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Market Orders and Price Moves

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October 23, 2009 – Comments (0)

A question came up on an investing board asking how a series of limit orders impact a stock’s price compared to market orders.  My reply received a number of recommendations so I decided to modify it a bit for a blog post.  This is old school for experienced Fools, but some newer Fools may not be familiar with the process.  Savvy Fools can correct my mistakes or add key points I’ve missed.

The scenario is an advisory service or analyst has just issued a buy recommendation on some stock and investors have responded by placing several buy orders in rapid succession.

A stock’s quote shows only part of the story.  Typically the last trade and possibly the bid and ask price are shown.  The order book behind the bid and ask price, the next orders in line to be filled, typically aren’t shown.

With a large cap, very liquid stock the order book will typically have very narrow spreads between the bid and ask and very small gaps, if any, between the orders behind the current bid/ask.  As I’m typing, the order book for YAHOO shows a one-penny spread between the bid and ask and orders at one penny intervals going out for more than 10 cents in either direction.

Not so for many smaller, thinly traded stocks.  HWKN, a stock I own, is showing a 49 cent spread between the bid and ask.  More critical for a scenario where multiple orders might arrive in quick succession, there aren’t a lot of orders behind the bid and ask and there are sizable gaps between the orders.

The top of the ask order stack is:

100 shares @ 23.65
100 shares @ 23.66
1100 shares @ 23.90
485 shares @ 24.64
100 shares @ 28.20
100 shares @ 46.11

As far as I know, nobody’s issued a buy recommendation on HWKN, but let’s assume some analyst put out an upgrade and a number of investors jumped on it with market orders.  With a market order, the buyer has told the broker to fill the order now at the lowest price from the ask offers, whatever that price is.  If a flood of market orders hit an illiquid stock, they get filled from the stack of ask orders. Unless sellers come in, the market orders keep taking out the next lowest priced sell offers driving up the price.

For this hypothetical, assume market buy orders for 400, 300, 400, 300, and 500 shares are received and no new sell orders hit the book.  They would get filled as follows:

Order 1 – filled with 100 @ 23.65, 100 @ 23.66 and 200 @ 23.90
Order 2 – filled with 300 @ 23.90
Order 3 – filled with 400 @ 23.90
Order 4 – filled with 200 @ 23.90 and 100 @ 24.64
Order 5 – filled with 385 @ 24.64 , 100 @ 28.20 and 15 @ 46.11

In all likelihood, sellers or the market maker would have stepped in as the buy orders pushed the price up, but this illustrates how a rapid influx of orders can drive the share price up quickly.

Now let’s assume our imaginary investors placed their orders for the same number of shares, but all had a limit price of 23.75.  In that scenario, the first order gets 200 shares filled; 100 @ 23.65 and 100 @ 23.66.  The rest of the first order and the other four orders would wait until either a market sell order or a sell order with an ask below their limit was placed.  The limit orders don’t have the potential to drive the price up like market orders because they’re, well, limited.  With a limit order, the investor does run the risk of the order not getting filled.

The same thing works in reverse for sell orders.

The key point is to take care when placing orders.  A market order on a heavily traded stock will nearly always get executed very near the last trade price.  A market order on a thinly traded stock can result in an unpleasant surprise.

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