Market Orders and Limit orders: Grasping the Basics of Trade

Meanings:

Market orders are directives to execute transactions instantly at the prevailing market price, with the emphasis placed on completing the trade rather than selecting a specific price. Since the trade execution process entails some time element, the final price of the stock is confirmed only once the order is completed, potentially leading to a difference between the anticipated and actual cost. However, such orders have a high probability of being fulfilled and are particularly effective in highly liquid markets.

In a limit order, the transaction is set to occur at a specified price, with the focus on achieving the desired stock price rather than on immediate trade execution, unlike market order. The buyer or seller will wait out the price fluctuations, and the order will only be executed once the target price is reached. There’s no guarantee of the trade happening, and if it isn’t executed within the day, the order will be canceled. This leads to uncertainty in trade execution. Limit orders are particularly well-suited for markets with limited liquidity.

In similar manner, there is another type of order called stop-loss order. Once the stock is purchased, the investor can place a stop-loss order based on their risk preferences. Hereon, at an adverse scenario, if the stock price declines to the stop-loss level, the order will be initiated to sell the stock and minimize losses.

Risk:

Market order has no control over the market price and hence if the bid/ask spread is high, a market order could be executed at a price that is significantly different from the recently trade, potentially leading to an unfavorable trade outcomes.

In a limit order, there is a non-execution risk associated with limit order if the market price does not reach the specific price. This reliance on the specific price can result in opportunity costs, as the risk of losing potential profits increases if the market price approaches but not precisely meet the limit.

Example of Market orders and Limit Orders:

Market orders:

Let say, an investor places an order to buy 100 shares of Company A. This means the investor is willing to pay whatever the current price is, ensuring the trade is executed quickly. If the shares are priced at Rs.400 each, the investor's order would be filled at a total cost of Rs.40,000. However, the investor often doesn't know the exact price at which the shares will be bought when placing the market order. For instance, the other party may have quoted the shares at Rs.380 each at the time the order was placed, as this could have been the market price while the order was being processed.

Limit orders:

Suppose the current market price for Company B is Rs.250. The investor expects the stock to fluctuate between Rs.240 and Rs.260 during the trading period. To tap into this, the investor sets a limit order to buy 100 shares of company B at Rs.245 each. Since the market price is higher than the order price of Rs.245, the order won't be executed immediately. Later in the same day, when the company’s share price drops to Rs.245, it triggers the limit order (given the orders are matched), and the investor successfully purchases 100 units of shares for a total of Rs.24,500. Even if the share price falls further to Rs.230, the transaction is complete since the order was filled at the specified price.

Impact on market:

Substantial market orders can drain liquidity by consuming significant amount of available cashflows that will widen the bid/ask spread making it more costly for traders to enter or exit positions. It is also important to note that market orders placed after the trading hours are stocked at opening market price of the next trading day. It can further trigger stop loss orders which contributes to market volatility.

Limit orders close to current market prices help to create narrow bid/ask spread. Significant volumes of such orders (both buy and sell) creates a resistance and support levels as stock prices will bounce off through these levels without breaking out. Limit orders absorbs price fluctuations preventing excessive volatility.

Additionally, both market orders and limit orders can influence the market sentiments. Large-scale buy orders can lead to bullish sentiment and encourage additional buying pressure. Conversely, extensive sell orders can lead to bearish sentiment. Traders’ use market/limit orders to manipulate low-cap stocks temporarily. These fabricated move does not reflect the true value of the stocks.

Identification

By its characteristic, market orders get executed quickly at the current market price, therefore, if trade occurs almost instantly at the current bid/ask price and frequent price fluctuations are observed, then its probably market order. Additionally, a rapid cut-back in the size of the order book at current price level is also a signal of market order.

Limit orders at specific prices are visible on the order book as it remains there until gets executed or cancelled. Limit orders can be identified with ease by analyzing the order book as they provide price and volume data on both bid and ask sides.

Suitability:

Market orders should generally be placed for stocks of well-established high-cap companies with low volatility that are highly liquid, i.e., stocks trading with high volume and tight bid-ask spread. Further, market orders should be placed during normal trading hours to reduce chances of price gaps or slippage that occurs during the opening and closing hours of the business. Market orders can be of high significance if used when trying to enter or exit a position quickly in a fast moving market. Moreover, for a long-term investment, placing a market order to acquire stocks at the current market price is usually the best approach. Over long periods, the specific price at which you buy the security becomes less important due to the effects of compounding growth.

Limit orders are best suitable for less tradable low-cap stocks having a wide bid-ask spread which are highly volatile to market fluctuations. This way, by setting a limit order, you avoid overpaying or over selling stocks in volatile markets. For example: If you believe that the stock price will fall to a certain level before rebounding, you can place a limit order to buy at that lower price. In similar manner, during a rally, if you think that the stock price will hit certain peak before falling, you can place a limit order to buy at lower price. Using a limit order is a strategic way to control price at which you enter or exit a position.

In summary, use market orders for urgency and simplicity, particularly for long-term investments, while limit orders are beneficial for price control and when dealing with high volatility or large trade volumes.

About the Author:

- Sandeepa Paudel, ACCA Student
- Research Analyst
- Garima Capital Limited