Jun

7

When conducting system design, you have to decide what type of order your system has to implement. A limit order allows a pre-specified number of shares to transact at a pre-specified price, but it will not cause an immediate and certain execution. On the other hand, the market order is an order to transact a pre-specified number of shares at market price, which will cause an immediate execution, but is subject to price impact.

Limit orders ensure a "discount" when buying a security, although the time-to-fill and the probability to fill are elements which are key to effectively define the effectiveness and profitability of the system. On the other hand, market orders may have an impact on price. Slippage could affect significantly the overall performance of the system, especially when trading a short term system.

Liquidity refers to these different aspects. Based on these differences, liquidity providers or liquidity takers can advantaged in specific market conditions. Assessing the price impact and slippage in case of a market order is easy, especially when trading a limited number of contracts on the e-mini. Much more difficult and challenging is to assess the probability of execution and time-to-fill of a limit order.

I guess that several variables are to be taken into account, such as volatility. How active is the market in terms of transactions/time unit is also to be taken into account. Therefore, traders have to be careful when designing and subsequently testing their systems to accurately quantify the probability of execution of a limit order before jumping to conclusions about the profitability of their system.

Brian Haag comments: 

Limit orders sell a price discovery option; market orders buy the same option. The process of valuing said option is the crux of micro structure and algorithmic execution research. Harris' Trading and Exchanges is a good trailhead.


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