There is nothing worse than a trader not realizing the effects of various types of orders on his or her trading result. Incorrectly placing an order leads to missed opportunities or even regretful losses. As markets get increasingly complex, masterful use of orders is what helps to achieve better results.
Through QuantifiedStrategies.com, we learned about limit order trading strategies to improve your trading performance. Limit orders are different from market orders because with the latter, one purchases instantly, whereas the former requires specific price points before buying or selling securities. This difference may greatly impact the results of your trading strategy.
In this article, we are going to go deep into the subtleties of a limit order trading strategy and analyze them with the help of backtesting, so you will see their efficiency. We will compare the result of a mean reversion strategy based on a market order with a limit order strategy, so you’ll see the advantages and trade-offs.
By the end of this article, you will get a better idea of how to implement these trading strategies in your platform.
What Is a Limit Order Trading Strategy?
What Are Limit Orders?
A limit order trading strategy lets you buy or sell a security at a specified, predetermined price-or better. This means that you specify the most you’re willing to pay when buying or the least when selling. This allows you to have more control over the trading of your orders, thus better management of risks is possible.
Why Use Limit Orders?
In volatile markets where the price moves fast, limit orders are of very great use. Using a limit order to:
Avoid Slippage: This is when a market order executes at a price different from the expected price.
Control Entry and Exit Points: You can define the exact price at which you wish to enter or exit a trade.
There is no substitute for knowledge of limit orders in crafting a proper trading strategy aligned to your goals.
Backtesting Trading Strategies: Market Orders vs. Limit Orders
Overview of the Mean Reversion Strategy
To compare market and limit orders, we’ll backtest a simple mean reversion strategy. A mean reversion strategy takes advantage of mean reversions wherein one buys when the price is at its low and sells when the price is high.
Market Order Strategy
In our first backtest, we apply a limit order for the mean reversion strategy on the NASDAQ 100. The key results are the following:
- Average Gain per Trade: 89%
- Annual Return: 10.4%
- Time Invested: 18%
This is extremely powerful performance, yet it means that there is a very long period in which the capital is simply sitting idle and earning interest while waiting to be traded on signal.
Use of Limit Orders
Then we rebroadcast the same mean-reversion strategy but this time using limit orders. The new trading rules will be: long the following day if and only if today open < yesterday close.
Limit Order Strategy Results
The above results in the following:
The number of trades decreases dramatically, going down by more than half.
- Average Gain per Trade: The overall performance shows that though less trades were made, the average gain per trade has surged from 89% to 112%.
- Annual Return: This is a fall in annual return to 7.6% from the standard 10.4%.
Leveraging the Trade-off
This is an eye-opener for one: though limit orders do bring about more gains per trade, they definitely reduce the number of trades and therefore the overall returns.
Role of Market Conditions
The value of the limit order trading strategy also, at some times, depends on market conditions. For instance, in trending markets, the efficiency of the market orders in capturing the gains is relatively high, but in the range-bound markets probably in limit orders entry and exit points are very effective.
Advantages of Limit Orders
Improved Points of Entry and Exit
It may enable the traders to get better entry and better exit points. For example, you feel that the stock happens to be undervalued, then you can buy at some price that is acceptable with the aid of a limit order instead of overpaying which is seen in the case of a market order.
Better Risk Management
An important function of limit orders is in the process of risk management. In other words, you can safeguard your capital from unexpected market moves by placing a price that you want to sell at. This is a great aspect for a trader who cannot keep watching the market round the clock.
Reduced Emotional Trading
Using limit orders can also help minimize the psychological trading decision. You specify prior prices so that your manner of trading is structured since you will not be reacting impulsively to changes in the market.
Limit Orders Drawbacks
Opportunity Cost
The major disadvantage of a limit order is loss of potential trades due to missing price movements. If the price moves quickly and your limit price isn’t reached, then you may end up missing a profitable opportunity. This is particularly relevant in fast-moving markets where prices can change rapidly.
Less Frequent Trades
As our backtesting results have demonstrated, trading mainly with limit orders will dramatically reduce the trade executions. Consecutively, a less number of trade execution may cause a very minor decrease in profit as a whole if the profit is greater per each trade.
Conclusion
Market and limit order trading strategies differ differently. Limit order trading strategies are considered better in that they give greater control, better risk management, and ideal entry and exit points. However, there are also some drawbacks concerning the possibility of missed opportunities and fewer trade frequency.
All this pretty much leads to a point: trading is guided by a strategy- or a rationale. Decide on whether to use a market order, versus a limit order, remembering that your market conditions are unique.
For more information and advanced trading strategies please check out QuantifiedStrategies.com. Arming yourself with knowledge will make you make smarter trading decisions and maximize everything inside and outside the markets!