Stock Trading: Speed vs. Price
There's a tradeoff between speed and price when buying or selling stock. In the U.S., our markets favor trading quickly rather than getting the best price for investors....and I don't think a lot of small investors understand this. Should market orders be banned?
There was an article in the Wall Street Journal today about the SEC examining how the stock markets work and whether it is better for investors to get the best possible price when they trade stock, or to get their trades done quickly.
About time!
Not many individual investors understand the trade-off between speed and price when buying or selling stock, and our stock markets assume that investors will prefer speed over price. Except for very active traders, I would guess that most investors actually prefer to get a better price than have their trades complete quickly.
Here's (a simplified version of) how it works: Let's say you want to buy 1000 shares of ABC Company. The price is $50/share. So, you log on to your online brokerage account and enter an order to buy 1000 shares of ABC Company.
The first thing to keep in mind is that $50/share isn't the real price of the stock. There are two prices, the bid and the ask, based on what other market players are willing to buy or sell the stock for. If the last trade was at $50, the bid might be $49.95, and the ask $50.05. If you are buying stock, you have to pay the asking price, and if you are selling, you get the bid. The ask is always higher than the bid, and the difference between the two is the spread, or $0.10 in this case. The spread is what allows the brokerages to make a profit by buying or selling the stock if nobody else wants to.
Those bid and ask prices are the best prices (i.e. the lowest ask and the highest bid) being offered by other market participants at any given time. Chances are, you entered your 1000 share order as a "market" order, which means you're willing to take the prevailing price at that moment.
Here's where speed vs. price comes into play. The market price for buying the stock is $50.05, but that price might only be good for 100 shares. Especially for stocks which don't trade much ("illiquid" shares), there might be one person willing to sell you ABC for $50.05/share, but he'll only sell you 100 shares. Someone else might sell it to you for $50.10, and he's good for another 300 shares. A third person might sell you 1000 shares for $50.15. These different prices and share amounts are "Limit Orders" and are collected in an "Order Book."
Your 1000 share order is filled by taking the best prices in the order book until the order is filled. So, you will first buy 100 shares at $50.05, then 300 shares at $50.10, and finally 600 shares for $50.15, for an average price of $50.125/share. Remember, the last trade was $50.00, and the ask was $50.05. In order to fill your order immediately, you paid an extra $75, or $0.075/share.
Okay, you say, but that was the best price I could get for the stock. Not really!
You see, there's a lot of gamesmanship which goes on in the stock market, and market players often don't disclose what they're really willing to pay or how many shares they're willing to buy or sell. Everybody is afraid that they'll give up too much (which I don't believe, but that's a topic for another day), so there may be better prices available than what are shown in the order book at any given moment. The guy who was willing to sell the stock to you for $50.05 might have really had 5,000 shares to sell, not 100, but he thinks he can get more waiting. And guess what: he's right! You paid as much as $50.15/share. Now that the price has gone up, he's going to enter a new price of $50.10 for another 100 shares.
Now, what do you do if you're willing to wait a bit to buy your stock to get a better price? Let's say that you've decided that ABC is worth $50.00/share, and you really don't want to pay any more. It seems logical that you should be able to get that price, since the bid/ask is $49.95 - $50.05.
Instead of entering a market order, you can enter a limit order for 1000 shares at $50.00 exactly. Now your limit order becomes the new bid (sort of--there are some markdowns and intervening steps to make sure your broker makes a profit), and the next person who comes along willing to sell ABC for $50.00/share sells it to you. You might have to wait for your order to fill, or it may never get filled at all if ABC starts going up and never comes back down, but if and when the order fills, you've saved $125 over the market order.
Or, you can enter the limit order for $50.10. You'll buy the first 400 shares right away (100 at $50.05 and 300 at $50.10), and then become the new bid at $50.10, waiting for someone else to sell you 600 more shares at $50.10. You got half the order filled right away, and still save $30 as compared to the market order.
So why don't more individual investors understand and use limit orders? I think there are two reasons:
The stock market and the regulators currently assumes that most people want speed, rather than the best price.
Large brokers make a significant profit from filling market orders, and don't really want individuals using limit orders. Some on-line brokers even charge extra for a limit order.
I think the whole concept of a "market order" is inherently unfair to small investors. There's no reason not to make every order a limit order, and people who want speed instead of price can always enter a price well above the market. Part of the reason for the IPO craziness in the dot-com bubble was that there were thousands of small investors, each of whom had, by placing market orders, told their brokers to buy the stock at any price. There were even cases where there were more market orders than stock available to fill them.
Should market orders be banned?
I'm not a professional trader, but if every order to buy or sell stock had to have a maximum or minimum price, I think individual investors would benefit. At the very least, the investor would have to think about the tradeoff between speed and price.