Market and Limit Orders
This article is a continuation of an introduction to exchange trading that explains how fundamental market concepts can be applied to understand the dynamics of cryptocurrency exchanges. The first part of the series is Exchange Trading Fundamentals. In this second part, market and limit orders are explained.
Cryptocurrency markets are just like all other markets. There must be a buyer and a seller for a market to exist. The buyer and the seller must agree on a price for the transaction to occur. However, a buyer or seller in a hurry to make a trade is indifferent to price. Due to pressing need, they must trade the asset as soon as possible. Since they must make an asset exchange, they will take the best price offered to them. When this happens, the buyer or seller is called a taker. It doesn’t matter if they are selling or buying the asset. As they have no reservation price, they take the best price available to them so that they can speedily complete their transaction. Both buyers and sellers can be takers.
For example, a livestock market is a type of exchange and a horse is an asset. Actually, a horse is an animal. However, since people like to own them as property, and use them to move from place to place as an economic resource, a horse may also be classified an asset. Alice, a cowgirl from Wyoming, holds the utilitarian view of a horse. Alice needs a horse to get to the top of Monte Verde one morning on vacation in Costa Rica. There are a couple horse vendors in the livestock market nearby. One sells horses for $500. The other sells horses for $499. From a utilitarian perspective, the horses are identical. Being rational, Alice will buy the horse for $499. She is a taker.
Later that day, at sunset, Alice returns to the livestock market to sell the horse back to one of the horse vendors. She no longer needs a horse. Not only does she see no further utility in the horse, she also cannot take the horse back to Wyoming with her. Her return flight to Wyoming leaves at 7 AM the next day. Both vendors have many horses and urgently want to go to the bar for some ice cold Imperial beer. They have no immediate need for another horse. Consequently, one vendor offers Alice $200 for the horse. The other vendor offers her $201 for the horse. Being rational, Alice sells the horse for $201. She is still a taker, even though she is selling the horse this time.
The best price available to the taker is called the market price. Consider Alice and the horse vendors at the livestock market in Monte Verde. Alice was a taker on both occasions. As a horse buyer, she paid $499. As a horse seller, she received only $201. There is a relatively large difference in market price for the same horse depending on whether Alice is buying or selling a horse. This is called the spread. The price is different because the horse vendors have different ask and bid prices for the same horse.
If the exchange has no spread, then the taker pays the same price whether they are buying or selling the asset. This may be ideal for the taker. Unfortunately, it is not always the case.
Should Alice feel indignant and taken advantage of, she could choose to set the price she is willing to accept when buying or selling a horse. When Alice sets the minimum amount that she is willing to accept for a horse, she sets the limit price of the sale. Similarly, when Alice sets the maximum amount that she is willing to pay for a horse, she sets the limit price of the purchase. Once she decides to set the price, she becomes a maker or market maker. She is a market maker because she doesn’t need to take the market price.
For instance, if Alice postponed her return trip to Wyoming, she could set the limit price at $450 and wait for the peak of the travel season when all horses are typically sold out. Then she could return to the livestock market with her horse, become a vendor, and take advantage of the asset appreciation.
Fundamentally understanding market and limit prices are important to developing a trading strategy. When a buyer or seller sets a limit price in the centralized order book of an exchange, they are making a limit order. When a buyer or seller accepts (takes) the market price, they have made a market order.
Cryptocurrency exchanges make money every time an order is executed. Exchanges have different ways of imposing fees for market and limit orders. Although the fees are not exorbitant, exchanges charge either the taker, or both the maker and the taker.
For example, Binance charges both the maker and the taker a fee of 0.1%. For the average cryptocurrency trader, GDAX usually charges a taker fee of 0.25% and charges the maker nothing at all. That means frugal traders would always try to be market makers on the GDAX exchange and avoid fees.