What is a 'Market Order'
An investor makes a market order through a broker or brokerage service to buy or sell an investment immediately at the best available current price. A market order is the default option and is likely to be executed because it does not contain restrictions on the price or the time frame in which the order can be executed. A market order is also sometimes referred to as an unrestricted order.
BREAKING DOWN 'Market Order'A market order guarantees execution, and it often has low commissions due to the minimal work brokers need to do. Avoid using market orders on stocks with a low average daily volume. These stocks usually have large spreads and result in large amounts of slippage when executing trades at the market price.
Market Order Slippage
Security broker/dealers (market-makers) quote market prices using a bid price and an ask price. The bid is always lower than the ask, and the difference between the two prices is the spread. When a trader wants to execute a trade using a market order, the trader is willing to buy at the ask, or sell at the bid. Thus, the trade is immediately out of the money by the amount of the spread. This amount may increase in the form of slippage if the market order that is placed cannot be satisfied with the current volume that is associated with the current bid/ask price quoted.
For example, assume that XYZ stock is quoted at a bid/ask of $50/51, with 500 shares at the bid and 500 shares at the ask. If a trader places a market order to buy 1,000 shares, the first 500 shares will be executed at the quoted ask price of $51 (the current market price). Thereafter, the remaining 500 shares are executed at whatever the ask prices are for the sellers of the next 500 shares listed at the ask price. Those ask prices will increase above $51 according to the current supply in the market. The average price for the entire 1,000-share order will ultimately be more than the $51 that was the market price when the market order was originally placed. The difference between the two prices is referred to as slippage. Using market orders usually results in some slippage. Slippage may increase in a highly volatile fast-moving market, and on securities that have low liquidity and wide spreads. The best way to avoid undue slippage is to use limit orders in lieu of market orders when possible.
Backtesting with Market Orders
Accounting for slippage is critical for traders that use automated trading systems and perform backtesting to perform their strategies, if market orders are used in their strategies. The aggregate amount of slippage over the entire backtesting period could be the difference between a profitable strategy or a losing strategy. Most backtesting software packages provide include ways to account for slippage resulting from market orders.