Today, we’re looking at the difference between two order types – market vs limit order. Let’s get started.
Contents
Introduction
There are two major types of orders that you can put into your broker platform when you buy or sell equities or options.
Buying and selling shares using a market order is fine for liquid equities.
However, when you buy or sell options, it is almost always better to use a limit order.
We’ll take a look at why that is the case.
By “liquid,” we mean the difference between the bid price and the ask price is small.
The bid price is the lower of the two and is the price at which the buyers are willing to buy.
The ask price is the price that sellers are asking for.
The “mid-price” is the average price between the bid and ask.
A trade is executed when the buyers and sellers come together at a price somewhere in between that they agree on.
The bid ask spread is much wider on options than on shares of stock.
The differential between the bid and ask price of an option contract varies greatly on many factors, some of which are:
- the liquidity of the underlying asset
- the strike and expiration of the option, such as is it in or out of the money and is it short-term or long-term.
- the volatility of the market at the current time
- the volume and open interest of the particular option strike
- the time of day
Market Order
A market order tells your broker to fill your order as soon as possible at whatever market price it is able to get filled at.
That means that if you are trying to buy a call option with a bid price of $3.34, it is not getting filled.
The broker can keep increasing that price until it gets filled.
The fill price at which the option is purchased could end up being $3.85.
Perhaps that is more than what you had wanted to pay for the option. It doesn’t matter. You end up with whatever price it got filled at.
The market order tells the broker that your first priority is to get the order filled. The price at which it is filled is secondary.
Limit Order
The limit order tells the broker that your first priority is getting the specified price. Whether the order is filled or not is secondary.
Suppose you are trying to buy an option with a bid price of $3.34 and don’t want to pay more than $3.35 for that option.
Then you would set a limit order to buy at $3.35.
Your broker will not purchase that option for you unless it can get it filled for $3.35 or better (which means $3.35 or lower since you are trying to buy).
If the value of that option increases due to price or volatility changes and the market price of that option moves up higher than $3.35, then it is possible that your order will never get filled.
When you put in your order, you can specify whether that order is:
1) good till the end of the market day. This is known as “Good Day.”
or
2) good for subsequent trading sessions until you explicitly cancel the order. This is known as “Good Till Cancel.”
The “Good Till Cancel” specification does not mean that the order is good forever.
Depending on the broker, they may automatically cancel it after some time (like, for example, six months) if it is still not filled.
They assume you probably forgot about your order.
Market vs Limit Order
If the limit order has been sitting there for a few minutes and is still not filled, many investors will cancel the order and put in a new limit order with a higher limit price.
This tells the broker that you are willing to pay a nickel more to get filled.
Many brokers have an “order replace” feature where you don’t have to re-enter your entire order; just update your limit price.
But internally, it still is doing a cancel and new order for you.
Because the new order is also a limit order, it too may still not get filled.
The investor can replace it with a higher limit price until it gets filled.
This is known as “negotiating the fill price.”
In effect, the investor is doing “price discovery” to find the fair value of the option they are trying to buy.
They do not want to overpay.
By incrementally increasing the limit price, the investor knows they got a good price because the price that was a nickel less was not being filled.
Depending on the option, the limit price can sometimes be incremented by a nickel.
And for other options, the limit price can be incremented by as little as a penny.
Some investors are tough negotiators because they increment their limit price by a penny each time.
And they can spend hours waiting.
You get a good price by negotiating, but then you run the risk of the price running away from you, and you have to chase it.
Whether you are a tough negotiator or whether you want to get filled quickly depends on your trading style.
FAQ
Are market orders more expensive than limit orders?
Broker fees for market orders are often cheaper than limit orders.
Limit orders give the investor more control over the trade execution price but do not guarantee that the order will get filled.
Because limit orders are more complicated trades for the broker to execute, the broker may charge a higher fee.
Market orders are the easiest and quickest way to get filled on a trade.
However, if there is a wide bid-ask spread, the execution price can result in slippage.
Most stocks trade with a tight bid-ask spread, so the difference between placing a market vs limit order is not substantial.
Certain options can have wide bid-ask spreads; therefore, using a market order vs. limit order could have a big difference in the trade execution price.
Yes, market orders are filled before limit orders, assuming both are triggered at the same price. This is because the market order attempt to get you filled as soon as possible.
When should a limit order be placed?
Limit orders (as well as market orders) can be placed anytime, during trading hours or off trading hours. That does not mean it will get filled when placed.
What happens if I place a market order after hours?
Market orders placed outside regular trading hours will get queued for execution as soon as the market opens.
Can I place a limit order before the market opens?
Yes, you can place a limit order (as well as a market order) before the market open.
Can a limit order be canceled?
Limit orders (as well as market orders) can be canceled anytime, as long as they have not been filled.
How long does it take for a limit order to execute?
It depends on when the limit price is met. It may fill right away if there are buyers at that limit price. Or the price might move away from your limit price, which may never get filled.
Conclusion
A market order is usually fine for buying and selling stock on liquid symbols.
Whether you do limit or market order, the price that you get filled will likely be very close since so many people are bidding on the price.
This is not true of options.
If you ever try getting filled on a multi-leg option structure on SPX (which is the quite liquid S&P500 index), you will see that the bid and ask price fluctuate quite a bit.
You can’t even tell what the mid-price is because it is jumping around. Instead, you have a mid-range.
Therefore, a limit order is needed. When paying a debit, place the order with a limit price at the low end of the range and slowly negotiate the price upwards. You don’t want to overpay.
When initiating a trade for a credit, place the order with a limit price at the high end of the range and slowly negotiate the price downwards.
You want to get as high of a credit as possible.
In short, a market order guarantees a fill but does not guarantee at what price.
A limit order guarantees a particular price or better; it does not guarantee that it gets filled.
You can “have your cake” or “eat it,”; but you cannot have both.
We hope you enjoyed this article on market vs limit order. If you have any questions, please email us or leave a comment below.
Trade safe!
Disclaimer: The information above is for educational purposes only and should not be treated as investment advice. The strategy presented would not be suitable for investors who are not familiar with exchange traded options. Any readers interested in this strategy should do their own research and seek advice from a licensed financial adviser.
Thanks, Good article!
Just a small doubt a need clarify. When in your article you say to place the order with a limit price at the low end of the range and slowly negotiate the price upwards. You are refering to the low end range of bid-ask spread or to the low end range of mid price?
Thank in advance and best reagards
Luis
Low end range of the spread.
Thank you again for your promt response!
I am very sorry for repeating the question but I was not sure about if I sent it correctly the first time.
Best Regards
Luis
No problem.
Gavin,
Good article! Many thanks for sharing your knowledge.
I have got a small doubt and I will be very glad if you could clarify it to me.
When it comes to limit orders you say “When paying a debit, place the order with a limit price at the low end of the range and slowly negotiate the price upwards”
Do you mean the low end of bid-ask range or low end of mid-price range?
Thanks in advance and best regards
Luis