Loopring Learning Series, Part 3: Order Types
Depending on what a trader is more sensitive to — price or time — a limit order or market order will be preferable, respectively.
An important concept in trading financial securities (or cryptocurrencies) is order types. Broadly speaking, there are two types of orders: limit orders and market orders. We will dive into each, but the important concept to understand is that they represent a fundamental trade-off that any trader must make: what is more important for a specific trade — price, or immediacy?
In creating a limit order, traders have set a limit on what price they will purchase or sell a given asset for. A trader will specifically state the price they want when submitting an order, and be assured to receive this price, or better.
When submitting a bid (buy) order, the limit price represents the highest price a trader is willing to pay. Inherent in this statement is the assumption that if they can buy the asset for a cheaper price, they will, as that is better for them. This is why it’s called a limit order — it represents a limit — in this case an upper bound.
When selling a security with a limit order, the ask/offer price a trader specifies represents the lowest price they are willing to accept. Thus, the limit acts as a lower bound — there is no way the order will be filled for less than this amount. Again, if it’s possible to be filled at higher (better) price, they will.
Thus, limit orders guarantee price execution, but do not guarantee trade execution itself. It’s possible that a limit order can sit on an exchange’s (or dealer’s) order book for weeks until some counterparty on the exchange accepts that price and executes. [If we take an extreme case, it’s possible a limit order can remain unfilled forever — imagine creating a limit buy order for ETH at $5 — it just ain’t gonna happen! Hopefully :/]
Every order we see above (an expression of quantity & price) is a limit order. The fact that they remain up there proves this — these traders are waiting for their limits (specifications) to be satisfied. As such, these limit orders are what ‘makes’ the market. On an exchange, the traders who placed these orders would be called ‘makers’, in an OTC system, they would be called market-makers, or dealers.
The bid @ $602.55 and the ask @ $603.91 represent the best prices going in each direction. Together, they are called the inside market (or simply, market). All ‘worse’ limit orders behind those two, in both directions, must wait for the better limit orders to get filled for their limit orders to become first in line. Of course, new limit orders can jump the queue at any point if they submit more compelling prices. In a very liquid and actively traded market, the bids and asks may converge on something like $602.99 & $603, respectively.
If instead of being price sensitive a trader just wants to ensure they can execute their transaction now, buying or selling at ‘whatever’ price is currently out there — whatever price the market gives them — they will submit a market order. As opposed to makers, these market order traders are called takers, as they take the order off the book.
This essentially means coming in to the market and saying “I need to make this trade happen, what’s the best price I can get?” — and execute. Thus, they have no price guarantees, but they do guarantee they get the trade done.
Above, if you wanted to buy ETH and placed a market buy order, you would get filled at the current best (lowest) limit offer, which is $603.91 per ETH. If you placed a market sell order, you would be filled at the current best (highest) limit bid, which is $602.55. Thus, market orders are always filled by the best opposing limit order.
‘Best’ is a slippery slope, however. Indeed, you are subject to facing some slippage — receiving a worse price than anticipated. While you can see the order book before placing a market order, there is no guarantee that the market won’t ‘move’ before you are filled. In the example above, if someone ever-so-slightly edges in front of your market bid, you may have to pay $604.21 per ETH, or worse. Aside from someone else being filled right before you, the limit order can also simply be removed by the trader a millisecond before you click.
Thus, market orders pose pricing risk, especially in volatile and erratic markets. Market orders also expose traders to the risk that a dishonest exchange or broker can ‘game’ their order by giving them poor execution, since there is no price limit.
Furthermore, given the depth of a limit order (how much quantity per price), it’s possible that your market order can fill the best limit order’s full size, and then drop down to the next price, which is by definition worse, and continue to be filled there.
Note that limit orders only work if you place the limit price on the proper side of the market. Otherwise, these are effectively market orders. For a limit buy order, place the order at a price that is below the lowest ask price — less than $603.91 in our above example. For a limit sell order, specify a price that is higher than the highest bid — greater than $602.55 above. If not, you will simply be filled as a market order.
When to use each?
Generally, it would be prudent to always use limit orders to protect yourself from any of the above potential pitfalls. However, sometimes you need to act quickly, and get in or out of a position ASAP.
Let’s say there is a terrible news release on a security you own, and you’re quite certain the price is heading lower. It may not be worth placing a limit sell order in an attempt to get a “good price”, but rather just using a market sell order to get out of the position. (Of course, if others are thinking the same, their market orders may be entered ahead of yours, and you will execute at worse prices).
Market orders are especially dangerous for securities that are illiquid. If a security doesn’t trade often, it’s likely that the spread between the bid and ask is quite large (since price discovery is more difficult, and traders protect themselves by trying to buy lower and sell higher). If a less experienced trader were to see the ‘last traded’ price of a security (looking at a securities recent trade history), be happy with it, and submit a market order, it’s possible that they will be filled at a much worse price than expected. So it’s important to keep in mind that ‘last traded’ is not where a market order will be filled — you must look at the order book, the best bid or ask, and the corresponding sizes.
Professional investors don’t usually make hasty decisions and FOMO into trades, and they are more likely to use limit orders to carefully manage their entry and exit. However, sometimes, ‘exit and entry doors’ are quite narrow, and they can become crowded quickly. When getting in/out the door is a priority, market orders should be considered.
A different reason to prefer limit orders over market orders is the pricing scheme of some exchanges. Since makers are helping the exchange provide liquidity by putting and keeping their order on the books, many fee structures give them preferred treatment in the form of 0% fees or rebates on their limit trades. On the other hand, since takers remove orders (liquidity) from the exchange with market orders, they often face higher trading fees. For active traders, these fees become an important consideration.
Right now, Loopring only supports limit orders, with a desired exchange rate set by the trader. Not only can price improve due to traditional limit order functionality, but also because the order-ring technology enables more token pairs to be mix and matched, which leads to further price improvement potential. Market orders are something that are difficult to accommodate on a fully decentralized exchange because of certain blockchain characteristics, such as trade collision, and general latency and race conditions. [There are ways to solve this, which we will explore in the next post on relay strategies.] Loopring does not distinguish between makers and takers.
Bonus: Stop orders
There are some other sophisticated order types which use limit or market components.
Stop orders require a trader to specify a price — the stop level — at which point a limit or marker order is triggered. As such, the order is dormant until the stop level is reached, and then becomes active as a simple limit or market order. A stop-market order becomes a market order when the stop level is reached, and a stop-limit order becomes a limit order when the stop level is reached.
Whereas limit orders try to take advantage of price improvement, stop orders are the opposite, guaranteeing a worse price for the trader! Buy stop orders are placed above the current market price, and sell stop orders are placed below the current market price. This may seem odd, but is useful when you are seeking confirmation before executing a trade. It’s like asking the market to prove itself that the new trend is strong before jumping in/out.
The most common type of stop order is a stop-loss order. These are used to protect yourself from an adverse move, and specifies the amount of risk you’re willing to take. For example, if you own an asset, you would place a stop-loss somewhere below the current market price, and if that point is reached, it would trigger a market or limit order to exit your position.
This was the third post of a series on general financial market concepts. If you’d like a specific topic to be explored, please reach out or say so in the comments.