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Market Orders Versus Limit Orders: Informed Traders Prefer…

| | Posted in: Individual Investing

In the October 2004 version of their working paper entitled “So What Orders Do Informed Traders Use?”, Ron Kaniel and Hong Liu apply the “probability of informed trading” measure to trading in 144 stocks around the end of 1990 to determine the trading habits of informed traders (those with private information related to asset valuation) regarding the use of market orders versus limit orders. They show that:

  • Informed traders prefer limit orders on average.
  • The probability that informed traders use limit orders can be so high that limit orders convey more information than market orders.
  • The horizon of the private information is critical to the market-versus-limit decision and is positively related to the use of limit orders. When the horizon is long, informed traders can afford to wait for better prices.
  • The horizon of the private information is negatively related to the bid-ask spread. When the horizon is short, informed traders tend to use market orders, putting pressure on the market maker in the direction of informed trading.

In summary, informed traders prefer price certainty over execution certainty unless the value of their private information is about to expire.

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