The Limits of Limit Orders

For some time now I’ve been suggesting that ETF investors use limit orders—never market orders—when placing trades in their accounts. A market order will be filled (usually immediately and in full) at the best available price. A limit order allows you to specify the maximum price you’ll pay when buying, or the minimum you’ll accept when selling. But judging from some of the comments I’ve received recently, many investors are not clear on the reasons for this advice.

Some seem to believe that placing limit orders will allow them to get a “better price” than they would have obtained with a market order. But if the exchange functions the way it’s supposed to, that’s not true. Using limit orders is not like haggling with a salesman on a used car lot: you can’t get a good deal just because you drive a hard bargain.

Consider three ETF investors—Mark, Cheryl, and Barney—who want to buy 100 shares of the Vanguard Canadian Aggregate Bond (VAB). They get the following quote from their brokerage:

VAB quote

Because they’re placing a buy order, our three investors look at the ask price, which is $25.54. Now imagine they do the following:

  • Mark places a market order for 100 shares.
  • Cheryl places a limit order for 100 shares at $25.56, two cents above the ask price.
  • Barney places a limit order for 100 shares at $25.52, two cents below the ask price.

What is most likely to happen?

Mark’s market order should be filled immediately at $25.54. You might think that Cheryl has tipped her hand and admitted she’s willing to pay more than the ask price, and therefore she’ll likely have her order filled at $25.56. But that’s not the case: a stock exchange matches orders from buyers and sellers and fills them at the best mutually agreed upon price. If 100 shares are available at $25.54, then Cheryl’s order will immediately be filled at that price, just as Mark’s was.

Cheryl placed what’s called a “marketable limit order.” Because she set her limit above the current ask price, her order is likely to be filled immediately at the same price as a market order. By the same token, if she places a sell order with a limit a cent or two below the bid price, that too would be a marketable limit order: it likely would be filled right away at $25.51.

The exchange is not a bargain bin

And then there’s Barney the bargain hunter, who thinks he can convince some hapless soul to sell him 100 shares at a discount. Nice try. Barney has set his price lower than the ask, which means there are currently no sellers willing to part with their shares at that price. This is called a “nonmarketable limit order,” and it probably won’t be filled at all—at least not immediately. If the price of the ETF happens to tick down because of movements in the market, then he may see it filled at $25.52 later in the day. But that would be due to good luck, not any cleverness on Barney’s part.

The lesson here is that limit orders are not necessarily designed to get you a better price than investors who use market orders when trading ETFs. They simply protect you from seeing your order filled at a price you didn’t expect. Maybe the quote you obtained was stale, or perhaps the price of the ETF will move during the minute or two it takes to make your calculations and enter the order details. Moreover, with thinly traded ETFs pricing anomalies can occur if, for example, your order is the first of the day. In much rarer cases, events like the Flash Crash can wreak havoc on those who place market orders.

So don’t try to get clever: you’re not going to outsmart the market makers. Just get in the habit of placing marketable limit orders when you trade ETFs. A good rule of thumb is to set your limit a couple of cents above the ask when buying, or below the bid when selling. And save the haggling for the flea market.

Easy listening

I was recently invited to be a guest on Radical Personal Finance, an excellent podcast series created by Joshua Sheats, a U.S. financial planner. Joshua invited me on the show to share my story about making the transition from journalist to financial advisor, and to discuss some of the uniquely Canadian challenges faced by index investors.

Joshua is a fine interviewer and a prolific podcaster: he launched Radical Personal Finance in July and has already created 117 episodes. Check out his archive and sample some of his recent podcasts, including his comprehensive review of the much-ballyhooed new investing book by Tony Robbins.

 

40 Responses to The Limits of Limit Orders

  1. Kurt December 15, 2014 at 9:24 am #

    At one time, I was sure my broker (Qtrade) charged a higher commission on limit orders than market orders, but I just checked now after reading this post and it seems either they’ve changed that, or I was mistaken in my previous understanding.

  2. Canadian Couch Potato December 15, 2014 at 9:28 am #

    @Kurt: You’re right, Qtrade used to charge an additional commission for limit orders. See this old review from Canadian Capitalist:
    http://www.canadiancapitalist.com/qtrade-review/

    That practice makes no sense. I’m happy to hear they have abandoned it and moved to a flat-fee commission schedule.

  3. Kurt December 15, 2014 at 10:58 am #

    My first couple of trades I had used limit orders based on what I read on this blog and in your book, but then I realized I was paying higher commissions and changed to market orders. I didn’t have any issues, but now that Qtrade isn’t charging more for limit orders, I guess I’ll go back to using that approach.

