Table Of Contents:
- The quick method to buying stocks
- What is a stock
- How old do I have to be to buy stocks?
- Where exactly do you buy stocks?
- Why companies issue stocks
- Buying stocks without a brokerage
- Buying stocks online vs with a physical broker
- Buying US stocks in Canada
- Making money buying stocks
- Avoiding losing money
- Key investment ratios to learn
- Basic investment strategies
- Picking a brokerage
- Buying stocks with particular order types
This article contains affiliate links to Questrade.
One of the biggest questions we get here at Stocktrades is “How do I buy stocks in Canada?” The answer is actually fairly simple, but we realize our readers are looking for much more than that. The question often throws a blanket over some of the more in-depth results our readers want to see. Not only do they want to know how to buy stocks in Canada, but they want to know how to buy good stocks.
The Quick Guide To Buying Stocks:
If you want to start buying stocks in Canada right from the comfort of your computer desk, you are only required to do a few things
- Have sufficient capital (you can get started with as little as $500)
- Find an online brokerage that suits your needs
- Open a TFSA, RRSP or non-registered investment account
- Fund your investment account (usually takes 3-5 business days)
- Research an investment method you’d like to follow (Stocks, ETFs, Index Funds etc)
- Monitor your investments and make changes as needed
- Adapt your strategy based on risk tolerance and portfolio size
However, there is a distinct difference in just blindly going out and purchasing stocks and actually putting forth the effort to buying good stocks. If you’re simply looking to get started immediately, the video below should give you a pretty good idea of how to set up a brokerage, make a deposit and be ready to buy in the next 4-5 days. Keep in mind as you open your account, if you’re planning to do any high risk/high reward investing, gains earned in a non registered account are subject to capital gains tax. Depending on how much you make, the bill can be quite high.
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But, anyone can buy a motorcycle, it doesn’t mean you know how to drive it. Because of this, we’ve developed this massive guide on how to buy stocks in Canada. To get started, lets go over what a stock actually is.
What Exactly Is A Stock?
When you invest in stocks in Canada, or anywhere else in the world for that matter, you are purchasing part ownership in the company. Now, it’s important not to get too excited over this in terms of ownership.
Chances are, unless you have a significant amount of capital, purchasing stocks of particular companies won’t yield you some extraordinary power. You’ll more than likely own a microscopic portion. To give you a little example, lets look at TD Bank (TD.TO). With over 1.78 billion shares trading today, even 100 000 shares purchased (which by the way, would run you up $7.49 million at the time of writing) you’d only own 0.0056% of the company.
It’s also important to note that when you purchase a stock, contrary to popular belief, you don’t actually own rights to the assets the corporation has. This is a very common misconception, and is one we have to explain to new investors often.
In the eyes of the law, an organization is treated as a separate entity. As such, the tables and chairs you would see in a bank like TD are owned by the company itself, not the shareholders.
This is called the separation of ownership and control.
Most common types
All in all, if you’re looking to learn how to start investing, you’ve got to learn what you’ll be buying.
Preferred shares, or preferred stock, is a class of stock that has a higher claim on the companies earnings than its counterpart the common stock, which we will talk about next. If a company you’ve invested in ends up in a sticky situation and must issue dividends, those dividends will be paid out to preferred shareholders first. In some cases, if a company you’ve invested in discontinues their dividend, preferred shareholders must be paid out in arrears if the dividend is re-instated before common shareholders can begin to be paid out.
Preferred shares in a company do not come with voting rights unlike common shares. Preferred shares usually trade at either a slight discount or premium compared to common shares, depending on the company’s credit and reputation.
As an individual investor looking to learn how to invest, you’re really not going to be looking at preferred shares. They are more for institutional investors due to their tax breaks compared to common shares.
If you’re looking to buy stocks in Canada, common shares are more than likely where you are going to be looking. Although common stocks are, well, the most common, they are typically on the lowest rung of the ladder. For example, if a company were to go bankrupt, investors that hold things like bonds or preferred stocks would be paid out first. But, if you’re new to investing in stocks, this article will help you avoid those companies that are on the brink of bankruptcy.
Common shares, for the most part, will outperform bonds and preferred shares of the same stock. The owners of common stocks also have the right to vote and attend shareholder meetings, regardless of how minuscule your ownership in the company is.
How old do I have to be?
A lot of people assume you have to be 18 years old to start investing. For the most part, if you’re looking to invest without any sort of supervision or parental guidance this is the case.
However, it is completely possible to invest in stocks younger than the age of 18, and if you’re current in this situation, I’d like you to give yourself a big solid pat on the back right now.
Most people don’t even think about buying stocks in their 30’s let alone as a young adult. So, what do you have to do?
