(Photo Credit - Chad Elliott)
Just as it's never a good to dive into a shallow pool, it’s never a good idea to dive into a ‘shallow market’ using a market order. Before explaining why exactly it's so important to use limit orders when trading marijuana stocks, first you need to understand bids, offers, market depth and the different order types available to you when trading marijuana stocks.
In case you aren't familiar for the order types used when trading stocks, read our primer on order types and marijuana stocks here.
Bid, Ask, What?
A bid is an expression of someone's willingness to buy the stock at or better than their specified bid price. The best bid is simply the highest price that someone is willing to buy the stock at any given time.
An ask is an expression of a market participant's interest in selling the stock at a price at or better than their ask price. The best ask is the lowest price that someone is willing to sell the stock at any given time.
When you place a market order to buy, you will get filled at the best available ask. Since you want to buy the stock, this means you need someone who is willing to sell it to you (someone who is posting an ask), hence why you get filled at the ask price - the lowest price that someone is willing to sell at.
Let's look at the same thing in reverse, this time it's a market order to sell. What price are you going to get filled at? You would get filled at the best bid price, because that's the lowest price that someone is willing to buy at. You want to sell stock, so you need a buyer on the other side, that buyer is the best bidder.
It takes many traders a while to get a grasp of bids and offers, so have no fear. It might take a while for you to get it, but once you do you'll never forget it.
(Photo Credit - David Purchase)
Market depth is the quantity of bids and offers in the market. Why does this matter? Well, in our previous example we ignored quantity. If the amount that you want to buy is greater than the number of shares at the best offer, you'll get partially filled at the best offer and the rest at the 'next best offer'.
Market depth is effectively the quantity available at this 'next best offer', and the one after that, etc. The greater the market depth in a stock, the greater quantity you can buy or sell without moving the price significantly. Market depth is one measure of liquidity - or the ease with which an asset can be turned into cash at a price close to the market price.
Notice that when we mentioned bids and asks above we used the words 'at or better' to describe the price. For future reference, whenever you see the words 'at or better' in the context of trading, think limit order.
Limit orders let you specify a maximum price at which you wish to buy or a minimum price at which you wish to sell, but they don’t guarantee execution. That being said, once you know how to use them to your advantage in the markets, you can avoid getting bad fills while still making it likely that you get filled. This brings us to a special type of limit order - marketable limit orders.
Marketable limit orders are limit orders that can be executed immediately because their limit price is at or better than the current best bid or offer. They work like market orders in that nine times out of ten you get filled right away, and in thatother one time out of ten they protect you from getting a worse price than your limit price if the market moves against you or if there are not enough shares to fill your order at a price better than your limit.
Putting it All Together
You should always use limit orders when trading marijuana stocks because markets in these names tend to be shallow - meaning there's not a lot of additional liquidity below the best bid and ask) Even an buy order that seems small in dollar terms (in many cases less than $1,000) can make a big 'splash' in the market, taking out multiple 'levels' of waiting sell orders in the book, causing you to get a bad fill.
Investors ofttimes think that it doesn't matter how they 'get into the market' - but a bad fill relating to using a market as opposed to a limit order can significantly impact your returns. If you get filled at a price 5% higher than you could have if you were more careful entering the market, that means the stock has to rise 5% more before you break even on the investment.
A bit of time spent strategizing your entry is well worth it for investors and traders alike. Even using a marketable limit order instead of a plain market order can make a huge difference in your success navigating the exciting marijuana stock markets.
Hopefully this was a useful primer on why you should always use limit orders when trading marijuana stocks. Happy trading!
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