    I also had the mistaken idea that limit orders were an opportunity to get a bargain (or pay too much, depending on where you set the limit). Thanks for clarifying that.

  4. Michael James December 15, 2014 at 11:55 am #

    Good article. I’ve found that some people feel nervous about choosing a limit several cents worse than the current market price. As you say, this shouldn’t be a concern. The potential for harm is much greater with market orders.

    Back when I paid $25 for trades at InvestorlIne, I think limit orders were $29. But they’ve both been $9.95 for years now.

  5. Tyler December 15, 2014 at 12:18 pm #

    While Qtrade doesn’t charge more for limit orders any longer, they (also Questrade) do charge ECN fees if your order fills immediately, or if it’s an order for an odd lot. It’s a practice that also needs to end.

  6. MS December 15, 2014 at 12:49 pm #

    Hi CCP,

    I have had wholesalers from both Blackrock and Vanguard tell me that if you use a market order, there is an opportunity to be taken advantage of by a market maker or high frequency trader who would fill you for slightly higher than they would have been able to with a limit order.

    I could never figure out how this might work, and you clearly indicate otherwise as well.

    Are they out to lunch?

  7. Martin December 15, 2014 at 1:07 pm #

    Very instructive post, Dan, however, my own experience with placing market orders has never been risky. I understand limit orders, like Cheryl’s, are less risky, for the reasons you highlighted above, yet for the last few years, I’ve always placed market orders when buying ETFs (given, they weren’t thinly traded ones), and they were always immediately filled.

    How much more, in terms of percentage, should one add to the bid price when placing a limit order for shares of an ETF? Do you have some sort of ‘rule of thumb’?

    Thanks,

    Martin

  8. Sean December 15, 2014 at 1:11 pm #

    For thinly traded ETFs or for ETFs whose investors are mostly buy & hold (e.g. Vanguard), you are not trading with another investor but rather the market maker – quite often your own brokerage. Update the quote and place your limit buy order at the ask price or limit sell at the bid price – you’ll know within a second if it went through.

    In addition to your commisions and ECN fees, they also make money by the difference in the bid-ask price so they have an interest in making the spread as wide as possible.

    I hate those ECN fees, too. There is no cap. If you buy a large number of shares at the ask price, you could end up paying more than the flat rates at the bank brokerages! I was stung when I swapped XBB for VAB.

  9. Russ December 15, 2014 at 1:16 pm #

    The practice of charging different fees for different types of orders has to do in with the brokerage’s costs of doing business. Market makers appreciate it when limit orders are placed away from the market. It adds to liquidity, and they will pay brokers for providing that liquidity. Market orders, on the other hand, take away liquidity from the market place. Buy market orders remove the best asks, and sell market orders remove the best bids. It may make for a quick fill, but the market makers also want lots of bids and asks at varying prices so that there is more substantial depth to the market for that particular security. This attracts more brokers to route orders their way. You can argue that this charge should go away, but most likely the companies that don’t charge extra fees also have a slightly more expensive commission schedule.

    On the use of limit orders, I generally follow the example of “Cheryl” in this article. There is one instance in which I do things a bit differently, however. I have a number of individual Canadian stocks. When any single stock starts moving up in value above a maximum weighting I want to hold, I set a limit order to sell off a portion of those shares at the price that will get me back down to where I want the position to be. I aim to trim back that particular position by approximately $3000 so that the commission, $9.99, is only a small percentage of the proceeds. I then reinvest the proceeds in an asset that is the farthest below its target allocation. As this is occurs in a taxable account, I do have to deal with capital gains, come tax time the following spring.

  10. Canadian Couch Potato December 15, 2014 at 2:56 pm #

    @MS: I’m not sure whether that is true, or how that might work, but I suppose it’s one more reason to use limit orders. 🙂

    @Martin: Market orders are definitely less of a risk with large, frequently traded ETFs. However, regarding your comment “’I’ve always placed market orders… and they were always immediately filled,” that’s actually the one advantage of market orders: they will always be filled immediately. The question is, will they filled at the quoted bid or ask price?

    As for where to set the limit, a penny or two off the quoted price should be fine for most ETFs, except perhaps those with very high unit prices (like VTI, for example), where you might want to make it three or even four cents.

    @Sean: One potential problem with placing your limit order right on the quoted price is that a large order could get only partially filled. This is where it can help to have access to Level 2 quotes, though not many brokerages offer these without additional fees.

