sell my winners too soon but fall in love with my losers." If you never sustain losses, booking 10% or even 5% gains several times a year will amount to respectable gains. The problem is: gains are not possible without losses. If you book your gains too early, the sudden, inevitable, and sometimes unpleasantly large losses may still leave you in the red. Let the stock decide how high it wants to go. It will flash sell signals eventually. But it may be 50% or 100% above your buy point. Why limit yourself to 10% or 20%?

3) The flip side of No. 2): the stock stops a few pennies shy of your sell limit and reverses. Your insistence on getting the last few pennies out of your winner may turn that winner into a loser.

Another thing about limit orders is that, like it or not, we all think and act alike. If you feel $30.00 is a good "logical" place for your limit, chances are thousands of others think the same. This creates a congestion of orders at certain price levels that you don't see but the specialists / market makers do. These guys thrive on volatility; they don't care which way a stock is moving. A bunch of orders hanging above or below the market is money in their pocket - so they will move the stock there just to clear out the orders. Once the mission is accomplished, the stock returns to its natural trading range.

The bottom line: if you want to sell - sell, don't fight for the last penny. To protect your profits, learn how to recognize sell signals and place logical stops.

Slav Fedorov is a full time stock trader and founder and managing member of TradingZoom, LLC - a provider of proprietary trading data that swing traders can put to work right away.
http://www.tradingzoom.com/

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