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Why You Should Never Use Market Orders?

November 14, 2011 | About:
The Dividend Guy Blog

Intelligent Speculator

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In many ways, trading is as much art as it is science. Some trade on specific algorithms and have a lot of success doing so but others go by how they feel about the market and have been able to do just as well. One great thing about trading as in art is that no matter how you do it, there is no right or wrong way to trade. Some trade all markets and all asset classes while others put all of their energy on a handful of stocks. I personally have been using two vastly different but both successful methods that I discuss on this blog; long term passive income/dividend investing and long/short technology stocks trading which is much more short term.

There Is One Important Exception

To this day, I think it’s surprising that market orders still exist. It staggers me when I hear of brokers/traders or investors that put in market orders when buying or selling stocks or ETF’s.

What Is A Market Order

Imagine that you need to buy 1000 shares of a stock like Baidu (BIDU) which is currently trading at 135.94. There are a few different things you would look at before entering an order. First, what is the bid and offer. The bid is what someone else in the market is willing to pay for that stock and the offer is how much someone is willing to sell his stock for. A liquid market is one where the difference between those 2 is as small as possible. Let’s take the situation where the bid is 135.92 and the offer is 135.95.

Someone willing to buy will generally have to pay 135.95 but there are different ways that this could be done:

-You could enter a limit order to Buy 1000 BIDU @ 135.95: In such a situation, the trade will be executed as long as the offer does not change between the moment that you look and that you place your order. These quotes change very quickly so it is clearly something that could happen.

-You could place a limit order to Buy 1000 BIDU @ 135.93 – You would only have a successful execution if the offer moves to that price. That could or could not happen today.

-You could place a makret order to Buy 1000 BIDU. This means that when your order will be placed, you will be executed wherever the price lies at that moment

The Big Risk

The major downside to using market orders is that you could end up getting a very poor fill. Why? These days, markets move at record speeds and the number of “bad ticks” has increased every year. What does that mean? It means that for a few seconds, BIDU might trade at $142. It might only last for a few seconds and would likely be caused by a glitch in someone’s electronic trading system.

That Is A $6K Loss!!!

You could very well end up losing $6,000 within a few seconds of your trade. Such moments do not occur that often but they do happen, especially in volatile days or during volatility peaks such as market openings, closings, big announcements, etc.

There Is An Alternative

In a market where the offer on BIDU is at 135.95, you might want to make sure to get filled without doing a market order. The easy way to do that would simply be to place a limit order at a price a few cents aways. In this case, it would be:

Limit Order to Buy 1000 BIDU @ $136.00

In such a situation, the worst that can happen is for you to pay a few pennies more. Of course the downside is that you do have to actually check if you were filled and possibly modify it if you weren’t. But I think it’s the only way to trade. There is NO upside to trading using market orders.

How Do You Trade?

Do you use market orders? If so, why?


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