Market order vs limit order? Let’s dive in! Imagine that you are in need of cash, and, for that reason, you need to sell some shares of a stock you own. What type of trade order should you submit to meet your liquidity needs? If your need for cash is urgent, what you need is a market order. But, if you could wait a while for an opportunity to get a better price for your shares, you can submit a limit order instead.
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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. It can take a while for a limit order to be executed, and, if the share price starts to move in the opposite direction, that limit order may never be filled.
Market orders and price uncertainty
The market order ensures fast execution, which is helpful if you need to get in or out of a position as quickly as possible. However, 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 your shares 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. However, 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 would be filled at prices below $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 upward (downward) pressure on the price of the asset, causing you to pay more (get less) when buying (selling) shares.
Limit orders and execution uncertainty
If you are not in a rush to trade and believe that the shares you want to buy (sell) will trade at a lower (higher) price in the near future (remember you’re trying to “buy low and sell high”), it makes sense for you to submit a limit order. Such an order specifies the maximum (minimum) price you would be willing to accept for buying (selling) the stock you are interested in.
Going back to the example earlier where the market bid is $38.01 and the market sell is $38.04, you can submit a limit buy order of, say, $37 to get the shares at a lower price or can place a limit sell order of, say, $39 to sell your shares at a higher price.
Overall, it is impossible to know exactly how long you would have to wait before your limit order is executed. It may never happen. The share price might just keep moving in the opposite direction in which case your order would never be filled. This is referred to as execution uncertainty. Of course, if you observe that the share price is moving too far away from your limit order, you can cancel that and a place new one that is closer to the current price.
Video summary
Summary
Market order vs limit order? In this lesson, we have explained that the choice between these two types of orders involves a tradeoff between price uncertainty and execution uncertainty. Specifically, 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, it may take a long time for that to happen, creating execution uncertainty.
Further reading:
Harris and Hasbrouck (1996) ‘Market vs. Limit Orders: The SuperDOT Evidence on Order Submission Strategy‘, Journal of Financial and Quantitative Analysis, Vol. 31(2), pp. 213-231.
What is next?
This is the second lesson in our course on the fundamentals of trading.
- Next lesson: We will explain the difference between long positions and short positions.
- Previous lesson: We focus on the contrast between the bid price and the ask price.
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