Financial Economics 2021-I Rafael Serrano

Trading mechanics

Contents
1 Introduction 1

2 Execution instructions 2
2.1 Market and limit orders . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 2
2.2 Stop orders . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 6

1 Introduction
In transactional markets, buyers and sellers communicate with the brokers, exchanges, and dealers
that arrange their trades by issuing orders. These specify

• what instrument to trade,

• how much to trade, and

• whether to buy or sell.

Most orders also have other instructions attached to them. These additional instructions may include

• Execution instructions that indicate how to fill the order,

• Validity instructions that indicate when the order may be filled,

• Clearing instructions that indicate how to arrange the trade’s final settlement.

In most markets, dealers and other proprietary traders often are willing to buy from, or sell to, other
traders seeking to sell or buy. The prices at which they are willing to buy are called bid prices, and
those at which they are willing to sell are called ask prices or sometimes offer prices. The ask prices
are invariably higher than the bid prices. The traders who are willing to trade at different prices may
also indicate the quantities they will trade. These quantities are called bid sizes and ask sizes
depending on whether they are attached to bids or offers.
 Practitioners refer to those who offer as traders that make a market. Those who trade with them
are said to take the market. The highest bid in the market is the best bid, and the lowest ask in
the market is the best offer. The difference between the best bid and the best offer is the market
bid-ask spread. Traders ask What’s the market? when they want to know the best bid and
ask prices and their associated sizes. Bid-ask spreads are an implicit transaction costs. Markets
with small bid-ask spreads are markets in which trading costs are small, at least for the sizes quoted.
Dealers often quote both bid and ask prices, and in that case, practitioners say that they quote a
two-sided market. The market spread is never larger than dealers spreads.

2 Execution instructions

2.1 Market and limit orders

Figure 1: Market orders are buy or sell orders that are to be executed as quickly as possible at
current market prices, whatever those prices may be. In active markets, market orders will execute
immediately, but not necessarily at the exact price that the trader intended.

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 Many people mistakenly believe that limit orders specify the prices at which the orders will trade.
Although limit orders often trade at their limit prices, remember that the first instruction is to obtain
the best price available. If better prices are available than the limit price, brokers and exchanges
should obtain their clients’ prices.
Market orders generally execute immediately if other traders are willing to take the other side of
the trade. The main drawback with market orders is that they can be expensive to execute, especially
when the order is placed in a market for securities traded occasionally, or when the order is large
relative to the regular trading activity in the market. In that case, a market buy order may fill at a
high price, or a market sell order may fill at a low price if no traders are willing to trade at better
prices. High purchase prices and low sale prices represent price concessions given to other traders
to encourage them to take the other side of the trade. Since the sizes of price concessions can be
challenging to predict, and prices often change between when a trader submits an order and when the
order finally fills, the execution prices for market orders are often uncertain.
Limit price instructions help buyers and sellers mitigate the risk of trading at unacceptable prices.
The main problem with limit orders is that they may not execute. Indeed, limit orders do not execute
if the limit price on a buy order is too low or if the limit price on a sell order is too high. For example,
if an investment manager submits a limit order to buy at the limit price of 20 (buy limit 20) and
nobody is willing to sell at or below 20, the order will not trade. If prices never drop to 20, the
manager will never buy. If the price subsequently rises, the manager will have lost the opportunity
to profit from the price rise. Limit buy orders do not fill when prices are rising and limit sell orders
do not fill when prices are falling. In both cases, traders would be better off if their orders had been
filled.

Buy limit orders are a good technique to profit from a retracement1 movement on bullish2
trends. Bullish traders can place a pending buy limit order on the retracement level of a recent low
(support level) in the hope that after the consolidation period, the underlying uptrend continues to
make new highs. Once the instrument’s price reaches the determined limit price, or the next session
1
Retracements are temporary price reversals that take place within a larger trend. Since they are are temporary,
they do not indicate a change in the larger trend.
2
A bull market is a market that is on the rise and where the conditions of the economy are generally favorable.

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opening price surpasses the predefined entry level (in case of a very common weekend gap down
opening), the buy limit order becomes a buy market order.

Example 1 (Buy Limit Order). A trader is watching the price action on the EUR/USD, and the
main trend is up. After previously hitting a new low at 1.16300, the market is now consolidating at
1.21500. The trader believes if the price retraces down to the support level of 1.16300, then the trend
will continue to go up, and would like to enter the market with a buy position. Thus, the option here
is to place a pending buy limit order at 1.16300. Once the EUR/USD price hits that level, the order
is filled automatically at the current ask price and the pending buy limit order becomes a buy market
order.

Similarly, a sell limit order is a pending order to sell an asset at a specified higher price. It is
an order placed above the current market price, on a market trending down. Sell limit orders profit
from retracements on bearish3 trends. Bearish traders can place a sell limit order on the retracement
level of a recent high (resistance level), in the hope that after the consolidation period, the underlying
downtrend continues to make new lows.

Example 2 (Sell Limit Order). A trader is watching the price action on the USD/CHF, and the
main trend is down. After previously hitting a new low at 0.88850, the market is now consolidating at
0.89100. The trader believes if the price retraces up to the resistance level of 0.92900, then the trend
will resume down, and would like to enter the market with a sell position. Thus, the option here is
to place a pending sell limit order at 0.92900. Once the USD/CHF price hits that level, the order is
filled automatically at the current bid price and the pending sell limit order becomes a sell market
order.

