When it comes to buying or selling stocks, there are two main types of orders investors can use: market orders and limit orders. Understanding the difference between these two order types is crucial for anyone navigating the world of stock trading.
A market order is an immediate stock price quote, or better, a buyer accepts in a market. In contrast, a limit order is at a specified price an investor consents to buy or sell a stock. Like buying a gold bar, you may decide to buy one at whatever price the market offers at the moment(market order.) Or you may specify with a trader on a fixed price(limit order) before paying for it.
To gain a deeper understanding of market orders, limit orders, and how to use them effectively in your stock trading journey, read on to learn more about these essential tools for investors and traders.
Market Orders
The primary benefit of a market order is that you can sell a stock for the best-prevailing market price as quickly as possible. Stock liquidity is what matters in a buying or selling position. When it comes to dealing with a market order, you may pay attention to the following:
Execution priority and trade speed
A market order, a popular execution order in investing management, allows fast and quickly movable positions in the market, prioritizing your purchases over other orders like a limit order to a new market position. Besides, with the technology advances, a sophisticated computer can process a market order in milliseconds using mathematical algorithms.
Risks and Considerations
While market orders offer speed in executing trades, they come with the drawback of potential price uncertainty and heightened risks in illiquid markets. It’s essential to consider these factors when deciding to use a market order for your stock transactions.
Pro
- Quick Execution: Market orders are executed swiftly, ensuring that you acquire or sell the desired number of shares promptly.
Cons
- Price Uncertainty: Market orders offer limited control over the transaction price, potentially resulting in less favorable prices compared to the current market rate.
- Market Illiquidity Risk: In illiquid markets, market orders can lead to unfavorable prices due to the scarcity of buyers or sellers, as seen in the example with ABC shares.
Example
You are interested in a company ABC’s shares and send a market order of buying 100 shares of the company to your broker. The broker buys 100 shares of ABC for S$2,000 at S$20 per share – the instant price the market offers upon the order.
A market order is a stock order where you usually have no control over the price when buying or selling a stock. Therefore, you may find out later the ABC share is selling at S$19 per share moments after filling the order.
If ABC shares are illiquid, meaning there are few buyers and sellers for the share in the market, you may be forced to sell lower or buy higher at a price quite different from what you intended due to market illiquidity.
Suitable context for utilizing market orders
You are in a better position to execute a market order under the following circumstances:
- You want to buy or sell a stock as quickly as possible without being concerned about its price.
- You trade for a small number of shares in a market order, less than 100, to allow the market to accept them swiftly.
- You trade in a highly liquid market with a small spread between sell and buy prices for a stock.
Limit Orders
A limit order is set “at the limit” or “at a limit price” to buy or sell a stock at a specified or better price. A typical limit order lasts a limited time unless canceled by you before expiry. Contrary to a market order, an investor stipulates the price at which he is willing to buy or sell a stock in a limit order.
Pros
- Control Over Price: Limit orders allow you to specify the exact price at which you want to buy or sell a stock, giving you precise control over your trade execution.
- Possibility of Non-Execution: Limit orders protect you from unfavorable trades by ensuring that your order is only executed when the market reaches your specified price, preventing trades at undesirable rates.
- Cost Savings: In less liquid markets with larger bid-ask spreads, using a limit order can save you costs such as trading commissions, as you can set a price that accounts for the spread.
- Profit Opportunities: Limit orders can be used to capture stock prices in volatile markets, potentially leading to profit when the market reaches your specified price.
Cons
- Risk of Unrealistic Price Projection: Placing an unrealistic price projection in a limit order may result in missed trading opportunities if the market never reaches your specified price.
- No Deal in Unpredictable Markets: In unpredictable or highly volatile markets, your limit order may not get executed if the market doesn’t reach your specified price, potentially leaving you without any trade.
- Concessions in Illiquid Markets: If a stock is illiquid (low market demand or supply), you may need to set a less favorable price in your limit order to attract a counterparty, potentially leading to unfavorable terms.