You can have a parent or guardian open an account for you. As such, they would be somewhat of a custodian on the account, but if you work it out with them, you could have full control of the funds. If you’re interested in doing this, feel free to head to Questrade and ask their customer service for the appropriate paperwork!
However, what you really need to keep in mind is is this the best thing possible for me right now? What I mean by that is the money could be better spent on things like a college education, or getting a cheap, reliable vehicle to get you through the next 5 years.
But, if you’ve got all that under control, by all means, get an account open and start investing!
Where do I buy stocks in Canada?
Some people often get confused with where they need to start when looking to invest. There are endless amounts of advertisements available to us via television, Youtube and the radio.
You see banks, you see fund advisors, you see retirement specialists. The possibilities are endless.
And to be honest, any of these will do. You can buy stocks from any financial institution (if you have an account that is), you can buy them from a financial advisor, or you can even buy them directly from the company (more info on that later on.)
However, it’s key to identify your overall goals before deciding where you want to start investing. If you’re looking to go full blown DIY, as in analyzing and purchasing your own stocks, balancing your portfolio and reaping the hard earned rewards, a discount brokerage may be for you.
However, if you’re not comfortable doing this, you need to find something that aligns with your goals. Book an appointment with your local bank and see what they have to offer. Shop around and compare management fees. Talk to some individual advisors and see what they charge.
Although we are heavily on the do it yourself train here at Stocktrades, primarily because of the picture detailed below, we realize not everyone is comfortable doing so and sometimes it should be left in the hands of the professionals. Just know how much you’re paying first.
So why do companies issue stock?
The image below highlights for the most part why a company would want to issue stock. A company may need capital to grow and expand operations, capital that is not achievable through current operations.
In order to get what they need a company, at least for the first time, will issue an Initial Public Offering. At that point, institutional investors and brokerages will be allowed to buy the stocks, and they will enter the secondary market where you, the individual investor, will get an opportunity to buy the stock.
After the company has issued their IPO, money raised from the offering allows the company to spend capital on new projects, new infrastructure, new equipment or whatever they need to expand operations. In the end, if they are successful, so are shareholders. Keep in mind this isn’t always the case, and if you’re just learning, initial public offerings may be something you’d be wise to avoid. They require intricate research and attention to detail that you may not hold yet.
Looking To Invest In IPOs? Look At Up And Coming Industries Instead
Buying with or without a brokerage in Canada
We get asked this question, a lot. Many new investors want to learn how they can get started without a brokerage. And while we encourage an open mind, more often that not buying stocks without a brokerage is just going to lead to more hassle.
However, we love to give readers exactly what they want, which is why we have added this section. There are a couple of ways you can buy shares in a company without going through a brokerage:
Buy them via a direct stock purchase from the company
A direct stock purchase plan can be available, more often than not through a blue chip company trading here in Canada. Although I’m finding these plans more and more uncommon, especially with how cheap discount brokerages are getting, they still do exist.
These plans, when offered, often come with some restrictions and certain dollar allocations you must spend on the company every xx amount of months. In my mind, the process of having to go through the paperwork and process it takes to buy directly from the company is alleviated by spending $4.95 at a discount brokerage like Questrade to purchase the stocks.
Using a company’s DRIP program
Now this is something I can get behind, for good reason. Most companies offer a DRIP (Dividend Reinvesting Program) where a shareholder can reinvest dividends at no cost to them back into new shares of the company. You can check out an example of BCE’s plan here.
For example, if you have stock A worth $10, you currently hold 10 shares and it pays a $1 annual dividend per share, at the end of the year when your dividends are issued you will not receive $10, instead you will now own 11 shares of company A.
This creates a snowball like impact, allowing your wealth to exponentially grow over time. However, much like buying stocks directly from the company, a DRIP program can be set up via your brokerage absolutely free. It takes less than 2 minutes to apply for it, and will save you the headache of having to fill everything out yourself via the companies website.
Online vs a physical brokerage – Which is better?
Many financial advisors, banks and brokerages have brick and mortar offices where you can simply go in and place a transaction.
However, with the acceleration of online investing, this is becoming a thing of the past. If you’re looking to start buying stocks, I would highly suggest you buy them online. Why?
For one, brokerage fees in person tend to be a lot higher than their online counterparts. For example, if you phone in to make a transaction through Questrade, they can charge you up to $45 to do so.
It’s a thing of the past, and banks and brokerages are trying to slowly eliminate it by charging costly fees to do it over the telephone or in person.
The transaction is essentially the same thing whether you do it in person or not. So why go through the trouble of hopping in your car, driving to a physical brokerage or bank and paying an exorbitant amount to purchase a stock.
Why not just log in to your brokerage online, pay $5 and hold the stocks within a matter of seconds? This one is a no brainer for me, if you’re going to be investing in stocks, do so online.
