A question a lot of beginning traders have is, should they use market orders or limit orders in their trading. I thought I would weigh in with my opinion (which is “both”). Let’s start by looking at what are the strengths and weaknesses of each order type.
The good news is a market order guarantees you an execution. You will get filled more or less instantly.
The bad point of market orders is you effectively pay the spread. That is, if the bid and ask prices are 2 cents apart, you will incur that 2 cents as a cost getting in and out of your position. Stocks that trade with lots of volume tend to have narrow spreads and make market orders “cheap”. Thin and low-float stocks tend to have wider spreads and make market orders “expensive”.
The good news for limit orders is you are guaranteed a specific price (or better). For some commission plans, you also get a tiny rebate passed on to you from the exchange.
The problem with limit orders is you may not get filled, may get filled slowly, or may only get partially filled. This is especially true of odd-lot orders (not a multiple of 100 shares) because an odd lot limit order can be passed over in favor of a round lot order even if you were at a better price.
So, let’s look at some situations and how they apply to these two order types.
Trading breakouts means you are entering as the price makes a new high or new low. These moves can be explosive and easily leave behind a limit order completely unfilled. Limit orders may save you a few pennies compared to a market order, but they cause a number of problems
- You won’t get filled on many winning trades, causing you to miss those gains
- You will get filled on every failed breakout, taking all of the losses
- If you chase the limit order up with price, you will likely get a much worse fill than using market orders and not delaying entry
For breakout trades, you are much better off just using a market order and making sure you participate in every trade.
There are two alternatives if you want to use limit orders that can still work. The first is to start accumulating shares with limit orders before the breakout. As you see price consolidating at a level, you anticipate the move. The drawback is many times the move never materializes and you take a small loss.
The second alternatives is to enter breakouts on a subsequent pullback near the breakout level. This is called a “breakout-pullback”. Effectively, it is just a pullback trade and these lend themselves to limit orders placed slightly shy of the breakout level.
With a pullback you are fading a short-term move lower (for longs) and these lend themselves well to limit orders. You can just put an order in at your desired price and if the pullback is deep enough you get filled.
This assumes you are entering the pullback before it reverses. If your pullback strategy waits for confirmation, limit orders become more difficult. for example, if your rules are to wait for a break above/below the previous candle, resuming the trend, that is really a mini breakout entry inside of your pullback and you risk missing some winners with a limit order. It is still viable as the move will not be as explosive as a pure breakout, but you will need to track your live trading results to see. I recommend adding rows for the trades you missed and adding a column for the spread saved so you can ask “what if I used market orders” after 50 or so trades.
Stops (loss control)
Many trades have a built in stop level. If price moves beyond that level, you exit the trade. In general, you are trying to avoid the possibility of a catastrophic loss and you should just use market orders here.
A more complex stop system allowing for limit orders would be to have two stop levels. The outer stop would be the catastrophic stop. This is what you use to set your max risk on the trade and you would exit with a market order. The inner stop would be a tighter level that still causes you to exit, but as long as the outer stop is not touched you can manage the trade with a limit order.
Trailing Stops (trend followers)
Some traders use a trailing stop to manage their positions, particularly for trend trades. If price triggers the stop, it implies the trend is over and it is time to exit the trade.
In this case, you are not facing your max loss on the trade and hopefully are even exiting for a profit. This is effectively the “complex stop” scenario and you can manage the exit with a limit order. If price drops below your original stop for the trade, though, then you should get out immediately with a market order.
If you are using a profit target to exit your trade, a limit order makes perfect sense. As such, choosing this style of exit will reduce slippage costs in your trading.
Exit On Close
If you are exiting on the close, you want to be sure you get executed and a market order is virtually required. The spread is a small price to pay to avoid carrying overnight risk if the order does not get filled.
“Market” Limit Order
An alternative to market orders that I often use are what I call “market limit orders”. This is just a limit order, but instead of trying to keep the spread you put it beyond the current price by a few pennies.
As an example, say you are watching VIX for a breakout above 20. When the breakout occurs, the bid/ask will probably be something like 20.00/20.01. I might have a limit order ready to go at a price of 20.03. It’s very likely that I will get filled and will get the same price a market order would have had. However, I can be sure if some wild price spike hits that I will not pay more than 20.03. I am not using it to try to save pennies, just to protect myself from any extreme price gaps.
I recommend using this anywhere you would use a market order. How much to pad depends on your expectancy per trade, the price and how it moves. Use your intuition. If you frequently miss trades because price moves too fast, then you might need to use more padding.