Costs And Benefits Of Limit Order Trading
The order placement strategy depends on the relative merits and costs of limit orders and market orders (Harris, 1998). Let us first consider the costs and benefits from placing limit orders.
Limit order traders bear two types of risks and costs (Handa and Schwartz, 1996). First, the risk of adverse informational change is known as ex-post regret or winner's curse. This risk materializes when the market price moves against the limit order trader. Bearish news may cause the price of the stock to fall and the trader's buy limit order to execute or, equivalently, bullish news may cause the price of the stock to rise and the trader's sell limit order to execute. In both cases the trader will regret the execution. Second, the risk of limit order not executing (i.e., nonexecution risk) is a potential cost for limit order traders. This risk also depends on the price dynamics. Bullish news may cause the price of the stock to rise and the trader's buy limit order not to execute. Bearish news may cause the price of the stock to fall and the trader's sell limit order not to execute. From this discussion it seems that the limit order trader faces a situation like "Heads you win . . . tails I lose," since he or she gets the execution but regrets it or he or she correctly forecasts the price movement but does not get the execution.
Therefore, why should a trader place a limit order? Let us consider the benefits associated with limit order trading. The main advantage of using limit orders is the better price that results from limit order execution. Buyers who submit limit orders hope to buy at the bid. If they had submitted a buy market order instead, they would have paid the ask price (which is strictly higher than the bid). Sellers who submit limit orders hope to sell at the ask price. If they had submitted a sell market order instead, they would have received the bid price (which is strictly lower than the ask price). However, limit order traders do not always realize their expectations. Limit order traders receive better prices only if their order actually trades. If the market moves away from their limit price, they may never trade. If they still want to trade, they will have to "chase the price" by raising their bid or lowering their offer. For example, if the market price goes up and a buy limit order is not executed, the trader will have to raise the limit order's bid or to use a market order. This would make the final purchase price actually worse than the price that the trader would have obtained had he or she used market orders at the time of the first limit order submission.
Limit order execution depends on price dynamics as well and, specifically, limit orders get executed when a liquidity event occurs (Anolli and Petrella, 2007). A liquidity event is the arrival of a trader on the other side of the market who is buying liquidity (and is not an informed trader). In other words, the trader posted a buy limit order and an impatient seller arrived or the trader posted a sell limit order and an impatient buyer arrived. Alternatively, one can look at the same event as "mean reversion" in the pricing process: the trader posted a buy limit order and the price first went down and then up or the trader posted a sell limit order and the price first went up and then down. Based on this result, if we reconsider the question "Why should a trader place a limit order?", the answer might be stated in an alternative way: because the trader expects that sufficient mean reversion would offset the costs that might result from an informational change. This implies that the gain from limit order trading depends on the intraday volatility level. Mean reversion is usually associated with accentuated intraday transitory volatility. To measure the extent of this characteristic it is necessary to estimate the stock return autocorrelation (or serial correlation), that is the correlation of the return of stock i at time t with the return of stock i at time t — 1. Positive autocorrelation means that positive returns tend to be followed by positive returns and negative returns tend to be followed by negative returns (i.e., neighboring returns tend to have the same sign). Negative autocorrelation means that positive returns tend to be followed by negative returns and negative returns tend to be followed by positive returns (i.e., neighboring returns tend to have different signs). Negative short-run serial correlation is evidence of accentuated intraday mean reversion and creates ideal market conditions to submit limit orders (since the risk of nonexecution drops). In fact, intraday volatility is a natural property of order-driven markets (Handa, Schwartz, and Tiwari, 1998). Without intraday volatility, traders would not find profitable to submit limit orders.
The cost-benefit ratio of trading via limit orders depends on the type of volatility that the market exhibits (Foucault, 1999). Stock return volatility can either be permanent or transitory. Permanent volatility refers to the change in price motivated by the arrival of new information. A new piece of information makes the change in the stock value "permanent" and is known as efficient volatility because if the market is informationally efficient, the price must reflect the information as soon as it is available. This is the type of volatility that limit order traders would like to avoid. By contrast, transitory volatility refers to price movements that will be quickly reverted. Transitory volatility is generated by traders demanding liquidity and the price bouncing back and forth between bid and ask quotes which is also called inefficient volatility since such price movements do not improve to the price discovery process. This is the volatility that limit order traders would like to find. Trading by liquidity traders creates transitory volatility and trading by momentum traders reinforces it. By contrast, trading by informed traders creates permanent volatility since they move the price to the new equilibrium level.
Average user rating: 5 stars out of 1 votes
Post a comment