Market orders and limit orders

September 7, 2006

In chapter 14, Harris has a marvellously clear explanation of the interplay between market and limit orders. To simplify massively, imagine an order book with a very sparse flow of market orders. Traders placing limit orders on that book will have to improve on the prices of the existing limit orders to become top of book, and match with one of the rare market orders. But in doing so, they’ll narrow the spread between best bid and ask. As the spread gets narrower, market orders will trade at better prices, causing market order flow to increase, and spreads to widen. As spreads widen, market order prices worsen, making limit order based strategies more attracive. And so the system is in dynamic equilibrium.


2 Responses to “Market orders and limit orders”

  1. […] In his discussion of the interplay of market orders and limit orders, Harris goes on to point out that eSpeed charge a higher fee for market orders than limit orders. Which is interesting for me, since eSpeed is Cantor’s fixed income ECN, and our desk uses our system to trade on it. They charge more for market orders to encourage limit orders, and thereby narrow spreads between best bid and ask. In theory, narrower spreads should make eSpeed appear a more attractive trading venue than the other fixed income ECNs. Posted in books, trading, ecns, reading harris | […]

  2. […] I’m still reading chapter 14 of Harris, on bid ask spreads. As always with Harris, it’s highly enlightening and thought provoking. I commented earlier on how the dynamic equilibrium between market and limit orders affects spreads, and how eSpeed charges for market orders in order to minimise spreads. Later in ch 14 he goes on to enumerate the factors that determine the equilibrium spread in order driven markets. In decreasing order of importance they are: information asymmetry between traders, time to cancel limit orders, volatility, limit order management costs, value of trader time, difference between limit and market order fees and trader risk aversion. […]

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