In the world of liquid, large-cap stocks, market orders are often a convenient way to quickly buy or sell shares. However, when it comes to microcap investing, using market orders can be a recipe for disaster. The illiquid nature of many microcaps, combined with the absence of traditional market makers in the Canadian market (compared to historical US practices), makes them particularly vulnerable to price manipulation and unfavorable executions when using market orders. This article will explain the dangers of market orders in the microcap context and why limit orders are the much safer and more prudent choice for investors.
What is a Market Order?
A market order is an order to buy or sell a stock at the best available price in the market immediately. It guarantees execution but not a specific price.
What is a Limit Order A limit order is an order to buy or sell a stock at a specific price or better. With a buy limit order, the trade will be executed at the limit price or lower, and with a sell limit order the trade will be executed at the limit price or higher. It guarantees a specific price (or better) but not execution.
Why Market Orders are Risky in Microcaps:
- Low Liquidity: Many microcap stocks trade with very low volume. This means there may be a limited number of buyers or sellers at any given time. When a market order is placed, it will be filled at whatever price is available, which could be significantly different from the last traded price, especially if the order is large relative to the average trading volume.
- Wide Bid-Ask Spreads: Low liquidity often leads to wide bid-ask spreads. The “bid” is the highest price a buyer is willing to pay, and the “ask” is the lowest price a seller is willing to accept. In illiquid microcaps, the difference between the bid and ask can be substantial, meaning a market order could be executed at a much less favorable price than expected.
- Price Manipulation: The illiquid nature of microcaps makes them more susceptible to manipulation. Unscrupulous actors can use various tactics, such as “spoofing” (placing and quickly canceling orders to create a false impression of demand or supply), to artificially influence the price and take advantage of market orders.
- Absence of Traditional Market Makers (Canada): In the U.S., market makers historically had obligations to maintain a fair and orderly market, providing liquidity and narrowing spreads. While the role of market makers has evolved, they still play a role in price discovery. In Canada, particularly on exchanges like the TSX-V and CSE where many microcaps trade, there isn’t the same tradition of designated market makers. This means there’s less of a buffer to absorb large orders and maintain price stability, making market orders even riskier. Although some companies are now employing market makers.
- Volatility: Microcap stocks are inherently volatile. Prices can fluctuate dramatically in a short period. A market order placed during a sudden price swing could result in a very unfavorable execution price.
Example:
Imagine a microcap stock with a last traded price of $0.50. The current bid price (what you could sell for immediately) might be $0.48, and the ask price (what you could buy for immediately) might be $0.52. If you place a market order to sell, your order could be filled at $0.48 or even lower if there aren’t enough buyers at $0.48. This is especially true if the volume is low. Conversely, if you place a market order to buy, you might end up paying $0.52 or higher. In a thinly traded stock, a large market order could even trigger a series of trades at progressively worse prices, a phenomenon known as “walking the book.”
Limit Orders: Your Shield Against Unfavorable Execution
Limit orders are the preferred order type for microcap investors because they provide control over the execution price.
- How Limit Orders Work: When you place a limit order to buy, you specify the maximum price you’re willing to pay. When you place a limit order to sell, you specify the minimum price you’re willing to accept.
- Protection from Slippage: Limit orders protect you from “slippage,” which is the difference between the expected price of a trade and the actual execution price.
- Patience is Required: The downside is that your order may not be executed immediately if the market price doesn’t reach your limit price.
Best Practices for Using Limit Orders:
- Set Realistic Limits: Don’t set your limit price too far from the current market price, or your order may never be filled.
- Consider the Spread: Take into account the bid-ask spread when setting your limit price.
- Monitor the Order Book: If possible, monitor the order book (Level 2 quotes) to get a sense of the buying and selling pressure at different price levels. This is not always an option with microcaps.
- Be Prepared to Adjust: If the market moves significantly, you may need to adjust your limit order to increase the likelihood of execution.
Conclusion
While market orders offer convenience in highly liquid markets, they are generally a dangerous proposition in the world of microcap investing. The combination of low liquidity, wide spreads, potential for manipulation, and the absence of traditional market makers in the Canadian context makes market orders a risky proposition. Limit orders, on the other hand, provide investors with much-needed control over execution prices, helping to mitigate the risk of unfavorable fills and protect against the inherent volatility of microcap stocks. By prioritizing price control over immediate execution, microcap investors can make more informed decisions and navigate this challenging market with greater confidence.