  11. pjb December 15, 2014 at 4:58 pm #

    Hi CCP,

    It may be worth mentioning (at least with TDWaterhouse) that you can modify the limit price after the order is placed, without incurring an additional commission. I’ve done that a couple of times when the market moved against me after I placed a limit order.

    Once Barney sees that his order is unfilled or partially filled, he could add a few cents to his limit price, and the order should be filled right away.

  12. Reto December 15, 2014 at 5:35 pm #

    Note: Questrade charges additional ECN/ATS fees for any orders that are “removing liquidity from the market.” This includes:

    “Market or marketable limit orders (i.e. buy orders with limit prices equal or greater than the ask price, sell orders with limit prices equal or less than the bid price)” (from their website).

    So it sounds to me if you’re placing “Mark” or “Cheryl” orders you’ll get dinged a bit more. I’m not sure I really understand why a marketable limit order removes liquidity…but there it is.

  13. Pierre December 15, 2014 at 6:01 pm #

    I’ve been using Questrade for a few months (new index investor)…

    So far in my experience, they will ALWAYS charge ECN fees unless your order is a multiple of 100 shares.

    No matter how close or far I am from the Bid or Ask price…

    Also, if your order is say 150 shares, they will usually be split filled, one chunk is 100 shares with no ECN fees, the other chunk of 50 which will be charged ECN fees.

    Still cheaper than other brokerages, but the advice on their website on avoiding ECN fees doesn’t apply in real life if trading <100 shares.

  14. RJ December 15, 2014 at 7:23 pm #

    I also use Questrade and have gotten in the habit of placing limit orders at the bid price when buying and ask price when selling in an effort to reduce ECN fees as the order will not fill immediately, but on widely traded ETF regular volatility usually results in it being filled within 10 minutes or so. Of course I do watch it and modify the order as required so that it fills relatively quickly and to keep me within the bid ask range. I realize that this conflicts with the advice, but I am not doing it to get a bargain, but rather minimize ECN fees. I don’t bother with this if I am only investing small amounts that did not DRIP.

  15. Canadian Couch Potato December 15, 2014 at 8:49 pm #

    @RJ: I will have more to say about ECN fees in my next post, later this week. I’m surprised that you’ve found your nonmarketable limit orders get filled quickly. It seems to me your success rate would be about 50/50, since the price is about equally likely to move up or down in the minutes and hours following the order. If you are placing an order to buy and the price moves up, causing your order to go unfilled, there’s an opportunity cost there. It seems more prudent to just place a marketable limit order and accept the ECN fees, which are relatively small.

  16. Tennis Guy December 15, 2014 at 9:46 pm #

    Great Post.

    I recently was rebalancing and tried to sell 418 shares of a Canadian ETF that trades an average of 30,000 shares a day. I used BMO Investorline. I put the order in around lunchtime with a limit price equal to the bid price. 400 shares sold almost immediately but 18 shares remained. I didn’t want to change the limit price and pay a second commission and in any case the bid price was above my asking price. I presume that the small odd lot made the shares unattractive. My question would a market order been better in this circumstance as I would have sold all 418 shares?

  17. Canadian Couch Potato December 15, 2014 at 9:54 pm #

    @Tennis Guy: It isn’t usually a problem to buy or sell odd lots, especially if an ETF trades over 30,000 shares a day. I have seen a number of orders filled at two different prices, but partial fills like the one you describe a pretty rare in my experience. What may have happened is that only 400 shares were available at the quoted bid, and then the next lot had a lower bid price. You would have needed Level 2 quotes to have known this, however. (I’m starting to think this is another blog post…)

  18. Kevin December 15, 2014 at 11:24 pm #

    What happens when a larger number of shares are purchased in one limit order at the current bid price or a few cents above it as you suggest (say $100k is being purchased )in a ETF with lower volume. (Eg. XEF). With access to level II quotes you can see the volume is not there. If in the time period you wait for more sellers to come forth, the overall market goes down, you will actually continue to fill these at a premium by the market makers? If the market goes up your entire order will not be filled. I remember in another post you stated the ETF iitself will just issue more shares at the going rate? Is there a preferred way to purchase larger limit orders in an ETF ? (Multiple smaller amounts with limit orders?)(Do the money makers just fill the order themselves with a spread above the NAV?)

