The Limit Order, from Anatoly Veltman

September 23, 2012 |

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
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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3 Comments so far

1. Tom on September 25, 2012 5:45 am

Mr Veltman usually writes very thoughtful posts, unfortunately this is not one of them.

First, just because there are three possible outcomes does not mean that there is an equal probability of each occurring, so to conclude “only a 33% chance of winning with a limit order” is wrong.

Why only consider the use of limit orders to open, rather than to close a position? In fast or thin markets (eg gold), having resting limit orders are perhaps the only way to close or part close your position during a “spike” at your intended price. So a valid use is to capture liquidity where your reaction speed and connection delays may prevent you getting a good fill with another order type. As you are closing, you are not concerned with market risk of the market moving significantly through your limit price trapping you in a losing trade.

When considering bigger positions relative to the liquidity of the market, limit orders can provide a helpful way to scale out of the position while keeping market impact to a minimum.

As for your third scenario, that the market misses the order and goes the other way - rather than waiting on the sidelines “wistfully” a competent trader can read well enough to know when to adjust the price or go at the market. This business is about survival of the fittest and just because something may be difficult for the majority to do does not negate the value it may have in the hands of a more skilled operator.

Consider a small trader (100 lot) reversing a short term long position short. Lets say 100 lots are taken off at limit price close to where the trader anticipates the top, 50 lots a little higher than this to capture the final buying, and then a 50 lot market order to complete the transaction. This is just one example. The 100 lots is expected to be filled safely to go flat, partial of the short is established at limit price, and the final market order is put on at a slightly better or worse price depending on the market action and skill of the operator. In many cases this will result in a better average price than selling 200 at the market. (again, assuming a thin contract or trading an overnight electronic session). If the limit 50 only fills partially, then this gives even more information about the market condition being traded in.

Also, you ignore specialist cases such as liquidity provision by making an aggressive two way market in size, and the information which a size trader can read from how he is filled. Paul Rotters trading style was a good example, but he is certainly not the only trader who executes in this way.

Bottom line is that if even a small (100 lot) trader can benefit from improving execution and the appropriate use of order types, it is downright essential to medium and large size traders. For successful trading, the limitation very quickly becomes market liquidity in all but the large timeframes. Appropriate management of orders is necessary to make the most of the opportunities, especially in markets such as oil where the B/A spread can widen considerably at times of high pace.

Frankly I don’t expect any high level discussion of execution strategies to take place in public given the competitive nature of this business. Just pointing out that sometimes a limit is the appropriate and best tool for a certain job and it would be wrong to dismiss it due to the shortcomings of a hypothetical trader who isn’t very accurate in placing them or uses them in the wrong way.

2. Tom on September 25, 2012 6:19 am

Steve Ellison wrote:
‘’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.'’

I think Mr Ellison’s examples very apt, but how many people trade in such a way I wonder. This is the realm of “curve fitting” and “backtesting” which serves to ensnare many or even most in an endless journey without knowing the destination.

Approach A,B,C will make a little money when the market goes up and lose when it goes down. I suspect many fund managers etc spend endless hours going over data trying to come up with what are essentially more complex variations on this A,B,C theme. All with some sort of mechanical ruleset to try and avoid all the inconsistencies of human decision making.

In fact, aside from the few real superstars in trading who have grown to the point of managing billions of their own funds with no further need for OPM (some household names, some relatively anonymous) - do most fund managers really know anything? Why would a proficient trader wish the handcuffs of an imposed risk profile and the scrutiny of regulatory bodies? Are they just salesmen who get by on their 2 and 20 with mediocre returns for their clients? Throw out some multivariate regression analysis, quantitative models, etc and then end up being long the index any way. But of course this way is better-you go long the index but only on the Nth day of the month and out at the end, or some other curve fitted variation.

There are many such discussions here, between undoubtedly intelligent and sophisticated people, which seem to revolve around discussions of how best to predict the past. Trader “B” above doesn’t know if there is a way to capture the first 5 points instead of buying 5 points higher, and probably also doesn’t know that a market going up 5 points without any other parameters tells one exactly zero about the magnitude and direction of the next move.

We have these interesting discussions about negative sequences, correlations, variance, etc…and it all sounds good but does it really get anyone closer to the level of trading which they aspire to? For sure there is plenty of work being done both to come up with analytical approaches and the time taken to backtest and provide examples. In terms of solid approaches to generate alpha, people here either don’t know or are shrewd enough to keep it to themselves.

What I enjoy visiting this site for is the eloquent contributions of intelligent and thoughtful members on travel, life, philosophy, Objectivism, sport, games, etc. So I would venture this is site is truly a great read for everything except trading.

The reason is that everyone seems to think about and discuss only ever a few aspects of trading at a time without considering how it all fits together. Order types one week, why there might be big moves and how many times they have occurred the next week when there is a big move, what the flexions do when our political overlords are busy bailing out their buddies the next. All good reading for sure, but it all ultimately coalesces around reinterpretions or rehashing of the same old concepts. It seems to be that this is how many or most approach trading, and for this of course I am grateful.

3. Anatoly Veltman on September 27, 2012 12:18 am

Thanks Tom! Errata: the headline post was NOT my thoughts. As Clooney famously said in “Ocean’s 11″: I know a guy! The headline post merely quoted “that guy” I know. Sorry for editorial confuse.

This being duly clarified, the topic itself was interesting; and YOUR comments - very thoughtful