Limit Orders in Financial Markets

How limit orders work

Limit orders are fundamental building blocks of modern market microstructure. When submitting a limit order, traders specify:

1. Side (buy/sell)
2. Quantity
3. Limit price
4. Time-in-force parameters

The order remains active in the limit order book until either:

• It executes against a matching order
• It is canceled
• It expires based on time-in-force instructions
• Trading is halted

Price-time priority

Most markets handle limit orders using price-time priority, where:

1. Better-priced orders execute first
2. At the same price, earlier orders execute first

This creates a fair and transparent matching algorithm that rewards liquidity providers who take price risk by posting aggressive orders.

Market making and liquidity

Limit orders are essential tools for liquidity providers who:

• Post two-sided markets (both buy and sell orders)
• Manage inventory risk
• Earn the bid-ask spread

The collective interaction of limit orders creates market depth and price discovery:

• Buy limit orders become bids
• Sell limit orders become asks
• The spread between best bid and offer represents the cost of immediate execution

Limit order strategies

Common limit order variations include:

Passive limit orders

• Placed away from current market price
• Higher queue priority but lower fill probability
• Used for patient liquidity provision

Aggressive limit orders

• Placed at or near market price
• Lower queue priority but higher fill probability
• Used for urgent execution with price control

Hidden limit orders

• Full quantity not displayed to market
• May include iceberg orders
• Trade execution transparency for queue priority

Market quality implications

Limit orders contribute to market quality through:

1. Price discovery

• Reflect trader price expectations
• Create reference prices for market participants

2. Liquidity provision

• Build market depth
• Reduce trading costs through competition

3. Risk management

• Allow precise entry/exit prices
• Help control execution costs

The interaction between limit and market orders is fundamental to price formation and market efficiency. Modern electronic markets rely heavily on limit order trading to create deep, liquid markets with narrow spreads.

Risk considerations

Key risks when using limit orders include:

1. Non-execution risk

• Orders may never fill if price moves away
• Opportunity cost of missed trades

2. Adverse selection

• Orders may fill when market is moving against you
• Requires careful price monitoring

3. Queue position

• Long queues at popular price levels
• May require queue management strategies

Successful limit order trading requires understanding these tradeoffs between execution certainty, price improvement, and information leakage.