Ways to Limit the Risk of Trading in Pennies

USC finance professor Larry Harris, who has studied the pros and cons of decimal pricing, believes that the risks to U.S. investors might be significant enough to mandate a specific price “spread” on stocks.

Rather than penny increments, Harris favors a minimum 5-cent increment.

But the Securities and Exchange Commission has essentially said it believes markets should determine the minimum increment. And the New York Stock Exchange, at least in its planned pilot program, will use penny increments.

Assuming the markets adopt penny pricing, individual investors may have to adjust their trading strategies.

For example, for the last few years individuals have been advised to use “limit” orders rather than “market” orders. A limit order instructs a broker to trade at a specific price or better, while a market order is executed at whatever the prevailing price happens to be.

Limit orders have become popular because many investors in fast-rising stocks who expected to buy shares at, say, $40, ended up paying $60 or more as prices shot up before their market orders were filled.

Regulators and brokerages have counseled individuals to use limit orders to guard against that risk.

But with penny pricing, if individuals feel they’re missing out on profitable trades because professionals are “stepping ahead” of their limit orders, experts predict that small investors will turn back to market orders.

A market order all but guarantees that an order will be filled. And for stocks with minimal volatility, that may be the best way to go under decimal pricing, some experts say.

Harris recommends that individuals, especially when they’re trafficking in hot stocks, consider placing “marketable” limit orders. In the case of a buy order, this would be an order placed at the current market price or slightly higher.

For example, say a stock’s current “offer”--the price at which a dealer is offering to sell--is $20. If you’re eager to buy, you may bid $20.05. You would boost your chances of getting the stock, and still would get any lower-priced shares that are available. But you wouldn’t pay more than you want to.

If you’re seeking to sell, you can place a limit order slightly below the current market price.

Of course, if a stock is tanking and you really want out, you take a chance whenever you use a limit order.

Another strategy that may help under decimal pricing: If you’re thinking of placing a limit order for a large block of shares, especially of a lightly traded stock, consider breaking the order into smaller pieces and placing several orders for smaller quantities, Harris said.

A large order may entice professionals to step in front of you, he said.