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:

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 setting 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 $25.53 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.