The limitations and advantages of limit orders
Surely you’ve seen these wonderful citizens on the road. You’re driving along thinking you are in full control when another car pulls right into your lane and… BAM!
Suddenly the world has changed because you were not prepared to avoid the risk inherent in driving… Of course, the only way to eliminate all risk is not to drive in the first place. But since we all know that is not going to happen, being prepared to manage risk is the next best option.
The same thing happens to retail traders in the futures markets every day. They place orders using limit prices believing these orders protect their trades. Then they are rudely reminded that the institutional traders in the market don’t care what they believe. They also don’t care about the safety of your investment capital… until they take it from you.
The problem is many retail traders fail to understand exactly what limit orders are and how they work. Without a full understanding of the benefits and risks of limit orders, it is easy to use them when another order type would be more appropriate. Then your account can be crushed when you swerve in front of an institutional truck in the market.
How limit orders really work
Drivers who want to maintain complete control over their cars apply limits to how closely they follow other vehicles or the distance they keep when changing lanes. This allows them to operate with a higher level of safety. Limit orders in the futures market serve the same purpose for traders.
Limit orders in the futures market give traders complete control over the execution price at which their orders will be filled. It eliminates the possibility of a “bad fill”. A bad fill occurs when the market appears to be trading at one price but jumps or falls suddenly when your market order is placed. Just like that other car that swerves into your lane and causes your car to crash.
Limit orders to buy guarantee the maximum price a trader will pay to enter a new long position or close an existing short position. Limit orders to sell guarantee the price that will be paid to a trader to close an existing long position or open a new short position.
In most situations, limit orders are mainly appropriate for passive trading. It can take a lot of patience for traders to wait for an executions that may never come.
When are limit orders effective?
On the highway, you have no control of the actions of other drivers. They can cut you off or run you over in a heartbeat. In the futures market, you don’t have any control over the actions of other traders.
Limit orders can be be used to provide you with your orders some degree of protection. They are a bit like car insurance for traders. They are also effective for managing orders or positions that are not being actively watched.
Traders who have exact expectations for a particular position can enter a limit order to open or close a position and know exactly what will result from a fill.
Limit orders eliminate a trader’s risk of having orders filled at a price at which they are unhappy.
Stink bid orders are not placed because you expect them to be filled. They are to assure you get a great price if you are filled.
Limit orders can also be useful when it comes to placing what are known as stink bids. Stink bids are orders that are placed well beyond the normal trading range of an asset. These orders can be used to take advantage of “flash crashes” that occur in the market where an asset price moves suddenly and violently and then immediately recovers. Stink bids are not going to be filled very often, but they can provide exceptional opportunities when they are.
Why not always use limit orders?
The advantage to limit orders is that they provide traders with precise control over the execution price of the orders they place.
However, they are totally unsuitable for aggressive trading techniques where order executions are more important than a few ticks on price. Traders who are aggressively scalping trades would not find limit orders to work toward their benefit.
The risk of using limit orders is the risk that the market doesn’t touch your price and you orders go unfilled. It is hard to make money on orders that never get opened or closed.
Limit orders do provide more certainty related to the actual fill price. They also expose traders to missing potentially profitable trades.
Limit orders have limits but they also have their place
Limit orders do provide an extra level of protection for your orders by controlling the price of executions. However, that protection has its own price. Using limit orders can also limit your opportunities. Learning the benefits and disadvantages of each order type available is the only way to know which one is the best fit in each trading situation you will encounter.
The only way to avoid all trading risk is to never get behind the wheel of your account and start driving. Where you focus needs to be at all times is controlling and limiting your risk by using all of the tools available to you by having a complete set.
You don’t fix a smashed fender with a socket wrench and you don’t use a limit order for every trading situation. But socket wrenches and limit orders both have their places in any complete tool set for fixing or trading.
You can learn how to use all of the various order types in just a few hours. If you learn them now, you can be using them effectively later today. Then you won’t be watching your trading account being smashed by ruthless institutional drivers with no concern over damage to your account. Instead, you will be driving the right orders for every situation to better success and fewer portfolio repairs.