  19. Canadian Couch Potato December 15, 2014 at 11:36 pm #

    @Kevin: It’s hard to answer your question with any confidence: a lot of what happens behind the scenes is known only to the market makers. In general, there should be enough market depth to have your order filled close to the current price unless it’s very large. Even $100K should not be a problem: with most Canadian ETFs trading in the $20 to $30 range this is only 3,500 to 5,000 shares, which the market makers should be able to handle. But you may well get the order filled in more than one tranche, with each one at a slightly different price.

    ETF providers say you can call them to arrange a “block trade” if it’s a very large order, but we’re talking about seven figures: an advisor, for example, might do this when buying for several clients at the same time.

    When I spoke about the ETF creating new shares, this is again only relevant for very large cash inflows. New units are typically created in blocks of 50,000.

  20. Bob December 16, 2014 at 2:16 pm #

    I deal with RBC. They have a 20 minute delay so you never really know what the actual price is if you buy at market.

    The limit order has been a great tool for placing an order in the morning; going off to work or play for the day confidant that in a falling market, you have the product at the price you feel is ‘right for you’.

  21. Canadian Couch Potato December 16, 2014 at 3:21 pm #

    @Bob: RBC Direct has real-time quotes available free. But to qualify you need to fill out a number of online forms from the various exchanges, essentially attesting that you are a non-professional. This is definitely worth doing.

    The comment about placing the order and waiting for a falling market is exactly the type of thing I was advising against. There is no reason to be confident of the market’s direction. If you place a lowball order to buy and the market goes up that day (which will happen about 50% of the time) your order will go unfilled and you’ve paid an opportunity cost.

  22. Matt December 16, 2014 at 9:55 pm #

    Hi Dan,

    Great post. I do have a quick question though… In previous posts you have mentioned about ETF market makers creating and redeeming units depending on supply and demand (this was in the context of liquidity). If this is the case though, why do we have to worry about second level quotes. Shouldn’t the market maker just be able to create the number of units we want to buy based on our order (provided our limit order encompasses the market value of the ETF)?

  23. Canadian Couch Potato December 16, 2014 at 10:06 pm #

    @Matt: The market makers only create new ETF units when there are huge new inflows of cash. Retail investors are always going to be trading existing units.

    Level 2 quotes can be relevant when you’re placing a large order. For example, let’s say 5,000 shares are available with an ask price of $20.00 and another 5,000 are available at $20.01. If you place a limit order for 10,000 shares $20.00 you may see your order only partially filled. With the Level 2 quote you would have been able to anticipate that, and you could have placed your limit order at $20.01 to ensure you got all 10,000.

  24. sleepydoc December 16, 2014 at 11:52 pm #

    The Level 2 quotes have become almost mandatory for me now after having a number of limit orders only partially fill even though I placed the limit 2 cents above the ask, (granted, always on thinly traded or high dollar value/share ETFs). There is nothing more irritating than paying another commission to trade away the last 10 shares after the first 5000 went through under your limit. My brokerage (national bank) has no problem with me calling in to find out the depth of the market and then I place my limit accordingly – saves me the $10 commission and a whole lot of forehead smacking.

  25. Que December 17, 2014 at 2:19 pm #

    @Dan: This is another great post, thanks.

    I’m looking forward to the next one you mentioned about ECN fees. You are right, they are usually quite small and don’t add up to much, but most of the conversations on here are about reducing your costs for investing.

    Those ECN fees drive me crazy, because I always feel like the way Questrade describes it, its something I have done wrong, and I should have done something different to avoid those fees.

  26. Oldie December 17, 2014 at 3:08 pm #

    @sleepydoc: It’s great that you have a brokerage that is amenable to your requests and that you have the experience to know when to call for Level 2 quotes as needed. For those of us who don’t, this article’s topic is a great reminder for me, at any rate, of the fundamentals of Passive Index Trading as it relates to trades. Even though I had read the initial primer on purchasing or selling, when it came to setting the limit orders, I had somehow slipped into the error of thinking of the limit order as a bargaining chip, as Dan has specifically cautioned against. I’m somewhat comforted to know I’m not alone in this, and it seems to be an easy thinking error to make if you are not absolutely clear of the fundamental principles involved.

    So, in your example, where I might have been tempted in the past to set the limit order at 20.01 where the spread was 2 cents, (say, 20.19 to 20.21), remembering that the idea is only to avoid some catastrophic purchase as a result of some online computer trading blip causing a transient buying price anomaly, I would nowadays be inclined to spread the limit margin up to 20.26 or so, knowing this would be always be filled at the market price at the time, such as it was. If the market happened to be dropping, the order would be filled at the dropping price and correspondingly, ditto at the rising price. In other words, the higher limit order did not automatically limit you to a higher price (which may have been the unconscious fear of those trying to finesse the limit order price).