Buying US stocks in Canada – Is it feasible?
This is another question we get asked a ton here at Stocktrades. Primarily because the US market is a lot more active, and to be honest, more lucrative in recent memory than its Canadian counterpart.
However, new investors often run into a lot of trouble opening up a CAD account and purchasing stocks in USD.
First off, it is very simple to buy US stocks in Canada. In fact, it can be done with a simple click of a button. However, brokerages offer more often than not horrendous exchange rates. The money you could be paying to exchange your CAD to USD to initiate the transaction could be eating up a large majority of your returns on the investment, depending on how much you buy.
Some brokerages can charge upwards of a 1% to 2% fee just to initiate the transaction. That means on a $1000 investment, you’re losing $20 right off the top. Coupled with that, like I said they won’t offer you the best exchange rate.
If you’re looking to invest in American listed stocks, you may be wise to open up a USD account with a brokerage like Questrade. Or, you can try this sneaky technique, Norberts Gambit, to get your currency exchanged for cheaper.
So how exactly do I make money?
This is a question that requires a more in depth answer than you’d expect. The simple answer would be if the stock you’ve invested in goes up, you’ll be rewarded if you sell.
However, as a new investor looking to start investing in Canada, it’s important you truly understand how the stock market works. Much like a motor vehicle, it’s fairly easy to drive one. But when it breaks down, you’ll wish you had the inside knowledge to diagnose the problem and fix it yourself.
Investing in stocks is a matter of supply and demand
Stocks go up and stocks go down every day. But why do they go up, and why do they go down?
If something is popular, there is more often more demand for the product. A prime example of this is is a commodity market. When there is a lack of the commodity, like crude oil for example, it tends to drive the price higher and prospective buyers will be willing to pay more. But, as the market is flooded with supply, people will notice and will begin to pay less, as they won’t ever struggle to get it.
Looking To Buy Stocks That Focus On Commodities?
If you’re looking to invest in Canada, your company’s earnings period is going to be very important for you. And it’s fairly easy to get a solid example of how the supply and demand of the stock market works directly after an earnings period.
If the company you’ve invested in produces an excellent earnings period, chances are there will be more buyers than sellers. At this point, because the stock is popular, the price will be driven up. Investors are willing to pay more (high demand) for a stock that is performing well.
However, if the company you’ve invested in posts mediocre or poor earnings, typically investors will be lining up to move on from the company and sell their shares. If there are more people willing to sell than buy, the stocks price will inevitably fall.
In the end, when you’re investing in stocks, there is nothing special going on behind the scenes. It’s simply supply and demand.
Supply, or lack thereof is sometimes unjustified
If investing in stocks was as easy as purchasing promising companies and instantly reaping rewards, everyone would be a millionaire. It simply doesn’t work like that.
Supply and even demand can be artificially inflated. We typically see this with high potential growth stocks. There is a very good chance you’ll see companies trading on the TSX or even the NYSE or NASDAQ that have a high demand, yet haven’t posted a profit. In fact, they may be losing money.
Investors are purchasing these stocks based on future earnings estimations. Think of it like your buddy approaching you with a start up business he’s sure will make both of you rich one day. His business is worthless at the time, but you’re investing on the off chance it succeeds.
One of the biggest examples of this in recent memory was the dot-com bubble of 2000. The internet boom of tech companies like Amazon and Microstrategy was causing extreme inflation and asinine valuations of these company’s stock prices. Microstrategy’s stock price had gone from as little as $7 to over $330 dollars a share in a year. When investors caught on to unjustified stock prices, Microstrategy’s stock plummeted more than 60% in a single day.
How to avoid this situation
It’s fairly easy to avoid situations like this when you’ve just started buying stocks. The short answer?
Don’t buy these stocks.
The long answer? Don’t buy these stocks, and instead calculate what a stock is truly worth.
A key component of becoming a strong investor is the ability to judge whether a company is over or under valued. Defining the true worth of a company’s stock is often accomplished by calculating the stocks intrinsic value. Investopedia has an amazing piece on calculating the intrinsic value of a company here.
Now, this isn’t to say you can only buy stocks that are below or at its intrinsic value. There is definitely something to be said about investing in the potential growth of a company. But, you’ll need to learn how to figure out if this premium you pay in terms of stock price is worth the risks.
I’m an avid growth investor myself, in fact I’ve bought some stocks that have made me as much as 600% in a single year. However, the attention to detail and precision required to identify winning stocks like this is something that should often be left to the experts.
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How to not lose money
When beginners are learning how to buy stocks, a plain old “buy and hold” strategy isn’t the first thing on their minds. Why?
Well, first off, it’s boring. They want to be like those guys you see on Youtube ads, making $10 000 a day trading stocks. I can tell you right now, that’s not going to happen. At least for 95% of the investors that try to head down that path.
