Market order is an instruction to sell or buy through a broker at the best available price. There are no restrictions on the price or the time frame in which a market order can be executed. Market orders can sometimes be referred to as unrestricted orders because there is no limitation on the order on like limit order. Traders sell at the bid price and buy at the ask price.
Breaking down Market Order
With market order, brokers do less work which translates into low commissions for the trader. You should not use market orders on stocks with very low average daily volume. Because they have large spreads and this results in large amounts of slippage when making trades.
Market Order Slippage
Market makers set the market prices using the bid price and ask price. The difference between the bid price and ask price is called spread. Traders who are willing to make trades using market order will have to buy at the ask price or sell at the bid price. Ego the trade is instantly out of the money by the amount of spread gained. Different traders use different order types in order to increase the returns of their risk-adjustments. Market orders can be good for certain transactions but limit orders on the order hand can be used to make sure trades are executed at the appropriate price.
For instance, let’s say that the quote for XYZ is at bid/ask price of $50/51. There are 600 shares at the bid price and 600 shares at the ask price. If a trader makes an order to buy 1,200 shares, the first 600 shares will be sold at the ask price of $51. After that, the other 600 shares will also be executed to the sellers of the next 600 shares at whatever ask price. The amount of these ask prices will increase above $51 in accordance with the current market supply. At the end of the day, the average price for the entire 1200 share market order will be more than $51 which was the initial market price at the time the trade order was originally placed. The difference in the two prices is termed slippage. In a highly-volatile market, the slippage value may increase. In order to avoid slippages, you have to use limit order.
Backtesting with Market Orders
It is very important especially for traders that use the automated trading system as well as perform backtesting to account for slippage in case market orders are used in their strategies. The total slippage amount over the backtesting period can be considered as the difference between a strategy that yields profit and a losing one. Most of the time, backtesting softwares provide means of accounting for slippages that have resulted from market orders.