Bad News on Limit Orders

Posted by: Ben Steverman on November 20, 2007

New research suggests widespread use of limit orders may be one reason individual investors do poorly when trading stocks.
When they trade their own stocks, amateur investors tend to underperform the market. Research shows the more they trade, the more they tend to lose. Even as taxes, fees and trading costs eat into returns, individual investors also tend to make poor choices, buying losing stocks and selling winners. That’s why many experts recommend simple index funds for most investors.
University of Chicago Graduate School of Business professor Juhani Linnainmaa is out with new research on the use of limit orders. When investors buy stock, they can either place a market order, paying the current market price, or a limit order, which will only be executed if the stock falls to a certain price.
Here’s the problem, Linnainmaa shows: When new news comes out on a stock, limit orders go “stale” but amateur investors are rarely able to withdraw their old limit orders in time. He writes:

A stale limit order does not reflect current market information. … The problem is that individual investors don’t have the resources to constantly monitor the market, which places them at a disadvantage relative to institutional investors.

When news breaks, quick-acting traders take advantage of all those stale limit orders, reaping profits while amateur investors lose out.
Limit orders are popular among individual investors. Linnainmaa, using data from a U.S. discount broker, estimates almost 75% of individuals’ orders are the limit variety.
Despite his findings, he says investors might still use limit orders in some cases. But don’t set limit orders so low that they’ll only be executed in the event of news, he adds.

Reader Comments

Agnes Wilson

May 4, 2010 6:27 AM

Indeed interesting post as for me. It would be great to read a bit more about such topic. Thanks for posting that material.

Agnes Wilson
Finding Trustworthy Suppliers

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About

Bloomberg Businessweek’s Ben Steverman focuses on the latest moves in financial markets and emerging trends in stocks, bonds, and funds, always with an eye toward giving readers a better understanding of the sometimes confusing and often chaotic world of money. Standard & Poor’s senior index analyst Howard Silverblatt will also provide his take on companies’ finances and the markets. Voted one of the “Top 100 Finance Blogs” in 2007.

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