Imagine that you own shares of Twitter, Inc. and are thinking of selling those shares to help finance the purchase of a new car. What type of trade order should you submit if you want to purchase the car as soon as possible? And, what type of order is more suitable if you would prefer to sell these shares at a higher price and can wait for some time before you purchase the car?
- Define the concepts of market order and limit order.
- Recognize how these two types of orders affect liquidity demand and supply.
- Understand the tradeoff between price uncertainty and execution uncertainty.
Demanding (supplying) liquidity with market (limit) orders
A market order is a trade order to either buy or sell a security immediately at the prevailing market price. An investor who submits a market order is demanding liquidity from the market. That is, she is wishing to trade the security as quickly as possible and at the best price possible. In contrast, a limit order is an order to trade if the security reaches a certain price. An investor who places a limit order is supplying liquidity to the market as their order waits in the order book to be matched with a market order.
Market orders and price uncertainty
If you would like to sell your Twitter shares as quickly as possible, you should submit a market order. While this ensures fast execution, it creates some price uncertainty as you have to accept the prevailing market price at the time your order is executed.
Suppose that the market bid price and ask price for Twitter are $38.01 and $38.04, respectively. If your order size is small (i.e., you are only selling a few shares), you may be able to sell all your shares at the market bid price of $38.01 unless the bid price moves before your order is executed. If you are trying to sell a large number of shares, there is an added complication: Depending on the depth of the order book, only part of your order is likely to be filled at $38.01, while the rest being filled at prices less than $38.01. This is known as the price impact, and it contributes to price uncertainty. So, bear in mind that large market buy (sell) orders exert upwards (downwards) pressure on the price of the asset, causing you to pay more (get less) when buying (selling) shares.
Limit orders and execution uncertainty
Alternatively, if you are not in a rush to sell and believe that Twitter shares will gain value in the coming days, weeks, etc, you can submit a limit sell order. Such an order specifies the minimum price you would be willing to sell your shares at, say $38.5. So, your order would be executed when TWTR shares climb up to that value. It is impossible to know how long that would take, though. It may never happen. The share price might just keep falling in which case your order would never be filled. This is referred to as the execution uncertainty: You don’t know when and if your limit order will be executed. Of course, you can cancel your limit orders and/or place new limit orders.
A tradeoff between price uncertainty and execution uncertainty
In summary, market orders offer fast execution but traders should be willing to accept the market price. Thus, market orders inherit price uncertainty. On the other hand, for traders who can wait, limit orders provide an opportunity to trade at better prices conditional on the share price moving in the desired direction. However, the price may never move in that direction, creating execution uncertainty.
What is next?
This post is part of the series on trading basics. The next post in the series contrasts the bid price and ask price. The previous post explained what a trade order is.
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