There is a time and a place to invest in highly volatile stocks. Fortunately, that time is almost never. But, it’s what new investors looking to buy stocks in Canada put themselves through on a consistent basis.
If You’re Dead Set On Striking It Rich
These new investors don’t have the experience in the stock market to be able to identify the fact exorbitant returns are not possible, unless you happen to run across a heavy batch of luck. The next Facebook or Apple is out there. But, you’ll never get to them before the institutional investing firms do.
Buy stocks that will provide long lasting returns, and not short term bursts
To become good at investing, one needs to do the heavy lifting i.e. quality research. If that is not your cup of tea, the next best option is to invest in blue chip dividend stocks, or possibly bonds. And if you’re looking for someone to learn about bonds from, look no further than Jeffrey Gundlach.
These companies are large, established and financially sound firms that have existed for long periods of time.
When teaching people how to buy stocks, we often preach Canadian bank stocks. They are a great long-term investment. These banks are protected by mammoth, almost impenetrable barriers to entry because of Canadian Banking Regulations.
The industry is like an oligopoly, and Canadian banks make a handsome profit each year, which in turn means great returns for investors via consistently rising stock prices and dividends.
Sure, you’re not going to see the whopping 500% returns on these stocks in the short time you could achieve it buying stocks in heavily speculative areas. But, they aren’t going to leave you empty handed like most highly volatile stocks will.
Investment ratios you need to learn
When you’re just beginning to invest, most of the information online can look like native tongue. However, in reality the terminology for buying stocks is really quite simple. This isn’t the be all end all of financial ratio definitions, but learning these key ratios will allow you to at least get the basic picture of a stock before you decide to buy it.
PEG and P/E ratio
The go-to ratio for almost everyone in the industry, a comparison of the firm’s stock price against its actual earnings (P/E stands for price-to-earnings). We go in depth on the P/E ratio in this article.
Ratios on their own are pretty useless, you need an appropriate yardstick for comparison.
A good choice would be the industry average. The P/E ratio for the firm that you are interested in might be 30, which is extremely high. However, if the industry average is 60, your stock is a steal, provided it is sound in all other areas.
An ingenious enhancement of the P/E ratio is the PEG (price-earnings-growth) ratio. As a rule of thumb, look for companies with a PEG close to 1.0, which implies that the market’s expectations are based on realistic assumptions about the firm’s growth prospects.
Let’s assume that the P/E ratio of a firm is 10, and the expected growth rate is 5%. In this case, the PEG is 2 (10 divided by 5). Even though a P/E of 10 might be low compared to industry average of 15, the PEG raises a huge red flag.
Return on equity (ROE)
The net income earned expressed as a percentage against shareholder investments.
Plain English: A measure of the management’s ability to use money invested in the business. If you want to beat the market, a ROE of at least 10% is essential.
An extremely important ratio. Too much debt can cripple a business during tough periods, eventually leading to bankruptcy.
Furthermore, this ratio is a good way to gauge the management’s claims. For instance, they may claim that they are going to double their business by borrowing money from banks. But if the D-E ratio is 2, no bank will extend a loan to the firm. Look for firms with D-E less than 0.5.
Percentage of stocks owned by big institutions such as mutual funds, pension funds, endowments, hedge funds or other large investors.
There are two ways to look at this metric. High institutional ownership means that big analysts are confident about future prospects of the company.
But this also limits upside as the stock is not ‘hidden’ from big players. Around 50% institutional ownership is the sweet spot.
Earnings per share (EPS)
The earnings per share is the portion of a company’s profit dedicated to common stocks. A simple example would be if a company made $100 and had 100 shares outstanding, its EPS would be $1.00. If the company posted a loss of $100, its EPS would be -$1.00. In the simplest terms possible, EPS is a good judge of a company’s profitability.
Price To Book
The price to book ratio simply takes the company’s market price per share and divides it by its book value per share, which is often calculated using the balance sheet. A low price to book, such as something under 1.00, can signify undervaluation.
Digging a little deeper prior to investing
So, you’ve looked at a company’s PEG, price to book and price to earnings and you think you’ve found a winner and you’re ready to buy the stock. Right? Wrong.
There is a lot more to look at. You can relax and take a break from the numbers, but it’s time for qualitative analysis.
Start with the quality of the management, something very hard to assess but probably the most important.
A good management or CEO can make or break the company. McDonald’s would not be a multi-billion dollar fast-food chain if it weren’t for Ray Kroc’s vision. A good place to start is the historical performance of the management. See how often the company has issued shares. Are they buying back shares? Do they have a history of improving the company’s earnings and sales? A company is only as good as the management team behind it.
How the heck do I know what a good management team looks like?
