The Pitfalls of Market Orders

Have you ever noticed the advertisements from the discount on-line Brokers that say $3.00 or $5.00 per trade? Right! We’ve all seen them and wondered how they can do it. Well, there’s two reasons for this: 1) They sell their order flow to Market Makers or 2) The fine print says “Market Orders”.

There’s an old mantra in the day trading community that basically says, “Never use a Market Order; always use a “Limit” order. In reality, there is a time and place to use Market Orders, however, it is very limited in scope and requires great care in doing so in order to prevent from getting stuck with a bad order fill price.

You can better understand why not to use a Market Order if you take a moment to look at what it really is. A Buy Market Order will be filled from the best available “Ask” (Seller side of the market) price. A Sell Market Order will be filled from the best available “Bid” (Buyer side of the market) price. I know, it sounds a little twisted around but stop and think about it for a moment. When placing Orders in the stock market, Buyers and Sellers are matched to each other.

This is all well and good however, you never really know exactly how many Market Orders are waiting their turn (first come, first serve) to be executed.

Level 2 large spread

As shown in the Level 2 screen shot in Figure 1 above, we get to see the best Bid and Ask Limit Orders from each of the Market Makers and ECNs on the NASDAQ Market.

Most of the time, your average investor doesn’t have the advantage of a NASDAQ Level 2 display. They only have Level 1 which displays the Best Bid and Ask.

OK, I know, the subject here is Market Orders, not Limit Orders. Right? Wrong! You can’t talk about one with getting a bit technical about the other. But first, a little explanation on how to read the Bid and Ask is required.

Now let’s look at our example:

1=100 shares

Let’s say that you place a Market Order to Buy 100 shares. Normally, when looking at Figure 2 you would probably think that your order will be filled immediately from the Limit Order that is being held by BOOK with a price of 439.65 Right? Well, … maybe. It all depends on how many Buy Market Orders are sitting in front of your order. Remember, orders are executed on a first come, first serve basis. So, if there are orders for 100 shares executing in front of yours, your order will be filled from the Market Maker NQBX.

Now, here’s where Market Orders will get you into real trouble. If there are orders for 1000 shares executing in front of yours, you will be filled from the Market Maker BATS at the higher price of 439.74. Well, you say, “that’s OK as it’s only 9c higher so that’s not so bad”. Right? No, wrong? Because in the real world of the market there could literally be Thousands of Market Order shares executing before you so your price could really be much higher. Especially if the price of the stock is rising rapidly. The same holds true in the other direction for Selling shares.

We heard stories on the News broadcast that a buyer put in a Market Order when the price of a stock was low only to be filled $2-$3 higher than when it was first placed with their Broker. With high volatility stocks it may take a few seconds before your order will move up in the line to be executed. Also, if you are using a Web based program to execute orders it may take a second to get the order processed and moved to a Market Maker or ECN to be placed in line for execution.

Day traders like it when a lot of Market Orders are being placed because that means the stock price will be moving steadily in one direction or the other. With direct access software day traders, Brokers, and Market Makers have the means to take advantage of all of those Market Orders filling all of those Limit Orders.

What’s this you say, “Brokers, have the means to take advantage of all of those Market Orders”. That’s right! Those Brokers that actively trader their own or House accounts just love Market Orders as those orders provide constant movement in prices. Remember, those Brokers are also using Limit Orders to Buy and Sell stock. Yep, it’s a real Bummer. They get their commission plus get their orders filled at the same time.

Now, when is a Market Order OK to use? Typically, Market Orders can be used if there are no executions at that time. However, if you place an order for a large number of shares your order may be broken up into smaller lots and filled at several price levels.

Also, if a stock price is moving against you and you want to liquidate your holdings fast, you can take the chance and place a Market Order. However, we strongly recommend that in this case, you pick a lower or higher price, depending on the direction of the price movement, and place a Limit Order.

A good rule of thumb though is to stay away from fast moving stocks, especially IPO’s until you gain a lot of experience trading in the markets.

The SEC Steps In
The SEC has taken steps to ensure that investors get the best execution / price, with rules forcing brokers to report the quality of executions on a stock-by-stock basis, including how market orders are executed and what the execution price is compared to the public quote’s effective spreads.