Whether you’re buying stocks, options, or crypto, knowing the difference between a market order and a limit order is a necessity, especially if you’re a trader. Limit orders allow you to decide at what price you want to get in — and out — of trades. They can prevent slippage when trading low liquidity positions, and allow traders to “set it and forget it”. On the other hand, market orders allow you to quickly enter and exit positions, guaranteeing order execution every time. Both have their strengths and weaknesses, but not knowing when to use a market order vs limit order can be very costly.
Market Order: “I want it right now at whatever the going price is.”
Market orders are often the default for many brokerages. A market order facilitates either the immediate purchase of a security at the ask price, or the immediate sale of a security at the bid price. Think of a market order like walking into a car dealership and not negotiating the price. You want the asset, you want it immediately, and you will pay whatever the asking price is. Market orders are simple to deploy and are the most nimble order type.
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When to Use a Market Order
- When the stock or security has high liquidity and a tight bid/ask spread.
- When the price of a stock or security is moving fast and you need to get filled immediately.
- When you can afford the possible slippage.
Slippage: An order getting executed for an unexpected price, common with market orders.
Example: The mid price of a security is $1.00. You issue a market order to sell the security expecting to get $1.00. The order executes, you receive $0.98. Your order experienced $0.02 of negative slippage.
The liquidity issue is highly important. For example, if the bid/ask spread of a security were $0.50/$1.50 and you issued a market buy order, you’d likely get filled near the top end of that range. That means starting out the trade with a “paper loss” — your cost-basis is already higher than the mid price. For situations like this, you’ll want to deploy a…
Limit Order: “I know my price, and I can wait.”
Limit orders are the other most common order type, and their function is simple. A limit order sets the exact value that the buyer or seller is willing to trade at. Unlike market orders, limit orders do not guarantee execution. That means if a security is moving fast, it may get away from you before your order is executed. On the other hand, in situations where liquidity is low or even moderate, limit orders are essential to prevent the possibility of costly slippage. Limit orders offer predictable trade prices, and allow traders to cast their order, and then step away.
When to Use a Limit Order
- When you need to buy or sell a security at a specific price.
- When the stock or security has low liquidity or a wide bid/ask spread.
- When you don’t mind waiting for an order to be executed.
- During “thin trading hours”, like premarket and after hours.
Between the two, limit orders are often the go-to choice for option traders, while stock traders (especially those trading small lots) can sometimes get away with a market order. That’s because most well-known stocks have a reasonably tight bid/ask spread. Shares of stock are simply traded at a much higher volume than options, and have far more fractionality. For instance, the bid/ask spread in a stock might be a single penny.
On the other hand, the best case scenario for the bid/ask spread in an option contract is $1 ($0.01 in premium, $1.00 in actual dollar cost) — and that’s if you’re lucky. If you aren’t trading a high volume option contract, that bid/ask spread may be much wider. As a rule, even when deploying a limit order, option traders should avoid wide bid/ask spreads and low-liquidity contracts if at all possible. Even if you can enter the trade without much hassle, there’s no guarantee that you’ll be able to close the trade with the same ease — which could cost you if you’re forced to exit the trade at an unfavorable price.
Market Order vs Limit Order
Much like comparing different option strategies, there is no “best order type” — but if you’re only using one, you’re handicapping yourself. Both have specific strengths and weaknesses, specific situations that they perform better in. Understanding the different use cases for market orders and limit orders will give you more flexibility as a trader, and will help save you time, frustration, and maybe even some money.