An excellent way to learn about the company, and develop your own business and analytical skills, is to listen to the conference calls where management of the company answers analyst questions and discusses its pain points and future plans.
If you were to follow the advice thus far, you would be better than 90% of investors out there. New investors are prone to mistakes though, and nobody will ever be perfect.
Investment strategies for beginners
Dollar Cost Averaging
Dollar cost averaging is somewhat of an automated form of buying stocks. When an investor dollar cost averages, they are deciding to set aside an allocated amount toward a particular stock, regardless of the price. This can be every week, month, semi annually or even yearly.
The key to dollar cost averaging when buying stocks is to buy an exact dollar figure of the stock regardless of the price.
So, as an example, you’ve allocated $1000 every two months to stock ABC. The price currently sits at $50 a share. Your first purchase allows you to buy 20 shares. Over the course of the next two months, the stocks price has dropped to $40. You’ve done your research, the investment thesis on the company hasn’t changed, so you purchase another $1000 in shares. You’ve now dollar cost averaged your way down in price, as you now own 20 shares from your initial purchase at $50 a share, and 25 shares at $40. You now own 45 total shares for $2000, or an average price of $44.44 a share.
Dollar cost averaging allows you to capitalize on short term market volatility and build growth over the long term. It’s important to keep up with the overall health of the company. If something has changed, especially for the worse, you may want to cease your dollar cost strategy and instead sell your position.
Remember our talk about intrinsic value? Well, value investing digs into analyzing the true worth of a company, comparing it to the market price and capitalize on buying stocks that are below their intrinsic value.
Value investing is one of the more rewarding, yet more challenging ways to buy stocks. It requires extensive research and a deep understanding of company fundamentals and the analysis of company balance sheets, quarterly earnings statements and annual reports.
For the purposes of this article, especially with most people reading this just getting started buying stocks in Canada, I’m going to combined dividend (income) investing and dividend growth investing.
This is probably the most popular investment strategy out there, and it is something new investors looking to learn how to buy stocks in Canada can employ quite easily.
Income investing for the most part is investing in companies that provide a dividend. Investors seek high yielding, established blue-chip companies to build their wealth through payments received by the company in the form of a dividend.
Blue-chip companies tend to lag the next type of stock we will be talking about in terms of stock appreciation. But, with what they lack in appreciation they make up for in dividends. A stocks price growing a mere 4-5 percent in a year is nothing to write home about, but combine that with a 4 percent dividend yield, and you have a very healthy 9% return.
A more advanced income strategy, one that beginners looking to start investing in stocks may have to take some time to learn, is dividend growth investing. This investment strategy puts investors in a situation where they are not only seeking solid dividends from a company, but they are looking for consistently growing dividends as well.
Growth investing, which is my favorite investment strategy, focuses on investors finding prospective growth companies that will provide above average market returns. Because these companies do not issue dividends, they tend to spend cash flows and profits on things like acquisitions and expansion.
Find Emerging Markets For Extra Growth
Growth investing is one of the riskier investment strategies, especially for beginners just learning how to buy stocks in Canada, but with carefully planned execution and solid experience, it is likely to be the most profitable strategy an individual investor can deploy.
Finding the right brokerage
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Knowing the destination is not enough, you need a vehicle to reach the final point.
Buying and selling stocks requires a broker, this is our theoretical stock market vehicle.
In fact, you can learn most stock market basics right from your brokerage. Take for instance Questrade. They have numerous courses and learning opportunities available right on your desktop or phone.
This is why it may be a good idea to open a brokerage account even before beginning your research because most brokerages provide tools that can be conducive to research.
Choosing the correct online brokerage is key, and you need to get it right
Selecting a good broker is a research project in itself. Some have unnecessarily complex interfaces that can confuse and frustrate even the most seasoned investor.
Because we are investing online, we personally prefer online brokers. They provide a no-frills and fast approach to investing, especially ones like Questrade
As already mentioned, these are the simplest of all categories of brokers. They are order takers and not in the business of providing advice. For those who are uncomfortable with using an online terminal, an option to order over the phone is also available. Keep in mind this is usually at a huge cost.
Online broker with assistance
As the name suggests, these are discount brokers that provide advice, which is a little less than full service consulting.
These brokers usually provide monthly newsletters and investing tips, and may provide more research options as compared to a straight discount broker.
For a person beginning to invest, all the numbers and charts can be highly intimidating, but just keep practicing and you will be a master in no time.
These are the traditional kind that has existed since the early stages of the industry. Their job is to assess your financial situation, perform comprehensive research and provide recommendations. In other words, they do the heavy lifting for you.
Keep in mind this also implies that you trust them to have advanced analytical and research skills. You should try your best to verify this prior to investing with one.
Not really a broker, but worth a mention as most people confuse them to be one.
