Sep

23

Let's examine the limit order in more detail. There are essentially three scenarios that can occur when you place a limit order. One - you are brilliant. You caught the bottom, nicked the top and got in at an excellent price and can now manage a trade with great risk/reward profile. Two, you were right on the overall direction of the instrument but because you tried to be cute with price you missed your entry and now watch wistfully as prices move away from you while you remain empty handed. Three - you got your fill and now you wish you hadn't as price continues in the opposite direction of your bet.

So in summary in two out of three cases you have a negative outcome. Now if you happen to be a superb market timer that may not matter, but if you are just an average Joe (and we all are) then your chances of execution are basically 33% on each scenario which means your chance of winning is only 33%. That's why limit orders are a sucker's bet. They play to our desire for a bargain, but in the end they cost much more than we think.

Steve Ellison writes: 

"… your chance of winning is only 33%. That's why limit orders are a sucker's bet."

Here is a quick test of that proposition.

Imagine that traders A, B, and C each make at most one round trip trade in the S&P 500 futures every week. Trader C is a permabull, so every Sunday afternoon when Globex opens, he immediately buys the contract. He sells at the close on Friday.

Trader B wants to only "trade in the direction of the price flow", so he only buys the contract if it goes up 5 points from the Sunday open. Then he sells at the close on Friday.

Trader A fancies himself a tough negotiator and places a limit order 5 points below the Sunday open. He is last in line, so his order is only filled if the price drops to 5.25 points below the Sunday open. If filled, he also sells at the close on Friday.

Here is how each trader would have fared in the last 64 weeks.

Trader A, the user of limit orders, would have had 59 of 64 orders filled. He would have been "too cute" 5 times and missed out on big gains. 7 of his fills would have suffered from adverse selection as the market continued down, and trader B stayed out of the market. Trader A's net profit on his 59 trades was 223 points. 37 of the 59 trades were profitable.

Hence the 2 out of 3 things that can go wrong with limit orders occurred less than 20% of the time empirically. Trader A won far more than 33% of the time. Even after detrending the data to correct for the upward drift during the period, trader A's limit orders were profitable 34 of 59 times (58%).

Trader B would have avoided all the adverse selection weeks in which the market did nothing but go down. However, his net profit on his 57 trades would have been only 53 points.

Trader C, the always-in trader, would have traded all 64 weeks and had a net profit of 172 points.

In this test, the user of limit orders did better than the follower of price flow.

Sample data:

Week          Net profit
Ending   Trader A  Trader B Trader C
 7/8/2011    12.4     2.4      7.4
7/15/2011   -18.6      –    -23.6
7/22/2011    32.1    22.1     27.1
7/29/2011   -36.7   -46.7    -41.7
 8/5/2011  -100.4  -110.4   -105.4
8/12/2011    12.1     2.1      7.1
8/19/2011   -50.4   -60.4    -55.4
8/26/2011    59.4    49.4     54.4
 9/2/2011    -1.7   -11.7     -6.7
 9/9/2011    -2.6   -12.6     -7.6
9/16/2011    79.7    69.7     74.7
9/23/2011   -65.2   -75.2    -70.2
9/30/2011     9.2    -0.8      4.2
10/7/2011    35.9    25.9     30.9
10/14/2011     —    56.2     61.2
10/21/2011   22.0    12.0     17.0


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