Limit or Market ?

Jim’s been watching this stock for weeks. He’s done all of his research, and he’s set in stone that he’s only buying it if it dips below a certain price. A few days later, he finally sees that it’s down to his ideal price, so he goes ahead and buys it. Order executed, an average cost of $15.72 for all the shares, but he was only willing to buy them if they slipped below $15.25! But the ticker said $15.18, so what happened?

To understand Jim’s mistake, it is important to consider the mechanisms under which our electronic markets operate. While the ideas presented may seem simple, misunderstanding them can leave you scratching your head (and out of some money) just like our poor investor Jim.

The first important concept to understand is what determines the price for every stock. Simply put, it is supply and demand. The stock market consists of a large pool of buyers and sellers who constantly need to agree upon prices under which they will exchange their shares. Thus, if the demand for a stock is greater than its supply, the stock should appreciate.

Conversely, if the supply of a stock exceeds the demand for it, the price will fall. Understanding these forces that affect stock prices is not enough, however.

The next idea to consider is how buyers and sellers communicate with each other about their willingness to buy and sell their shares. In the past, investors would typically call a broker who would then try to find another party willing to engage in the second half of the transaction. Once the broker was able to, the shares would be traded, and the rest is history.

While the environment is much different today with fewer phone calls and much less shouting across the trading floor, the same concept is still happening. The prices that buyers and sellers desire are known as the bid and ask. The bid price represents the maximum amount out of all buyers that someone is willing to pay for shares while the ask represents the minimum amount out of all sellers that someone is willing to let go of their shares for. These prices are typically followed by quantities that reflect the number of shares that are up for interest or offer.

There is typically a gap between the bid and ask which is known as the bid-ask spread.

When this spread reaches zero in theory, shares are then traded because a buyer and seller have agreed upon a price. With the speed at which markets move today, this happens very frequently, so a general rule is that the wider the bid-ask spread gets, the less liquid that particular stock becomes while the smaller it gets, the more liquid the stock becomes.

So now we understand what’s going on in the market, but how do individual investors express their willingness in the market?

There are two ways to do so: through either a market order or a limit order. When buying, a market order signals that the investor wants the stock immediately at the best available price. This is identical to the ask price because the ask price represents the lowest price out of all willing sellers.

When selling, a market order signals that the investor wants to get rid of the stock immediately at the best available price, which is the same as the bid price.

The most important thing to note here is that a market order does not mean a buy or sell at the current price that is displayed on the ticker!

This price is merely a reflection of the last price the stock was traded at. A limit order on the other hand is a signal to only buy the stock at a certain price or lower or to only sell the stock at a certain price or higher.

Investors can make use of limit orders to guarantee themselves a certain price or better because the order will only be filled if the current market conditions fit the parameters.

In other words, if I have a limit buy order on Apple at $186.44, I am guaranteed to buy my shares of Apple at $186.44 or cheaper.

So, let’s go back to our investor Jim from the beginning and see what really happened.

He wanted his shares below $15.25 and saw the last price was $15.18. Seeing this, Jim put in a market order, thinking that he would get all of his shares at $15.18, but in reality, the stock wasn’t that liquid, and the ask was at $15.72. His market order searched for the best price available (the ask price) and found it at $15.72. To ensure himself a price of $15.25 or below, Jim should have used a limit order.

In general, limit orders are better when trading stocks with high bid-ask spreads (low liquidity) and when markets are extremely volatile.

Sometimes, however, it isn’t really a big deal to use a market order.

Let’s say you want to buy shares of Lockheed Martin after its recent dip. If you are happy with the general price and aren’t sweating about a few cents here or there since you plan to hold it for the long-term, a market order guarantees you to get your shares near the last price that you liked.

If you were trying to use a limit order at $300.00 and the shares dipped to a $300.37 low, however, you would have never picked them up. Six months later, the shares are at $385 and now you’re mad at yourself. Hopefully now the picture is much clearer on how orders work in the electronic markets and when it makes more sense to use which one.