If you are a trader in the equity markets you must be familiar that it is very important to get the best price possible. As a buyer your aim is to buy at the lowest price possible and as a seller your aim is to sell at the highest price possible. That is where the understanding of the two important types of stock market orders (viz. market orders and limit orders) is extremely useful. Let us understand the conceptual difference between market order vs. limit orders. Also there are specific instances when to use market orders and specific instances when to use limit orders.
Understanding market orders and limit orders..
A market order is an order to buy or sell the stock at the available price in the market. The NSE system is tuned to give you the lowest price while buying and the highest price while selling. The market order does not specify the price at which a stock should be bought or sold and it is more subject to available liquidity. For example, if you are buying 200 shares of a stock at the CMP of Rs.600 and if 100 shares are available @Rs.600 and 100 at Rs.610, your trade will be executed accordingly. So your average cost will be Rs.605. Hence you need to check market depth and available trade offers before you put in a market order.
In a limit order the trader who places the order will specify the price beforehand and the system will execute accordingly. For example, if you are buying 500 shares of Reliance, you can specify your price limit as Rs.925. The system will execute the trade at Rs.925 or less only. Similarly, if you are selling 500 shares of Reliance, you can specify your price limit as Rs.940. The system will only execute the trade if the price is at Rs.940 or above, not otherwise. A very important point to note is that a limit order is not guaranteed to be executed. If you specify a price of Rs.925 to buy RIL, then even if the price touches 925.50 and bounces back again, the limit order will not be executed.
When to use limit orders and why?
Having understood limit orders, it is essential to understand when and why to use limit orders. The use of limit orders has the following advantages..
You can specify the price to buy or sell and that will help you make the best of the volatility in the market. Over a longer period of time, for a trader, the limit order approach helps you to reduce your average cost of buying and improve your average cost of selling.
You can actually put technical charts to good use by using limit orders. In case you are placing a buy order, you can place the buy order slightly above the support level of the stock. Similarly, in case you are selling then you can place the sell order a little below the resistance of the stock.
As a trader you have better control over the price you want to execute transactions and that eventually reflects in your trading performance. This control makes the entire trading activity more predictable as downstream transactions can be planned accordingly.
Limit orders are a great learning experience for a trader as it forces you to track the prices in a closer and more aggressive manner. This gives you insights about how to tweak your limit orders in future and in the process makes you a better trader.
When to use market orders and why?
If one were to look at the merits of limit orders, it may appear that market orders may not be adding much value. That is not the case. There are 3 specific instances when market orders can actually make a lot more sense than placing limit orders. Let us understand these situations…
When you have a margin shortfall and you need to urgently liquidate your positions, then what do you do? You obviously cannot wait long enough to let your limit orders to get executed. Since the primary focus is liquidity, using market orders will make more sense.
When the markets are falling vertically then how do you go about placing buy orders? Placing limit orders may not be the right strategy as you really are not sure of the limit. In such cases, it would be wiser to spread your order and place market orders to get the best of volatility.
When you are trying to exit a stock that is illiquid or a stock that has suddenly become illiquid, then market order is a better bet. In such cases, the focus is to exit the stock quickly rather than wait for your chosen levels.
The bottom-line is that both market orders and limit orders have their own applications. You need to use them judiciously according to the circumstances.