Wall Street wants your business.
But those cut-rate commissions are just a trick to lure you in. Brokerage firms really make money by filling stock trades at prices that work for them – not for you.
Here's how it works. If you put in an order to buy 1,000 shares of Microsoft (Nasdaq: MSFT) now, without specifying a price, your broker will fill your order with any stock he can find, and it will be filled at the ask price. The ask is the price at which a seller of a stock is willing to sell shares, while its partner, the bid, refers to the price a buyer will buy a stock from you. The difference between the two is the bid-ask spread. An example will clarify the concept.
Let's say Microsoft has a bid/ask of $25.15/$25.18. That means your broker will likely fill your order for $1,000 shares at $25.18. But your broker may have another client that wants to sell some shares of Microsoft. The broker will buy the shares from the seller at $25.15, and then he'll turn around and sell them to you for $25.18, pocketing three cents on each share 'traded.' That may not sound like much, but all those pennies turn into millions in profits over time.
Brokers can also take their sweet time filling your order. What you thought would be a $25.18 per share purchase may end up being $25.40 if shares have started to move while your broker dawdles. Curiously, the converse never seems to be the case -- it's quite rare that a broker bought a stock for you at a better price than you expected.
You need to keep brokers honest by moving beyond simple buy and sell orders (also known as 'market orders') and specifying more restrictive trading parameters.
For many investors, limit orders have become the best tool to make sure they're getting the best 'execution,' which is a scary way of saying transaction. Let's say you like Microsoft's shares at $25.18, but you like them a lot more when they're at $22. A limit order puts you in line to buy shares automatically if they fall to $22. note that limit orders when you sell are a mistake. If the stock skips over the specified price, the order will never be executed. It's better to use a stop-loss order, which we'll talk about a little later.
Orders can be good for the day or good-until-cancelled. Using the above example, let's say you want to buy 1,000 shares of Microsoft and have decided you want them at $25.17 per share. If you place a day order, the broker can fill the order at that price at any time until the end of that day. If the trade is not filled, it will expire and you can try again the next day with the same strategy.
That may be too much effort, in which case a good-til-cancelled (GTC) order is the right one for you. In this instance you can specify a price, and the order will get filled whenever shares become available at that price, even if you have to wait a week or two. (Note that many brokers make these GTC orders expire after 30 or 60 days -- check with your broker.) GTC orders can also be used when it's time to sell, ensuring you get the price you want.
You can also have your broker sell a stock if it falls past a certain threshold, even if you're not around to see it happen. These are known as stop-loss orders and can be very handy for those that fear the next market rout. If you bought Microsoft, you may decide to automatically sell the stock if it falls $1 below your purchase price. At $24.17, you'll be 'stopped-out.' Of course, if you're stopped out and the market quickly rebounds you may kick yourself, so make sure your stop-loss orders are not overly restrictive. (Note that a stock may be falling so fast that a broker can't fill the order right at your stop-loss price, but hopefully it will be fairly close.)
Some investors choose to use a clever trade order to continually and automatically alter their stop-loss price. This trailing stop order ensures that you can lock in a profit after a recent gainer sees a pullback. When the price goes up, it drags the trailing stop along with it, but when the price stops going up, the stop-loss price remains at the level it was dragged to. A trailing stop is a way to automatically protect yourself from an investment's downside while locking in the upside.
If you use these trading tools, you're bound to save yourself heaps of money and headaches by avoiding poorly filled stock orders. They may take a little extra time, but are absolutely vital if you want to see a portfolio steadily grow in value.