Introduction to the basics of trading
The Stock Exchanges works as a market place for buying and selling of securities. So, how this trade takes place is an important thing to understand. Trading of shares is somewhat the same as another trading, the buyers demand and the sellers’ supply. The price at which a seller wants to supply and a buyer wants to buys should be equal. This condition is necessary for the transaction to take place. For trading in exchange, the investors demand shares at a price and the companies supply those share at price. The investor gives out an order generally through a broker to the companies. Through these orders, they demand some shares of the companies at a given price. Now, we should know what there should be in order. An order must satisfy the security or securities for buy or sell and the quantity that you want to trade.
Basics of the trading: Market order and Limit order
Orders are of many types, among those one is Market Order. This type of orders executes at market price. The price available at the market becomes the execution price. Hence, it claims almost no uncertainty at all for the execution of such orders. But however, the price at which the execution takes place is highly uncertain.
Another type of order is the Limit Order. To avoid trading at a price that is unacceptable to the parties this kind of orders are used. For placing a limit order apart from the above mentioned three instructions you may also specify the price at which the trader wants to trade. For a buy order limit ensures that you do not buy at a higher price than the limit quoted. Similarly for a sell order limit price is the least at which you are willing to sell. In such orders, there is no price uncertainty but there is execution uncertainty.
How does trade happen in an order book?
The orders made are put up in an order book. When orders match the condition of the transaction the execution to take place. The uncertainty and certainty of price and execution mentioned above can be understood more clearly by understanding an order book.
Example: Order Book 1
Let look into order book for ABC
In the above order book, the sell-side has an order S1 to sell 150 shares at Rs 40 and the buy-side has an order B1 to sell Rs 39.5. The best ask price of the share is Rs. 40, the best bid price of the share is Rs. 39.5. The bid-ask spread refers to the difference between the best ask and the best bid price. Now, what will happen to such an order, if the best ask price and best bid price are not equal. In such a case, no exchange will take place. Putting differently, no order will be executed pointing out the fact of execution uncertainty in case of a limit order. The orders will remain standing in the order book. We call such orders as standing or passive limit order.
Example: Order Book 2
Moving forward, we see the following,
We see new sell order S2 of 300 shares at Market price and a buy order B2 of 500 shares at a limit price of Rs. 39.97. The execution will take place, S2 will correspond at market price which is Rs. 39.97 but what will happen to the previous order S1 and B1. They will continue to keep standing as the market operates at the best price. Here the best bid price is Rs 39.97 and best ask price is whatever it is in the market. So, S2 and B2 execute instantaneously clearing the order S2 completely and B2 after execution now has an order left at 200 number of shares at the price Rs. 39.97. The buy-side will have 200 shares left in the order book and will not execute with sell order S1 as the ask and bid price don’t match.
Form the above-mentioned details of the order book we can clearly point out that how a market order has execution certainty but price uncertainty as the execution took place at a higher price prevailing in the market.
Example: Order Book 3
Moving ahead let us take a look at new orders in the order book,
From the order book, we can now see that sell order S2 is completely executed, a new sell order S3 of 250 shares at Rs. 39.95 has come up. We find out that the existing buy order B2 of 200 shares at Rs. 39.97 matches the sell order S3 and trade can take place. We call such kind of limit orders which executes instantaneously as marketable limit orders or active limit orders.
Another kind of order is a Stop-Loss Order. As the name suggests investors use these kinds of order to prevent losses or existing positions. Suppose you brought 100 shares of ABC company at Rs. 40 per share. Now you will hope that its price will increase from 40 but since it is a market you should be ready for the losses. Suppose you are able to take up to 10% of the price, so Rs. 36 is the minimum at which you will trade. A price lower than this is not acceptable. So you put a stop-loss order in the order book at trigger price at Rs. 36, as soon as the price of the share will fall down to 36, the order will be triggered and the shares will be put up for sale. Having said so, the actual execution of such an order might happen at a little less than what is triggered price is quoted depending on the volatility of the market.
A simple difference between limit and stop-loss order is that any amount below the limit price is unacceptable while in stop-loss order as soon as the price touches the trigger price, the order becomes a market order and the execution certainty becomes the main aim rather than price certainty.
Author: Sneh Srivastava MA Economics