A limit order is an order type which has a defined maximum or minimum execution price and must fill at the defined price or better. This is opposed to a market order type which does not have a defined price and will seek liquidity at progressively further price levels until the whole order is executed. A limit order has no guarantee of executing, it will only fill if the stock (or other security) price reaches the limit order price, and enough liquidity transacts to execute the order partially or entirely.
Limit orders are used to control entry and exit points precisely. It is a way to guarantee that a fill will only occur at the price entered by the trader. A market order can create significant price slippage if there is a lack of available posted liquidity. A limit order takes away the risk of price slippage. The trade-off of course is that there is a risk of the order not being executed at all.
Limit orders are commonly used as profit taking orders because they can be set ahead of the price reaching the desired level. This can help traders take emotion out of the decision to exit a trade, and for some traders it is a way to automate their exit without watching every tick. Also this is helpful if a stock’s price makes a fast move which executes the limit order, and there is not time to react before the price moves back toward the entry. It usually is good practice to have an order out just in case this type of fast move happens.
Another benefit of limit orders is that there can be higher rebates from posting to certain ECNs. Some ECNs pay a rebate to remove liquidity, but most will pay a trader to add liquidity to their books. The rebates for adding liquidity are generally higher than the rebates for removing liquidity. This is also known as a passive or aggressive order and an explanation of the difference is below, but a limit order will often add liquidity to a stock’s book.
An example of an ECN paying a high rebate to add liquidity to its books is the BATS Exchange, which offers a rebate of up to .0029 per share to add liquidity. Done correctly a trader can defray a significant amount of his transaction costs from posting limit orders to the books. This of course is dependent on the trader using a broker which passes through ECN rebates.
When used as an entry, keep in mind that a limit order may be better suited to a slower moving stock or market. If a stock is volatile and moving very quickly, a trader could miss out on an entry completely. It takes time for the trader to set up the order, and even if the order is entered quickly a stock may not print the order if it posts passively. In the hopes of saving a small margin of money by placing the limit order, a trader may miss out on a very large move. A market order would guarantee execution but the final cost is unknown. This is something that must always be weighed and balanced when a trader makes a decision about which type of order to enter.
Keep in mind that a limit order can still be an aggressive order type, meaning it will cross the book to seek and remove liquidity. In this way limit orders can still be very effective at providing high quality execution to the trader. If a limit order does not cross the book it is considered a passive order, and adds liquidity to the stock’s book. When an order is passive there is no guarantee that any portion of it will be executed. If the order is aggressive the limit order will seek liquidity up to (or down to) the limit price entered until the order is completely filled. Assuming that there is liquidity on the book, the order will at least be partially filled. If the order partially fills and reaches its limit price, the remaining share balance will sit passively on the books at the entered limit price, and any further execution will add liquidity to the books. An example of this is below.
Example: Aggressive vs. Passive Limit Orders
For example, let’s say stock symbol ABC is bidding $7.00, and offering $7.01.
A limit buy order entered passively will be entered at $7.00 or lower. This will add liquidity to the stock’s book and will only be executed if someone else’s aggressive order removes them.
Let’s say that the buy order is entered at $7.01. Let’s say that the order is for 100 shares, and there are 200 shares posted on the offer. This order will remove liquidity from the shares posted on $7.01 and will be fully executed at a price $7.01.
Now let’s say that the buy order is entered at $7.02, and the order is for 500 shares. For the sake of the example, let’s say that there are the same 200 shares posted on $7.01, and 100 shares posted on $7.02. This order would remove the 200 shares posted on $7.01, and continue on and remove the 100 shares posted on $7.02. At this point there will be no more liquidity to remove in the range of the limit order, there will be 300 shares executed at an average price of $7.0133, and the remaining 200 shares left to be executed will post on $7.02 only to be executed if someone else comes in with an aggressive order to remove them. If they execute the full 500 share position will have an average price of $7.016
Keep in mind that a market buy order would seek liquidity from progressively higher price levels until the order is fully executed, so execution is guaranteed, but at final cost unknown.
As is evident from the example, a trader must consider his order type carefully, balancing his urgency of execution, volatility, fee structure, and available liquidity. Limit orders are a very beneficial tool, and are the best choice to control execution price.