The Limits of Limit Orders
By Jonathan Hoenig
May 24, 2001
IN LIFE AS in markets, we enjoy far less control than we'd like to imagine. There's a trading technique that many investors like to use because it gives them a comforting illusion of control — the limit order. It's almost always a mistake. As I've written before, it's not what you buy, but how you buy. Whether it's Palm (PALM) or pork bellies, placing the right kind of order with your broker is critical for success. And while it's tempting to use limit orders to save some pennies, good traders know they can be a pound-foolish way to trade, and use market orders instead.
Let's review some terms. A market order is an order that is immediately executed at the best available price. So if XYZ is bid at 50 and offered at 50 1/8, a market order given to your broker will have you buying the stock in a matter of seconds, most likely somewhere near the asked price of 50 1/8.
A limit order is an order to execute a trade at a specific price or better. So if XYZ is bid at 50 and you enter a limit order to buy at 48, you won't buy the stock unless XYZ trades at least two points lower.
Sounds like a good way to get into a stock on the cheap, doesn't it? Not in my book. In pulling the trigger on a trade, I want to get the best price available — but I also want to make the trade. And the problem with limit orders is that when they do get filled, it usually happens at exactly the worst possible time.
Call me old-fashioned, but I'm from the school that says if you like XYZ at 50, then buy it at 50. Buy it at 50 and tell yourself you're getting the steal of the century. The unlucky soul who sold you the stock at 50 will be kicking himself a few quarters from now. Hell, it's worth 100 a share! That's why you're buying it at 50.
The biggest challenge we face in trading isn't the market, but ourselves. And while you'd think most people who like XYZ at 50 would buy XYZ at 50, few can actually muster the courage to pull the trigger. We're cheap. In short, nobody wants to pay full price. So instead of buying the stock at 50, most people put in a limit order at 46 or 47. What does that mean they expect will happen? That XYZ will drop to their buy price, stop, turn around, and move higher from that point on. What are these people smoking?
When I buy XYZ, it's because I want it to move higher. So I use market orders and buy with the confidence that if I like it at 50, I'd better grab it at 50 before it shoots to 52, then 53, and never looks back.
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By putting in a limit order at below the market, you're setting yourself up for the worst possible scenario: being first in line to buy stock that nobody wanted two points higher.
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The other justification for using limit orders is to avoid paying the spread, or the difference between the bid and the offer price. With a limit order, if your bid or offer is hit, you're hit at your price, with no mysterious eighths or quarters involved. Theoretically, the spread is a major cost of investing. But in practice, paying the spread is problematic only when it's accompanied by overtrading — the real backbreaker to most people's portfolios. From a trader's perspective, you've got to pay to play. The spread is the price of getting into the market. It is the cost of doing business. So when it's time to buy XYZ, make the trade at the market and be done with it.
More than low commissions, fast executions or tight spreads, the biggest advantage you can have in the market is trading with the trend. So as long as I'm buying strength or selling weakness, I don't mind paying the spread, because when you trade with the trend, the wind is at your back. You're following the tape instead of fighting it.
And that's exactly what's wrong with limit orders. By putting in a limit order at below the market, you're setting yourself up for the worst possible scenario: being first in line to buy stock that nobody wanted two points higher. You're obligating yourself to buy stock at a price that will most likely get reached for all the wrong reasons. Using a GTC ("good until cancelled") limit order to try to buy stock below the current market price is a trading death wish. Simply put, if XYZ is falling, why are you buying?
"Buy low, sell high" is a dangerous way of thinking. All things being equal, I'd rather buy a stock that seems pricey than one that appears cheap. I like to buy strong stocks, buy 'em high and sell 'em higher. In stocks, just as in sushi and suits, you don't want too much of a deal. Strong stocks are expensive. And they're worth it.
So when it's time to move, I use market orders and pay up. In fact, when I buy a stock, I want to pay as high a price as possible — even higher then the current "ask." Why? I'll explain in my next column, one week from today.
Jonathan Hoenig is portfolio manager at Capitalistpig Asset Management (www.capitalistpig.com), a Chicago-based hedge fund.
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