First, to invest with money managers, you need a hefty amount of capital.
Second, you are not really in control of making investment decisions. Everything will be done by the manager.
There are some excellent money managers out there, who provide substantially better returns than the market.
However, as mentioned before, you need to have a significant amount of capital and be willing to pay mammoth management fees.
Order types you need to know
Once you have your brokerage set up, you are ready to learn about specific order types when buying stocks. We’ve had a lot of requests for us to add this section into this article, and so far it has helped a ton of beginner investors learn how to navigate their brokerage and buy the stocks they need.
The Market Order
While Questrade offers a pretty good order type help page, it doesn’t exactly give a clear idea of when to use the various order types available to you when you’re learning how to invest in stocks. We will start with the most basic order, the market order. Order types aren’t magic and aren’t going to guarantee you become any better of a trader or investor, but not understanding the basics could cost you money.
The market order is the most basic of all order types. It tells your broker to buy or sell at the prevailing price, without regard for what that price is. You don’t get to enter any information except the quantity of the security you want to buy or sell, and the duration (which we’ve covered in other articles).
When you need an order filled, right now
The market order makes sense when you want to get “filled” as quickly as possible – you want in or out, and you don’t care how much it costs you. For a highly liquid security, like $VT (Vanguard’s Total World Stock ETF), this won’t matter too much.
But when the spread on a security is higher than a penny, it does matter. Let’s start by revisiting the concept of spread. The spread is the difference between the bid price (the highest price someone out there is currently willing to pay for the security) and the ask price (the lowest price someone out there is currently willing to sell the security for).
In the case of $VT above, the spread is only a penny. But for many stocks, that spread is much wider. The “price” of a security that is generally used is the last price where the bid and ask matched up and a trade was made – the price where a buyer and seller agreed to transact. But that may not be the same as the current bid and ask. So if you think the price of a stock is $10, because that was the price of the last trade, but the ask price is currently $10.10, and you enter a market order, you may end up paying $10.10. Not a huge issue necessarily, but sometimes, this can have a significant impact.
You may be overpaying with market orders
Without getting into the nitty gritty, you may be overpaying the fundamental value of the stock. And why do we say “may end up paying” more than you expected? Because there’s also the possibility that between the time you see the stock quote on your screen, with bid and ask prices, and the time you hit “execute,” and then even the time between that and the actual execution (which on a market order should still take fractions of a second), the bid-ask can still change. You might find you get filled at $10.12!
Market orders can further compound this problem of the buyer not knowing for certain the price at which they’ll get filled when you introduce the problem of the size of the bid and ask. In the above example, the bid and ask are both 8 shares. But our order is for 20 shares. So what happens if we place a market order? Assuming the market order flow doesn’t change between the time we got our quote and the time we get filled, we get 8 shares at the market ask price of $56.02. But what about our remaining 12 shares? We’re going to get filled at the next best ask price, which could be higher or lower.
All these same issues also apply to sell orders. So, in short, market orders get you filled quickly, but it’s hard to know exactly what price you’ll get. It’s a order function commonly used by people just learning how to buy stocks, and it can have devastating consequences if you’re trading low volume stocks.
The Limit Order
We prefer the limit order for most situations. Simply put, they allow you to control your price. When you want to enter a trade, and you don’t expect it to be a very short term trade (seconds, minutes or hours), a limit order makes the most sense. The limit order looks intimidating just learning about trading stocks online, but it’s actually fairly easy.
Similar to the market order, limit orders have one more powerful feature
Limit orders look a lot like market orders except for one big change – we now have the ability to set a “limit price.”
This is simply the price we’re willing to pay or receive for the security – we’re no longer willing to just take what the market gives us. In this case, we’ve said we’ll pay $56.02 – the same as the ask.
This ensures we’ll pick up those 6 shares that are currently being offered at the ask price of $56.02. What about our remaining 14 shares? Well, because we don’t have level 2 quotes, we don’t know what the next ask price is, but because we entered a limit order, it doesn’t matter.
We won’t get those 14 shares until someone asks $56.02. If they never do, we’ll never get filled. So consider this when you’re placing an order – if you prioritize quantity over quality/price, you may need to enter a higher limit price.
You can set your price higher than the current stock value
There’s nothing wrong with entering a limit price higher than the current ask. If you think the stock is worth $56.08, you can enter that as your limit price. You’ll still get filled starting at the lowest available ask and working up toward your limit. We’ve often entered limits above the ask and been filled well below.
Sometimes, in a fast-moving market, if the ask drops below what it was when you got your quote, you’ll get filled there. We’ve entered limit orders at, say, $20, with an ask at $19.95, and been filled at $19.90, simply because the market dropped a bit between our quote and execution (if we were professional traders, we’d have mechanisms in place to manage this a little better, but fundamentally, if we think the stock is worth more than $20, and we get it at $19.90, who cares? If we were happy to own it at $20, then we’re even happier at $19.90).
