What is better: a market order or a limit order?

One of the first things you will notice when you trade on a stock exchange is the choice between a “market order” or a “limit order”. Let me explain what they are and which is best in which situation…

market order is an order where you buy a certain share or sell a certain share at the prevailing market price. The prevailing market price depends on whether you are buying or selling.
* If you are buying, it will be the lowest price someone is willing to sell her shares for.
* If you are selling, it is the highest price at which a buyer is willing to buy the shares from you.

Let’s say you place and order: Buy 200 shares of Capitec at Market

There is a seller willing to sell 100 shares at R320 and another seller willing to sell 100 shares at R340. Your order will first be filled with the 100 shares at R320 (the lowest price) and then the other 100 shares at R340 (the 2nd lowest price)  

A market order emphasizes immediacy of execution. The trade occurs at the market price when the order is placed. When you place the trade, however, you will not know what the exact trade price will be.

limit order is an order where you specify the maximum you are willing to pay to buy a certain share or the minimum you are willing to receive to sell a certain share. With this type of order you are certain of the worst price at which the trade will occur, but there will be uncertainty as to whether someone is willing to trade at that price.

A limit (sell) order would be something like: Sell 100 shares of BHP at R300.

If a buyer comes along and says that they are willing to buy those 100 shares for R280. The order will not go through, because it is below the minimum price you specified (R300).

Let’s say another buyer comes along with a limit (buy) order: buy 100 shares of BHP at R310.

Since the lowest price you are willing to sell at is R300 and the highest price that the buyer wants to pay is R310, the 100 shares will be sold at R300. The trade will not take place at R310, because the buyer will not pay R310 when he can get the 100 share from you for R300.

With a limit order, the emphasis is on price.

Which is better?

When I was first taught about trading shares, the teacher told us never to use a market order. His reasoning was that the distribution of buyers and sellers could drift from the “real” value of the share.

Let me explain with an example:
Let’s say you are trying to buy a share that trades very rarely. The normal price range is between R5 to R6. You place an order to buy 200 shares at market. A trader notices that there is a seller willing to sell 100 shares at R6. Your order is for 200 shares, though – the rest of the order still has not been met. This trader could conceivably enter an order to sell 100 shares at R100. As you have set a Market order, it will execute at R6 for the first 100 shares and R100 for the other 100 shares. I can assure you that you will not be very happy with this situation.

This is why you should be cautious when setting market orders.

There are situations where market orders are better than limit orders, though.

Here are two situations:
* You own shares of a certain company that has just been announced to be under investigation for accounting fraud. Let’s say you set a minimum price of R20. However, the prevailing price drops to R15, then R10, then R5. There is no buyer that is willing to buy the share from you for R20. You may be left holding worthless shares.
* You are trying to buy shares of a company that has just announced that they have found a cure for cancer. You offer to buy someone’s shares for R10. The problem is that no-one now wants to sell their shares for R10 when the price could be R20, R100 or R500. You will miss out on a good opportunity.

If you need liquidity immediately, a market order may be appropriate. Let’s say you have an emergency that requires immediate cash. If you set a limit order, you will have to wait for a buyer to come along who is willing to buy your stocks from you at the price you set. This may never happen.

The choice between market or limit orders depend on the situation of the trade. It is important to know the advantages and disadvantages of each before deciding on which to place.

Happy Trading!

Kevin Mzansi