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Investment profits or losses are simply the difference between the price you sell an investment for and the price you paid for it. This is true whether you invest in a stock, an ETF, a mutual fund or options contracts. One of the easiest ways to boost profits is to simply buy and sell at a better price.
The profit or gain is determined by how much the price of the investment changes, but in many cases you can take a simple step to actually increase the profit or decrease the loss by a small amount.
When you buy or sell a stock, an ETF or an options contract, there are actually several prices associated with the investment. The current price is the price the last trade was executed at. There will also be a bid price and an ask price.
Stocks, ETFs and options are sold in an auction market. Like any auction, there is a bid price, i.e., the price someone is willing to pay. If there are many potential buyers, the bid will rise. If there are no bids at the beginning, the auctioneer will usually lower the ask price. This is the same process we see in the stock market.
The bid is the highest price that someone is willing to pay to buy the stock. The ask price is the lowest price someone will accept to sell the stock. The bid will always be lower than the ask.
For example, there could be a stock that just completed a trade for $10. The bid might be $9.90 and the ask could be $10.10. That means an investor is willing to pay as much as $9.90 to buy the stock while someone is willing to sell at $10.10.
If you enter a market order to buy, you will pay $10.10 since that is the lowest price that induces a sale. If you already own the stock and are looking to sell, a market order will result in a price of $9.90. The difference is fairly small, only about 0.1% of the trade amount.
The difference between the bid and ask price is called the spread, and it is determined by the potential buyers and sellers in each stock. Spreads can be a penny or less if there are a large number of buyers and sellers, a situation we often see in SPDR S&P 500 (NYSE: SPY) and other equities that trade frequently. Spreads can be very large when there are few buyers or sellers, a market condition that is called illiquid.
In options markets, the spread can be substantial. Options generally trade at low prices and the spreads can be 10%-20% in size. For example, an option trading near $1 could have a bid of $0.90 and an ask of $1.10, a difference of 10% from the midpoint. Buying and selling at the market prices could have a significant impact on your return in this case.
There is a way to limit this cost for stocks, ETFs and options (mutual funds trade at the stated price and there is no way to limit trading costs). Rather than using a market order, you can use a limit order to state the highest price you are willing to pay for a buy or the lowest price you will accept when selling. A buy limit order can only be executed at the limit price or lower, and a sell limit order can only be executed at the limit price or higher.
For example, if you enter a "buy, limit $1," then all of the options contracts in the order will be bought for $1 or less. For a "sell, limit $1" order, all of the contracts would be sold for $1 or more.
A limit order does not guarantee that the trade will get executed, which is a risk you need to consider.
Limit orders can be placed between the bid and ask prices and they are often filled fairly quickly. To further decrease trading costs, limit orders can also be placed outside the spread, and although they might not be filled, they could get you in or out of a position at a better price.
With a limit order, you can reduce the cost of trading and increases profits. This is especially important for options and low-priced or low-volume stocks and ETFs where spreads can top 10%. This simple tool can improve your results by 20% or more in those types of investments.
Note: I always use limit orders when selling options. Doing so has led to my Income Trader subscribers bringing in a minimum of $1,873. Readers are easily scaling up to make $6,000... $19,500... even just under $150,000. Click here to learn how you can too.
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