Don’t get confused selling stocks
To be clear, sell limit orders work the same way, with the obvious adjustments considering they’re, well, sell orders. We need to look at the bid, not the ask. We set our limit and that’s what we’ll get for the sale of our security, regardless of the market. If we set a sell limit price below the bid, then we’ll get filled at the bid and beyond, to the limit price. If we set a sell limit price above the bid, then we may not get filled immediately, but rather, only when the market moves up to our sell limit order price.
To recap, a sell limit order is generally preferable to a market order. It allows you to manage your price. Especially on thinly-traded stocks (ones where the last trade was many seconds, minutes or even hours or days ago), we can avoid getting “gapped” – which is what happens when you see the last trade on a penny stock at $1, put in a market order to buy, and the next ask is at $1.30 – 30% more than you intended to pay.
The Stop Order
Note: Stop orders aren’t available on Canadian exchanges through Questrade. But that’s okay, because stop limit and trailing stop limit orders, which we cover next, are.
Stop orders are in some ways similar to limit orders, in that you have to set a price, and they only execute when that price is reached. But rather than setting a maximum limit to what you pay for a security, or a minimum limit to what you receive when you sell, they do the opposite – they set a minimum price you’ll pay to buy, or a maximum you’ll receive when you sell.
Why on Earth would you want to do that? Let’s explain by starting with the case where you’re selling.
When you want to lock in profits
Imagine you bought $VT when it was trading at $45 (it’s been a few years since that was the case, but this is just an example). Now it’s trading at $55 or $56 and change. You want to lock in that profit of roughly $10. But you don’t want to sell yet, because you want to keep watching the stock, in case it goes to $60. So you set a stop order.
A stop order on a sale will set a price where, if the stock falls to the stop price of $50 shown above, the order is converted to a market order, and assuming the market is liquid enough (on $VT it should be), it will be sold at the current price – hopefully around $49.99 or $50, and you’ll have secured your $5 gross profit without paying attention to the stock.
Note that we’re showing the duration of this order as “day,” meaning today. It’s unlikely the order will execute before the market closes at 4 pm Eastern time today. So this order will likely expire without being executed. In the scenario above, you’d probably want to change your duration to “GTC,” good until canceled – or “GTD,” good until a specific day.
Using a stop order to buy stocks, or short stocks
Let’s talk briefly about the scenario where you use a stop order to buy. We think an especially obvious use of this type of order would be for when you’re trading based on support levels. If $VT is trading around $56, but you think, if it hits $60, it will rise all the way to $65, then you might want to place an order than only executes if it does, in fact, reach $60. A stop order to buy will accomplish this for you. At $60, it turns into a market order and most likely executes.
The other scenario you’d need a stop order is when you’re shorting a stock, or covering a short (getting yourself out of the order). You would use a stop order to set a purchase price or manage your risk. We’re not going to get into this here – more on this in other articles.
Stop limits can post some significant risk
Overall, stop orders are a bit niche, and they do, in fact, present some pretty scary risks. In illiquid markets, a triggered stop to sell converts to a market order and is then in the market awaiting execution.
As we noted in our discussion of market orders, this means you could get filled at a much lower price than the price you set the stop at. Because security prices move dramatically overnight (due mostly to how exchanges price securities first thing in the morning), a stop order at $50 could get executed but filled at $30!
In extreme moves, you could lose a lot of cash. A great example is what happened to LinkedIn ($LNKD) between trading in Feburary of 2015. A huge miss on earnings meant the stock fell from almost $200 to just over $120 overnight. If you had a stop order in at $160, on the morning of February 5, that order was triggered, and you got filled at $120! You didn’t see that coming.
The Stop Limit Order
Once you understand stop and limit orders, understanding the stop limit order is pretty straightforward. The issues we described that face the stop order are avoided when you pair it with a limit order, with one caveat, which we’ll address momentarily.
On our example above, we’ve set a stop price of $50 for $VT, assuming we’re going to sell it at that price. But because we’ve also set a limit, we won’t sell for anything less than $49. So we don’t have to worry about selling for $30, similar to the case we described in relation to LinkedIn in the discussion of stop orders.
What about buying stocks with the stop limit order?
In the case of an order to buy, with a stop limit order, what we’re saying is that we are willing to pay a certain amount, say, a stop price of $60, but we might set a limit of $61, saying we’re not willing to pay more than $61 per share. This might be useful in the case of the technical trader making decisions based on support levels. But frankly, this is really the only case where we can think one might use a stop limit order to buy in a situation where one isn’t already short the stock. It’s a bit of a weird bird.