The probability that a limit order will execute depends on where the order is placed, relative to
market prices. An aggressively priced order is more likely to trade than is a less aggressively priced
order. A limit buy order is aggressively priced when the limit price is high relative to the market
bid and ask prices. If the limit price is placed above the best offer, the buy order generally will fill
partially or entirely at the best offer price, depending on the size available at the best offer. Such limit
orders are called marketable limit orders because at least part of the order can trade immediately.
A limit buy order with a very high price relative to the market is essentially a market order.
If the buy order is placed above the best bid, but below the best offer, traders say the order makes
a new market because it becomes the new best bid. Such orders generally will not immediately
trade, but they may attract sellers who are interested in trading. A buy order placed at the best bid
is said to make a market. It may have to wait until all other buy orders at that price trade first.
Finally, a buy order placed below the best bid is behind the market. It will not execute unless
market prices drop. Traders call limit orders that are waiting to trade standing limit orders.
Sell limit orders are aggressively priced if the limit price is low relative to market prices. The limit
price of a marketable sell limit order is below the best bid. A limit sell order placed between the best
bid and the best offer makes a new market on the sell side, one placed at the best offer makes the
market, and one placed above the best offer is behind the market.
3
A bear market exists in an economy that is receding and where most stocks are declining in value.

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Figure 2: Simplified example of limit order book. Orders are ranked by their limit prices for a
hypothetical market. The market is “26 bid, offered at 28” because the best bid is 26 and the best
offer (ask) is 28.

A trade-off exists between how aggressively priced an order is and the ultimate trade price. Al-
though aggressively priced orders fill faster and with more certainty then do less aggressively priced
limit orders, the prices at which they execute are inferior. Buyers seeking to trade quickly must pay
higher prices to increase the probability of trading quickly. Similarly, sellers seeking to trade quickly
must accept lower prices to increase the probability of trading quickly.
Validity instructions indicate when an order may be filled. The most common validity instruction
is the day order. A day order is good for the day on which it is submitted. If not filled or canceled, a
limit order automatically expires unfilled at the end of the trading day in which the order was initiated
(but may vary depending on your brokerage). However, if an investor wishes to keep a limit buy or
limit sell order active for longer periods of time, a good-till-cancelled (GTC) order can be used.
Although GTC orders will remain until canceled, brokerage firms may set a limit for the number of
days a GTC order can be active. This means that GTC orders will still expire at some point, but are
still helpful to use for orders you wish to let sit for weeks at a time.

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2.2 Stop orders
A stop order is an order in which a trader has specified a stop price condition. The stop order may
not be filled until the stop price condition has been satisfied. For a sell order, the stop price condition
suspends the order’s execution until a trade occurs at or below the stop price. After that trade, the
stop condition is satisfied, and the order becomes valid for execution, subject to all other execution
instructions attached to it. If the market price subsequently rises above the sell order’s stop price
before the order trades, the order remains valid.
Sell stop orders are a good method to use for trading breakouts on bearish trends. Bearish traders
can place a sell stop order on the break of the recent low (support level), in the hope that after the
consolidation period, the underlying downtrend continues to make new lows. This strategy profits
from an downward movement in an instrument’s price, by placing a pending sell stop order in advance
to enter the market when the price surpasses a particular point (last low, or a support level), to
ensure a greater probability of achieving a predetermined entry price. The sell stop price is entered
at a determined level and the order will remain pending. Once the instrument price reaches the
determined stop price, or the next session opening price exceeds the predefined entry level (in case of
a very common weekend gap down opening), the sell stop order becomes a sell market order.

Example 3 (Sell Stop Order). A trader is watching the price action on the USD/CHF, and the main
trend is down. After previously hitting a new low at 0.88850, the market is now consolidating at
0.89100. The trader believes if the price goes down again and hits 0.88800, the downtrend will carry
on, and would like to enter the market with a sell position. Thus, the option here is to place a pending
sell stop order at 0.88800. Once the USD/CHF price hits that level, the order is filled automatically
at the current bid price and the pending sell stop order becomes a sell market order.

Similarly, a buy stop order becomes valid only after a price rises above the specified stop price.
It is an order placed above the current market price, on a market trending up. Buy stop orders are
a good method to use for trading breakouts on bullish trends. Bullish traders can place a buy stop
order on the break of the recent high (resistance level) in the hope that after the consolidation period,
the underlying uptrend continues to make new highs. This strategy profits from an upward movement
in an instrument’s price, by placing a pending buy stop order in advance to enter the market when
the price surpasses a particular point (last high, or a resistance level), to ensure a greater probability
of achieving a predetermined entry price.

Example 4 (Buy Stop Order). A trader is watching the price action on the EUR/USD, and the
main trend is up. After previously hitting a new high at 1.23500, the market is now consolidating at
1.21500. The trader believes if the price goes up again and hits 1.23520, the uptrend will carry on,
and would like to enter the market with a buy position. Thus, the option here is to place a pending
buy stop order at 1.23520. Once the EUR/USD price hits that level, the order is filled automatically
at the current ask price and the pending buy stop order becomes a buy market order.

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Key takeaways
1. Market orders are transactions meant to execute as quickly as possible at the current market
price. They offer a greater likelihood that an order will go through, but there are no guarantees,
as orders are subject to availability.

2. Limit orders set the maximum or minimum price at which you are willing to complete the
transaction, whether it be a buy or sell. They are visible to the market and instruct brokers to
fill buy or sell order at a specific price or better.

3. A sell limit order is a pending order to sell an asset at a specified higher price.

4. A buy limit order is a pending order to buy an asset at a specified lower price.

5. A stop order is not visible to the market and will activate a market order once a stop price has
been met. It avoids the risks of no fills or partial fills, but because it is a market order, traders
may have orders filled at a price much worse than what they were expecting.

6. A sell stop order is a pending order to sell an asset at a specified lower price.

7. A buy stop order is a pending order to buy an asset at a specified higher price.