You sit down to begin negotiating with the car guy. But you have an edge. You know that the last customer paid $19,000 for the same car you’re planning to buy. The car guy knows you know this. So, the first thing you say is “the most I’ll pay for this car is $20,000.”
Why would you say that? The answer, of course, is that you wouldn’t say that. But in the world of limit orders for stock trading, this is perfectly reasonable behaviour as I’ll explain.
A sensible strategy for limit orders was explained clearly by Canadian Couch Potato. However, I’ve run into two people now who say they’ve read this article but say they just use market orders because they don’t want to dicker over small price differences. This comment makes it clear they’ve missed the point.
The point is to offer to pay more than the asking price for your shares. Yep, that’s right. Offer more. I assume that this point gets missed because it seems counterintuitive and readers get baffled by a jumble of numbers.
We all know that stock prices move around. Usually, they don’t move too much from minute to minute. So, if you see your stock with an asking price of $25 and you place a market order for 1000 shares, you’ll most likely get them for something very close to $25 each.
But sometimes stock prices swing wildly. What if the price suddenly jumps to $50 just after you place your order? You could end up paying $50,000 when you expected to pay about $25,000. This certainly won’t happen often, but even once is too often. How can you protect yourself against this?
Enter the limit order. Suppose you offer to buy your 1000 shares with a price limit of, say, $25.10 each. Does this mean you’ll pay an extra ten cents per share? In most cases the answer is no. If the asking price is below your limit, you’ll get the asking price. This means that in most cases your limit order with a price limit above the current asking price will work exactly the same as a market order.
So, why bother with limit orders? They protect you against wild market swings. When your price limit is initially above the asking price of a stock, it will only stop your trade if the stock price jumps sharply on you the instant after you enter your trade. If you’ve set a limit at the maximum price you’re willing to pay, then this works out perfectly. Either you get the shares for the best price available below your limit, or you don’t get them at all.
For selling shares, you can get the same effect by setting a limit below the current bid price for your stock.
It’s certainly true that you can use limit orders to dicker and try to save a few pennies per share by offering slightly less than the current asking price. But this doesn’t work well in the long run. Sometimes you’ll save a little, and other times your stock’s price will rise and you’ll have to pay more later. What we’re talking about here is choosing a limit price above the current ask price to protect yourself against wild markets.
So, it does make sense to offer more than the asking price when you’re buying stocks, but I don’t recommend it when buying a car. I seriously doubt that the car guy would listen to your bid and say, “That’s too high. I’ll give you the same price as the last customer.”