  27. Canadian Couch Potato December 17, 2014 at 8:57 pm #

    @Pierre: I actually took your question to Questrade to get an answer. It seems that odd lots (orders that are not a multiple of 100 shares) can qualify as “removing liquidity,” and therefore ECN fees may apply, even if you use a limit order that adds liquidity. I will explain more about these terms in a future post. Until then, there is some useful information on the Questrade forum:
    https://community.questrade.com/f/96/p/1103/3909.aspx#3909

  28. RJ December 17, 2014 at 10:56 pm #

    I have noticed that odd lot trades at questrade trigger ECN fees even if it is a non-marketable limit order. That said I am unclear if the ECN is only charged on the odd lot portion (eg.594 shares results in ECN on 94 shares only or is it on the whole order?

  29. Canadian Couch Potato December 17, 2014 at 11:45 pm #

    @RJ: Great question that I will deal with in my next post! The short answer is that odd lots can be subject to ECN fees even with nonmarketable limit orders, but the fees should apply only to the odd lot and not the whole order.

  30. Trevor C December 19, 2014 at 10:00 am #

    This is a great reminder. I just wish it had come a few days earlier. Last week I placed a buy order for VSB at one cent below the ask. The order went unfilled and I had to place the order again the next day. Meanwhile VSB went up 4 cents a share. When my order was finally filled, I’d cost myself over $100, trying to save 1 cent a share.

  31. Oldie December 19, 2014 at 2:51 pm #

    @Trevor C: Stop worrying about it — that, in a nutshell, is how I seem to learn my most memorable lessons. The best way of dealing with screw-ups like that, I find, is to think of it as indelible instruction from the University of Hard Knocks, and treat it as a huge bargain at $100 tuition fees for being taught about a mistake that you never need to make again.

  32. François December 20, 2014 at 8:06 am #

    Curious at one set of comment about paying additional commission for unfilled part of trades. Using TDDI when i see that there was not enough depth to fill the full trade at the bid price, so that order is only partially filled, I can go and increase my bid just to complete the trade with no extra commission…(still all within one trade)

    is this different at other brokers?

  33. KISS January 5, 2015 at 12:10 pm #

    The concept of “marketable limit order” was new to me. I put it to use this morning when I purchased VXC with my (and also my partner’s) 2015 TFSA contribution. It worked exactly as described in the article. Took the guesswork out of trying to figure out just how many shares to subscribe for. Very handy! Thank you to CCP for continuing to provide useful ideas to DIY investors.

    Btw, I purchased VXC instead of VUN+VDU+VEE. I concluded the gain in simplicity was worth the extra 5-10 bps in MER.

  34. Sam January 27, 2015 at 11:59 pm #

    Could we use this concept on stocks or it works only on ETFs?

    thanks

  35. Peter September 27, 2016 at 3:33 pm #

    Really interesting article, thought I believe it contradicts another article I was reading on Investopedia.

    Here’s a quote: “It is important to be on the correct side of market: when entering a buy limit order, the trader must specify a price that is at or below the current bid; for a sell limit order, the specified price must be at or above the current market ask” – Investopedia

    I recently put a buy limit order at 2 cents above the ask price, and it was filled at 2 cents above the ask price. My trading platform cheerily informed me I was already $4 in the red (I bought 200 shares). What did I do wrong? Using Questrade.

  36. Canadian Couch Potato September 27, 2016 at 10:28 pm #

    @Peter: The advice on Investopedia is correct. It’s possible that the price of your stock/ETF simply moved during the time it took to place your order. Had you placed it right at the ask price it may not have been filled.

  37. Peter September 30, 2016 at 7:26 am #

    Thanks for your reply! Much appreciated. The investopedia article makes it sound like a buy limit order should be placed at the bid, instead of the ask (or two cents above). Isn’t this the opposite of your view?

    What confuses me is that the bid price is what buyers are willing to pay… Why should I pay more than what others are willing to pay?

  38. Canadian Couch Potato September 30, 2016 at 9:59 am #

    @Peter: Sell orders should always be at or below the bid, while buy orders should be at or above the ask. Otherwise they risk not getting filled at all.

    It’s very important to understand that placing a limit order does not mean you are likely to pay more or accept less. The exchange will always fill your order at the best available price. So if 100 shares are available at $20 and you place a limit order to buy 100 shares at $20.02, your order will still get filled at $20. The limit order just protects you from surprises.

Trackbacks/Pingbacks

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