Definition: Market Order and Limit Order
A market order is a type of order used in financial markets to buy or sell a security, such as stocks, bonds, or commodities, at the current market price.
A limit order specifies a minimum price to sell or a maximum price to buy a security. The order can execute at a price higher than the minimum selling price, or it can execute at a lower price than the maximum buying price specified in the order.
Unlike limit orders, which allow traders to specify a particular price at which they are willing to buy or sell a security, a market order instructs the broker to execute the trade immediately at the best available price in the market. Market orders prioritize speed of execution over price, making them one of the quickest ways to enter or exit a position but not necessarily the most profitable way.
Further Read: Stock Market Order Types That You Should Know
Terms that you need to know
Securities: It is a broad term used for stocks, bonds, ETFs, or other types of investments.
Bid-ask spread: Difference between the ask price and the bid/offer price of an asset (shares, bonds, etc).
Support Level: It is a level at which the price of a security regularly stops falling and starts going up.
Resistance Level: It is a level at which the price of a security regularly stops rising and starts falling down.
KEY TAKEAWAYS
- A market order is an instruction to buy or sell a security immediately at the current price.
- A limit order is an instruction to buy or sell only at a price specified by the investor.
- Market orders are best used for buying or selling large-cap stocks, futures, or ETFs.
- A limit order is preferable if buying or selling a thinly traded or highly volatile asset.
How Do Market Orders Work?
When an investor places a market order to buy a security, the broker will search for the best available selling price in the market and execute the trade at that price. Conversely, when an investor places a market order to sell a security, the broker will search for the best available buying price and execute the trade at that price. This means that market orders are subject to price fluctuations between the time the order is placed and when it is executed.
How Do Limit Orders Work?
When an investor places a limit order to buy a security, the broker will search for the best available selling price and the order is executed at the limit price or a lower price if available.
when an investor places a limit order to sell a security, the broker will search for the best available buying price and execute the trade at the limit price or a higher price if available.
Market Order: Pros and Cons
Pros
- Fast Execution: It gets executed at whatever price is available so there isn't a big delay.
- High probability of execution as there are no conditions for the price.
- Simplicity: No limit specification makes it easier to set up.
Cons
- Price Uncertainty: You cannot control the price at which the order is executed.
- Higher Slippage Potential: Execution price can be very different than the expected price.
Limit Order: Pros and Cons
Pros
- Price Control: The biggest advantage of using a limit order is that you can control the prices at which it executes.
- Partial Execution: A large limit order can execute partially at various prices thus it provides more control over trade execution.
- No Slippage: Execution price is always equal to or greater than limit prices so there is no slippage.
Cons
- No Guarantee of Execution: The trade will only execute at limit or better prices so there is no certainty that it will execute.
- Delayed Execution: Execution can be delayed until the limit prices are matched.
- Complexity: Limit orders are more complex to set up as you have to choose limits after analyzing the markets.
When to Use Market Orders
Liquidity: Market orders are suitable when trading highly liquid securities with narrow bid-ask spreads, such as large-cap stocks or major currency pairs in the forex market.
Urgency: If you need to enter or exit a position quickly and are less concerned about the exact price, a market order is the best choice.
Day Trading: Day traders often use market orders to take advantage of short-term price movements. However, they should be cautious of potential slippage.
When to Use Limit Orders
Volatility Management: In highly volatile markets, limit orders can help you avoid being caught in rapid price fluctuations. By setting a limit order, you ensure that you buy or sell at a predetermined price rather than getting filled at potentially unfavorable market prices during periods of volatility.
Partially Executing Large Orders: When you have a large order to execute, you can use limit orders to execute it in smaller portions at different price levels. This helps avoid causing substantial price changes in the market and allows for better control over execution.
After-Hours Trading: Limit orders can be placed outside of regular trading hours, allowing you to participate in extended trading sessions or capture potential gaps in prices when the market opens.
Options Trading: Limit orders are commonly used in options trading to specify the maximum price at which you are willing to buy or the minimum price at which you are willing to sell options contracts.
Range Trading: When you expect a security to trade within a specific price range, you can set limit orders to buy near the support level and sell near the resistance level.
Conclusion
In summary, a market order is a straightforward and efficient way to buy or sell securities at the current market price. It offers speed and a high probability of execution, but traders should be aware of the potential price uncertainty, slippage, and gaps associated with market orders.
Similarly limit order a limit order can give you more control over the prices at which you buy or sell but it can cause delays and you might miss a great offer that was close but not equal to your offer.
Knowing when to use market orders and limit orders, is a crucial skill for any investor or trader. Ultimately, the choice between market orders and limit orders depends on your trading strategy, risk tolerance, and the specific market conditions at the time of your trade.
