Using a market order is like writing a “blank check” to the market makers, according to Dennis Dick of the CFA Institute. You don’t know where your trade will get filled, which makes it difficult to play out your strategy with precision.
Using limit orders means you’ll miss out on some trades, but knowing the price of something you’re buying or selling it vitally important.
Of course, there are rules in place like regulation NMS, which prevent market makers from filling your order at a less favorable price than the National Best Bid and Offer (NBBO), but this is your money at play.
In the time between you hitting your order button in your trading platform and when an exchange or wholesaler receives your order, many things may have changed. The stock could have ticked up or down several cents, making the risk-to-reward profile of the trade completely different.
For those of you who don’t want to miss out on trades because of limit orders, there is the marketable limit order. This is basically just taking liquidity from the market with a limit order. Here’s an example.
Limit Order Example
You want to buy XYZ stock and its bid-ask spread is $10.50 by $10.51. A marketable limit order would be placing a limit order to buy at $10.52. This ensures that you jump in front of the line and get filled first, and it also protects you from the “blank check” risk that a market order carries.
Depending on the stock price, liquidity, and volatility, you may want to adjust how wide you make your marketable limit orders, as sometimes a penny over the ask isn’t enough.
On the other side of the token, there’s evidence that using “passive” limit orders in favor of “aggressive” limit orders results in better results for retail traders. The idea here is that instead of taking liquidity, you provide liquidity.
Not only does this often result in ECN rebates rather than debits, but the data shows a better expectation. This, of course, will not apply to all trading strategies, though.