- Counterparty Preferences: In some cases, your specified price in a limit order may not align with what potential counterparties are willing to accept, resulting in no deal.
Example
You wanted to buy 100 company ABC’s shares because of its recent surge and placed a limit order with a specified limit price of S$15 when its current price was S$20. The purchase price was S$1,500 for your investment.
Now, ABS shares slide further and fall to S$13 per share. You lose S$2 per share or S$200 in value. If you changed the expected price to S$13 or lower per share on the limit order, you would not lose money at the book value. A limit order may not guarantee the best price for your stock.
Instances where limit orders are beneficial
You may need a limit order if you:
- You trade many shares(more than 100) at a time to keep its price in check.
- You trade an illiquid stock to prevent its value from sinking.
- You designate a stock with its expected price different from its market price.
Special considerations
You should consider several factors if you intend to use limit orders to invest:
1. Risk of limit orders
- Non-execution: A limit order may not materialize due to pricing mismatch and cause a loss of investment opportunity.
- Partial fills: A limit order may be partially filled due to stock illiquidity.
2. Brokerage fees: A high commission eats your profit even if you successfully place an order.
3. Usage in low-volume stocks: Investing in low-trading volume stocks may incur higher costs, whatever order types are used. The spreads for these stocks are higher than others due to a lack of marketability.
Additional Order Type: Stop Order
Definition and functionalities
A stop order is a trade order to buy or sell a security once a market price reaches a certain level. It differs from a limit order: a stop order at a certain level automatically triggers and converts into a market order, looking for the best-prevailing market price. The trading tool is widely used to manage risks and protect profits.
A limited order specifies a price at which an investor buys or sells a stock once the price reaches a price level. Investors often use limit orders to get the best price for stocks.
How a stop order combines stop and limit features
Below are the features of a stop order combining market and limit orders:
- Stop-loss order: If you own 100 shares of company ABC and want to limit the loss from the fall in price, you place a stop-loss order to sell at S$15 per share; your order will trigger and convert to a market order if it falls to S$15 or lower, called a stop price.
- Stop-limit order: Like the stop-loss order case, a stop-limit order will trigger and convert into a limit order once the stock reaches a limit price or better.
The primary difference is the type of order transformed. A stop-loss order transforms into a market order. In contrast, a stop-limit order changes into a limit order upon reaching a certain price level.
FAQs
1. Is a market order better than a limit order?
A limit order may be insignificant if you are a long-term investor, as you focus only on long-term prospects, such as growth. A market order is a popular option for most investors, especially as long-term investors pay little attention to short-term price fluctuations. On the contrary,
Short-term investors, aiming to profit from market momentums, embrace limit orders more often than others to lock in profits and reduce price risks.
Read Also: Long Vs Short Stock Position & Technical Vs Fundamental Analysis
2. Is a limit order cheaper than a market order?
A limit order includes more trading features, options, and customizations than a straightforward market order. Thus, a limit order can cost more than a market order; however, many brokerages offer them(some limitations attached) for free due to competition.
3. When should you use a limit order?
Investors use limit orders to lock in the pricing in a volatile market, where stock value changes quickly. Short-term traders can manage risks by controlling the prices of stocks.
Besides, stop-loss orders, or stop-limit orders, developed from the limit order, can provide investors with more options for preserving their profits and reducing the risk of loss, particularly in an unstable market.
Wrap-Ups
A market order is an open order to capture a prevalent market price for a stock. In contrast, a limit order is a semi-closed-end order to invest at a specified price or better. Besides, further investing options, such as stop-loss and stop-limit orders developed from limit orders, assist investors in managing risks and locking in profits. However, like other investments, the options are not a guarantor of success; you should evaluate your situation before using the options.
Key takeaways:
- A market order is a market instruction to buy or sell at a current price.
- A limit order is an order with a specified price for buying or selling a stock.
- A market order is generally popular, while a limit order is a favorite option for short-term traders.
- A stop-loss order is convertible to a market order once a stock price reaches a certain level.
- A stop-limit order is convertible to a limit order once a stock reaches a price limit.
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