So, that one caveat. When you add a limit to a stop order, you will, of course, face the possibility that the stock “gaps” right past the limit you’ve placed. $VT could jump in a single trade from $51 to $48, and we wouldn’t get triggered or executed. So now we’re stuck with a stock that may be heading downward. The lesson here is really the lesson that applies to every type of order – no order is foolproof, so you must always monitor your positions if you think you’ll be buying or selling soon.
The Trailing Stop Order
Note: Trailing stop orders aren’t available on Canadian exchanges through Questrade. But our next and last order type, trailing stop limit order, are.
Trailing stop orders of all kinds offer a rather valuable aspect – they allow you to place an order and have the price dynamically adjust to ensure you get the highest return possible.
Trailing stop orders are more often used when selling
Typically, we use trailing stop orders when we’re selling. We already hold the security, and we want to lock in a certain amount of gain. With a regular stop order, we could do that, but we might end up giving back a lot of our return. If we bought $VT at $50, and now it’s at $56, we could enter a stop order at $54, ensuring we make at least $4 on each share (assuming we don’t get gapped – see our discussion of stop orders for more detail).
But if the stock rises to $60, then back to $54 and sells, we earned none of that higher return we could have had if we’d just manually sold at $60. We left a lot on the table – $6 for every $4 we did get.
Trailing stop orders can set sell limits for the stock moving in either direction
With trailing stop orders, instead of entering a stop price, we enter a trailing amount, which is essentially a spread from the current price to the price we’re willing to sell at. If we enter a $2 trailing stop on $VT trading at $56, the stop order will trigger (and become a market order) at $54. But if the price first rises to $60, with a $2 trailing stop, our new stop order is at $58. If the stock then falls to $58, we get $8 per share – twice as much as the $4 we made using a stop order, and we leave only $2 on the table.
In the case of buying with a trailing stop order, our $2 trailing stop is now above the current price, at $58. If the security falls from $56 to $50, our stop is now at $52. If the stock then rises back to $52, our order is triggered, and our stop order becomes a market order at $52. The most obvious use of this order is for covering a short position, but some investors might find use for it when opening a position. If you were intending to purchase the stock only if it fell and then exhibited some recovery, a trailing stop would do that for you.
The Trailing Stop Limit Order
If you understand stop order and limit orders, then you can understand stop limit orders. And if you understanding trailing stop orders, then you can understand trailing stop limit orders. A trailing stop limit order just adds a limit to a trailing stop order. You use this order simply when you want to use a trailing stop order to lock in as much of your return as you can, but you also want to attach a limit to it, just to avoid being gapped.
Again, trailing stop limit orders are often used when selling
Typically, this order is used when you already own a security. You might have bought it months ago or thirty seconds ago. What you’re trying to do now is manage your potential loss. This type of order requires two price inputs – the amount you want to use to trail the current price, and the limit offset.
The trailing amount is an amount in relation to the current price. If the current price is $56, you might set a trailing amount of $2. This means that if the price of the security drops by $2 to $54, the order will convert and be available to be executed. Convert to what?
Unlike a trailing stop order, it doesn’t convert to a market order. Instead, it converts to a limit order. With what limit price?
Unlike a regular limit order, we don’t enter an absolute limit price (like $52). Instead, we enter an offset. This is the offset to the price once the trail is triggered. So, in this example, with a $2 trailing amount, and a price now at $54, our limit kicks in. A $1 limit mean that our limit order is at $1 below (because we’re selling) the current price – $53. This means our order is in the market as a limit order at $53, and won’t execute below that. We must receive $53 per unit, or the order will go unfilled.
Seems complicated, why would I ever use this?
And the purpose of all this? If you bought $VT at $50, watched it rise to $56, and then entered that trailing stop order, you’ve ensured that your order will convert to a limit order once the price drops by $2 (the trailing amount), but with a limit $1 below the triggered trailing amount ($53). You’ve ensured a gain of $3.
You may use the trailing stop limit order to buy stocks in certain situations
In some circumstances you might use a trailing stop limit order to buy. One case might be where you want to automatically cover a short, but without buying at too high of a price.
However, frankly, we’d find this a bit odd. Because losses on shorts are potentially infinite, the covering short seller is probably better off to just fill that order as soon as possible, without worrying about gapping.
There is a risk with a trailing stop limit order of having your order blown through without being executed. If the stock gaps down at the opening of trading, it might not get executed. So we try to set limits that are wide enough for us to be comfortable with. There are always extreme scenarios – even with a trailing stop limit order in place, owning LinkedIn on February 4, 2016 might have meant being stuck with shares worth far below what you paid. This is the chance you get when you trade aggressive growth tech stocks in bearish markets around earnings season. A diverse portfolio suffers less from this risk, to the point that it’s immaterial.
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