Over the past two decades, ETFs (exchange-traded funds) have grown from “tiny upstart” to the fund industry’s dominant force. Each of the past several years has seen a net outflow of money from traditional mutual funds and a corresponding inflow to ETFs. This shift has been reflected in the SMI strategies, which increasingly utilize these ETFs that act like mutual funds but trade like stocks.

This trading aspect introduces a new challenge for investors who aren’t used to trading individual stocks. Because ETFs and stocks trade throughout the day (unlike mutual funds, which are priced only once a day at the market’s close), there are a variety of order types available to make trading convenient.

To accomplish this, brokers offer automated buy/sell instructions (“Buy at this price, sell at that price”). In many cases, ahead-of-time orders can help you (1) buy at better prices and (2) protect your profits. But it’s imperative that you understand how these order types work so you can protect yourself because these automated orders can also introduce risk.

The plain-vanilla “market” order

To illustrate the basic concepts, let’s start with a simple “market” order, using an ETF as an example. Assume you want to buy 100 shares of a promising new tech ETF with the ticker symbol WOW-E. Shares are trading around $20. If your priority is simply to purchase 100 shares as quickly as possible, you would enter a market order. You’re willing to pay the current market price, whatever that is at the moment your trade is executed.

For heavily traded stocks and ETFs, this usually means you will buy within a few cents of the price currently being quoted. But there is no guarantee that is the price you’ll pay. It’s possible that just as you’re entering your order, the price could move up or down. In an extreme example, if the price moved sharply as you were entering your order, you could end up paying more, perhaps $20.50 or $21 — whatever the new “best price” available is when your order hits the system.

Other types of orders

If you want more control over your buy/sell prices, several options are available. Understand, however, that none of these order types is required to follow any of SMI’s strategies — simple market orders will work fine. Venture out to use the orders described below only if you think they will help in your specific situation.

  • A “Limit” Order
    This type of order places a ceiling on what you’re willing to pay for WOW-E shares. If you enter a “limit” order at $20, that is the most you will pay, period. The advantage is that you will never pay more than you want; the disadvantage is that your order might never be filled. It’s possible that WOW-E will trade for days, never going below $20.25, and then rocket to $30. When this happens, you’ll cry and ask yourself, “Why did I let WOW-E get away from me for a lousy 25 cents?!”

    It’s easier to see the advantages of limit orders when you approach them from the sell-side. Say your WOW-E shares have risen to $28 and you decide you’d be willing to sell them if they were to reach $30. Rather than trying to continually monitor the ETF throughout the day, you could enter a limit order. If WOW-E trades at $30 or higher, your limit order will execute. The risk is that the stock could advance to $29.99 and then fall, and you’d still own it. But with a limit order you know that you’ll at least get the price you specified, or you’ll continue to own the stock. It won’t ever get sold at a price that surprises you in a negative way.
     
  • A “Stop” Order
    You bought WOW-E at $20 and it has moved up to $28. This time, however, instead of wanting to sell soon, you’d like to hold on and ride it higher. However, you know there’s a risk the price could fall. To protect your original investment, you could enter a “stop” order to sell at $21.

    This order type does nothing unless WOW-E falls to $21, then immediately converts your order to a “market” order — the first type we discussed. At that point, your shares are going to be sold immediately at the best price then available. Because stop orders typically are used to limit the damage if the market moves into a downturn, they’re often called “stop loss” orders.

    Stop loss orders have been used for a long time, but the changing nature of the market has exposed hidden dangers in recent years. With so much trading now done by computer programs that can initiate—and withdraw—orders in milliseconds, liquidity can dry up instantly.

    These events are rare, but there have been a few extreme cases (such as the 2010 “flash crash”) where, as prices fell rapidly, many automated stop orders were triggered, converting those orders into market orders. But with all of the potential buyers temporarily stepping aside, the next available buy orders were often at prices well below the price attached to the stop orders.

    That’s why it’s crucial to understand a stop order doesn’t guarantee any particular price — just that you’ll get the next available price. Rather than getting $21 per share for WOW-E, you might have received $15 or $10 or $1...whatever the next highest available bid was. (See Recent Market Correction Exposes ETF Vulnerabilities for more detail.)
     
  • A “Stop-Limit” Order
    To avoid this danger of automatically selling at a drastically lower price than intended, some brokers allow you to enter “stop-limit” orders. This combines the benefits of both stop and limit orders. The stop feature says, “take action only if this price point is hit” while the limit feature says, “and at that point, accept a sale only if it’s at least as good as the price specified.” In our previous example, a stop-limit order to sell would mean no action would be taken until WOW-E dropped to $21, at which point the order would transform into a limit order to sell at $21 or higher, but not below.

    This solves one problem — the possibility that you’ll receive a much lower price for your ETF than you anticipated. But it creates another — what if WOW-E drops to $21 and keeps falling? Your trade would never fill, and you could ride the stock much lower without selling. Stop-limit orders are useful in “normal” trading conditions where prices are moving forward and back by a few pennies at a time. They can’t be counted on to get you out during a sharp selloff, but they do offer decent protection against “normal” declines in a stock or ETF price.
     
  • A “Trailing Stop” Order
    Let’s suppose WOW-E continues to move up into the $30-plus range. In that case, you may want to move your “stop” up as well — to lock-in a certain level of profit. You can do this manually by deleting your old stop order and entering a new one at a higher price. Or, some brokers will allow you to enter a “trailing stop” order, with either a price interval (for example, $5 below the current high) or a percentage (example, 15% below the current high) specified. These orders continually adjust upward as the stock rises, allowing investors to lock in a certain level of profit (at least in theory, providing they execute near the level at which they are set).

    But beware — trailing stop orders are subject to the same shortcomings as regular stop orders: they become market orders when their thresholds are hit. To avoid this issue, some brokers allow you to enter “trailing stop-limit” orders.

Practical application

Again, these advanced order types aren’t required for the SMI strategies. We normally recommend liquid ETFs that trade with a small “spread” of just a few cents between the quoted bid and ask price. For these ETFs, simple market orders are sufficient to get you close to the quoted price.

If you ever notice an ETF you are buying or selling has a large gap (10 cents or more) between the quoted bid and ask prices, entering a limit order within that price range can provide more price certainty, although there’s a chance the trade won’t execute because your limit price isn’t reached. If that happens, you’ll have to “chase” the stock higher (if buying) or lower (selling). The larger the amount of the trade, the more likely using a limit order will be worthwhile.

We recommend against using regular stop or trailing stop orders on ETFs — they’re too risky when markets hit periods of unusual volatility. If you need to use automated sell orders, stop-limit orders (trailing or otherwise) are safer. Assuming your order gets filled, they at least guarantee you’ll get an outcome close to what you’re expecting.

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