When an investor places an order to buy or sell a stock, there are two fundamental execution options: place the order "at market" or "at limit." Market orders are transactions meant to execute as quickly as possible at the present or market price. Conversely, a limit order sets the maximum or minimum price at which you are willing to buy or sell.
Buying stock is a bit like buying a car. With a car, you can pay the dealer’s sticker price and get the car. Or you can negotiate a price and refuse to finalize the deal unless the dealer meets your price. The stock market works in a similar way.
A market order deals with the execution of the order; the price of the security is secondary to the speed of completing the trade. Limit orders deal primarily with the price; if the security's value is currently resting outside of the parameters set in the limit order, the transaction does not occur.
Understanding Market Orders And Limit Orders
How Market Orders Work
When the layperson imagines a typical stock market transaction, he thinks of market orders. These orders are the most basic buy and sell trades; a broker receives a security trade order and that order is processed at the current market price.
Even though market orders offer a greater likelihood of a trade being executed, there is no guarantee that the trade will actually go through. All stock market transactions are subject to the availability of given stocks and can vary significantly based on the timing and size of the order and the liquidity of the stock.
All orders are processed within present priority guidelines. Whenever a market order is placed, there is always the threat of market fluctuations occurring between the time the broker receives the order and the time the trade is executed. This is especially a concern for larger orders, which take longer to fill and, if large enough, can actually move the market on their own. Sometimes the trading of individual stocks may be halted or suspended.
A market order that is placed after trading hours will be filled at the market price on open the next trading day.
For example, an investor enters an order to purchase 100 shares of a company XYZ Inc. at market price. Since the investor opts for whatever price XYZ shares are going for, his trade will be filled rather quickly – at, say, $87.50 per share.
How Limit Orders Work
Limit orders are designed to give investors more control over the buying and selling prices of their trades. Prior to placing a purchase order, a maximum acceptable purchase price amount must be selected, and minimum acceptable sales prices are indicated on sales orders.
A limit order offers the advantage of being assured the market entry or exit point is at least as good as the specified price. Limit orders can be of particular benefit when trading in a stock or other asset that is thinly traded, highly volatile or has a wide bid-ask spread. By placing a limit order, you put a ceiling on the amount you are willing to pay.
The obvious risk inherent to limit orders is that, should the actual market price never fall within the limit order guidelines, the investor's order may fail to execute. Another possibility is that a target price may finally be reached, but there is not enough liquidity in the stock to fill the order when its turn comes. A limit order may sometimes receive a partial fill or no fill at all due to its price restriction.
It is common to allow limit orders to be placed outside of market hours. In these cases, the limit orders are placed into a queue for processing as soon as trading resumes. Limit orders are more complicated to execute than market orders and subsequently can result in higher brokerage fees. For low volume stocks that are not listed on major exchanges, it may be difficult to find the actual price, making limit orders an attractive option.
If the investor above is very concerned about buying XYZ shares for a lower price and he thinks that he can get XYZ shares for $86.99 instead, he will enter a limit order for this price. If at some point during the trading day, XYZ drops to this price or below, the investor's order will be triggered and he will get 100 shares for $86.99 or less. However, at the end of trading day, if XYZ doesn't go as low as the investor's set limit, the order will be unfilled.
Traders need to be aware of the effect of the bid-ask spread on limit orders. For a limit order to buy to be filled, the ask price – not just the bid price – must fall to the trader's specified price.
The Bottom Line
While the process of buying and selling stocks may be daunting to new investors, knowing the differences between a market and limit order are crucial for being able to trade effectively. A market order is centered around completing an order at the fastest speed, while a limit order is concerned with ensuring that price considerations are met before a trade is executed. With an understanding of order types, investors can move on to the real challenges of choosing what to buy, when to buy it, how long to hold it, and when to sell it.