The Difference Between Market Orders and Limit Orders (and When to Use Them)
When you are new to the trading world, it can seem so daunting.
There is so much information on strategies, signals, money managers, secrets of the trade, and much more.
You know you have a long way to go, but you just want to learn the basics.
Like, how do I purchase a stock on the market?
Let’s assume you know what company you want to buy and you are ready to buy it.
You will have to use one of two orders, market or limit order.
What is a Market Order?
First you need to decide how many shares you want to actually purchase of a stock.
For this example we will assume you want to buy 100 shares of ABC Co, trading at $10.00.
The market order is equivalent to you saying okay market, I want to purchase 100 shares at the current market value.
So you figure, okay, $10 a share x 100 shares = $1,000?
You click okay.
You go to check your account statement and it shows that the total trade cost you $1,500 , or 50% more than you expected.
What the heck happened?
The Hidden Danger of a Market Order
You check the average daily volume and notice that ABC Co only trades 100 shares on a daily basis. Wow you think, I moved the market.
This is a dramatic example, but let’s explain what happened.
When you are trading a stock that has very thin volume you can move the market, because you are requesting to buy more shares than are available for sale.
The market order has a job to purchase your desired quantity, and you are willing to pay whatever price until you get the 100 shares you want.
So think about what happens? As you buy up all the shares, the price goes higher to find out if there are enough sellers at the next level up, which is often one cent. Let’s say only 2 shares are for sale. You move up higher and pay more to get the next 2, and so on until you purchase the full 100.
If the stock does not have enough volume and you are buying a lot, by the time it is all said and done you can run the price up so high that your market order fills 5%+ higher than what you saw as the last quote.
What’s the learning lesson here?
Most companies can easily handle a few thousand shares at a time. If you plan to buy big name companies you won’t run into issues using the market order, because there are 10’s of millions of shares traded.
However, smaller name companies can be very troublesome, and you should always check the average volume before doing market orders. In fact, don’t even even use market orders on small companies.
You are likely thinking by now, there has to be a better way. I want to buy 100 shares but I want to set a maximum price I am willing to pay!
Meet the limit order.
What is a Limit Order
Let’s now assume you want to buy 100 shares of ABC Co still, but you only want to pay $10.00 a share maximum to acquire the position.
The last sale shows that it traded at $10.00.
You would now use a limit order, which stipulates to purchase shares up to your desired quantity at the limit price OR lower only.
This order “limits” the maximum you pay for a stock.
If you buy 50 shares at $10.00 and the price increases to $10.01, you will not purchase any additional shares until the price drops back down to $10.00.
This means that using a limit order guarantees the fill price, but not the order quantity or time.
Basically, you are more firm on the price you pay then the quantity you wish to own.
Buying Stocks When they Are “Cheaper” with a Limit Order
You might be thinking, hey, if I can set the order to any price why wouldn’t I set it to one that is much lower?
For example, instead of $10 I want to buy it at $9.50, heck the cheaper the better. But is it?
The only problem is that it may never drop to that price, and it can continue higher without you giving you a chance to own it at your desired level.
Another issue with buying stock when you think it is cheap is that here might be a good reason it got that cheap in the first place, and in fact, it could be heading for much cheaper prices soon. This could mean that $9.50 is just a stopping ground on the way to something “cheaper”, like $2.00.
Or even $0.
So don’t treat the limit order as a boxing day buying strategy.
Use it responsibly and only own companies that are performing well and you expect them to continue this trend.
When to Use the Limit Order and Market Order
I put together a quick little graphic to help you out as a new trader.
You have the option to be guaranteed the price or the execution.
Do you prefer to get a good price or do you prefer to get out quickly and in full?
The Difference Between Market Orders and Limit Orders – Conclusion
In the market, like in life, there is no way to get everything you want AND pay the price you want to.
You have to chose one or the other.
If you are trading very thin volume stocks, you should definitely use a limit order. Even if you set the limit at the market price, it will ensure you purchase the shares at a predictable price and prevent any problems.
If you just want to get out quickly and get rid of your position or get into one, use the market order.
If the stock has good volume, the market order will not pose any risk at all.
Good luck and good trading.
Let us know, what order type works better for your strategy, and when do you use each?
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The information contained in this post is solely for educational purposes, and does not constitute investment advice. The risk of trading in securities markets can be substantial. You should carefully consider if engaging in such activity is suitable to your own financial situation. TRADEPRO Academy is not responsible for any liabilities arising as a result of your market involvement or individual trade activities.