Understanding market orders and limit orders

Market V/s Limit Orders

Why understanding of market orders and limit orders is crutial for trading? A limit order gives you price while a market order gives you speed. You can enter a trade with a limit order or a market order. When developing your trading system, two things you need to consider are the time it takes to enter the market and also how slippage, that is the price you are filled at vs the price you wanted, will affect your trade. This should be part of your money management plan. By defining how you will enter the stock market, you will know before you buy if you are decreasing or increasing your risk level.

What are Market Orders

A market order is an order to buy or sell a stock at the best available price.  Generally, this type of order will be executed immediately.  However, the price at which a market order will be executed is not guaranteed.  It is important for investors to remember that the last-traded price is not necessarily the price at which a market order will be executed.  In fast-moving markets, the price at which a market order will execute often deviates from the last-traded price or “real time” quote.

Market orders are the most simplest type of trade execution. Market orders simply tell your broker that you are willing to take whatever price is presented to you when your order is executed. These orders are often subject to the lowest commission since they are the easiest to execute.

Imagine you want to buy 100 shares of Apple Computer, Inc. (Symbol: AAPL). The current market price is $53.95. You log into your brokerage account or call your broker directly on the phone and tell him, “Place a market order for 100 shares of Apple Computer, ticker symbol AAPL”. By the time the order is actually executed a few seconds later, the market price may be higher or lower; $54.10 or $53.75 for example. Your cost before commissions will vary accordingly. In our example, the difference between $5,410 for the round lot and $5,375, or $35. That may not seem like much, but thanks to the time value of money, those savings can result in a substantially larger nest egg.

What are Limit Orders

A limit order lets you set a minimum or maximum price before your stock trade gets converted to a market order and sent to the stock exchange. Until you become very experienced, almost all orders should be limit orders to protect yourself. A limit order allows you to limit either the maximum price you pay or the minimum price you are willing to accept when buying or selling a stock. The primary difference between a market order and a limit order is that your stock broker cannot guarantee that the latter will be executed.

Imagine you want to buy 300 shares of U.S. Bank stock. The current price is $29 per share. You do not want to pay more than $27.50, so you place a limit order set to execute at $27.50 or less. If the stock falls to that price, your order should be executed.

There are three considerations you should take into account before placing a limit order:

  • The stock price may never fall (or rise) to the limit you’ve established. As a result, your order may never be executed.
  • Limit orders are executed by your broker in the order they are received. It is possible that the stock you are interested in buying (selling) will reach your limit price yet your trade will not be filled because the price fluctuated above (below) your limit before the broker could get to your order.
  • If there is a sudden drop in the stock price, your order will be executed at your limit price. In other words, imagine the stock you want is trading at $50 per share. You have a limit order placed at $48 per share. The CEO resigns, and in a single session, the stock plummets to $40 per share. As the security was falling in price, your order was executed. You are now sitting on a loss of $8 per share.

How should you buy or sell a stock: limit order or market order?

Limit order: Slow entry but reduces slippage
Market order: increases speed at which you will enter the market.

In the stock market you can either buy fast (market order), think about the hare in the hare and tortoise story or slow (limit order) like the tortoise.

Let us look at the stock market. For every stock there is a bid and asked price. For low volume stocks, say under 50,000 shares traded per day the bid/asked spread can be quite large.

Example: stock ABC bid 5.78 asked 5.86

This means that someone wants the stock but is only willing to buy it for 5.78, but the seller wants 5.86. Therefore, this stock will just sit there until either a buyer raises their bid price or a seller lowers their asked price. When the two match, you have a trade.

Now let us look at a stock that trades over 1,000,000 shares a day. Now the bid/asked will generally look more like this

Example: stock XYZ bid 5.81 asked 5.82

The spread is much narrower and trading occurs much more frequently.

If you decide to buy the above stocks, here is what would happen:

If you need the stock right now you need to place a market order. You would likely pay $5.86 per share for ABC and $5.82 per share for XYZ but you should get filled within seconds after placing your order. In a fast moving market, the asked price may change quickly. In the case of XYZ, just after you place your order, the asked price could jump to $5.85. You now just incurred some unexpected slippage and paid $5.85 for the stock.

If you want the stock but only want to pay $5.81 per share then you would place a limit order at $5.81. In the case of XYZ you would likely pick this up within a minute provided the stock price did not move up on you after you placed your bid. However, for ABC, you would only buy the stock if someone dropped their asked price. This could take minutes or hours but there will be no slippage in this transaction. However, there are times when you will not be successful in your purchase when you buy a stock this way.

The choice is yours. When you place a limit order, you know what price you are paying but you are unsure whether you will get the stock. When you place a market order, you know you will get the stock buy you will not know the fill price until after you purchase the stock.