Help Understanding Market/Limit Orders and Bid/Ask Price

Question

Kid gloves... this might be a stupid question, but I haven't found a real clear answer to this.

So I understand that market orders are orders to execute at current market prices and that the price is not guaranteed, but the trade will be as soon as shares are available. I understand the limit orders are (in the case of a limit buy order) to buy only at or below the stated price.

I also understand the basic difference in bid and ask prices.

Here's where it breaks down. If the market order does not guarantee price, then why isn't a limit or (even if it's a lowball one) executed as soon as there are available shares since the price on a market order is not guaranteed? (I know that there is probably some safeguards in here somewhere, but I would really like to understand it better.)

For instance (and forgive me if I mix up the usage of bid/ask... I promise it sorta makes sense in my head): A particular stock we will call GMMM (Get Me More Money) is trading between $100 and $105 per share in a given day. I want that stock, but not all that bad. I see that the ask volume is 800 (let's assume all market orders) and the bid volume is 200 (also all market orders). If I place a limit buy order for 100 shares at $95 and there are still 600 outstanding shares for sale (and we assumed those were all market order) then why is that limit buy order not executed?

Answer 1

Your logic breaks down because you assume that you are the only market participant on your side of the book and that the participant on the other side of the book has entered a market order.

Here's what mostly happens: Large banks and brokerages trading with their own money (we call it proprietary or "prop" trading) will have a number of limit (and other, more exotic) orders sitting on both sides of the trading book waiting to buy or sell at a price that they feel is advantageous. Some of these orders will have sat on the book for many months if not years. These alone are likely to prevent your limit orders executing as they are older so will be hit first even if they aren't at a better price.

On more liquid stocks there will also be a number of participants entering market orders on both sides of the book whose orders are matched up before limit orders are matched with any market orders. This means that pairing of market orders, at a better price, will prevent your limit order executing. In many markets high frequency traders looking for arbitrage opportunities (for example) will enter a few thousand orders a minute, some of these will be limit orders just off touch, others will be market orders to be immediately executed. The likelihood that your limit order, being as it is posited way off touch, is hit with all those traders about is minimal.

On less liquid stocks there are market makers (large institutional traders) who effectively set the bid and offer prices by being willing to provide liquidity and fill the market orders at a temporary loss to themselves and will, in most cases, have limit orders set to provide this liquidity that will be close to touch. They are paid to do this by the exchange and inter-dealer brokers through their fees structure. They will fill the market orders that would hit your limit if they think that it would provide more liquidity in such a way that it fulfils their obligations.

Only if there are no other participants looking to trade on the instrument at a better price than your limit (which, of course they can see unless you enter it into a dark pool) AND there is a market order on the opposite side of the book will your limit order be instantaneously be hit, executed, and move the market price.

Answer 2

At any point of time, buyer wants to purchase a stock at lesser price and seller wants to sell the stock at a higher price.

Let's consider this scenario

Company XYZ is trading at 100$, as stated above buyer wants to purchase at lower price and seller at higher price, this information will be available in Market depth, let's consider there are 5 buyers and 5 sellers, below are the details of their orders

Buyers List

Price($)          Quantity
   99                100
   98                100
   97                100
   96                100
   95                100

Sellers List

Price($)          Quantity
   101                100
   102                100
   103                100
   104                100
   105                100

Highest order in buyers list will contain the bid price and bid quantity, Lowest order in Sellers list will contain the offer price and offer quantity.

Now, if I want to buy 50 Stocks of company XYZ, need to place an order first, it can be either limit or Market.

Limit Order : In this order, I will mention the price(buy price) at which I wish to buy, if there is any seller selling the stock less than or equal to price I have mentioned, then the order will be executed else it will be added to buyers list

Market Order : In this order, I will not mention the price, if I wish to purchase 50 Stocks, then it will find the lowest offer price and buy stocks, in our case it will be 101. if I wish to purchase 200 Stocks, then it will find the lowest offer price and buy stocks, in our case it will be 2 transactions, since entire request cannot be accommodated in single order

1. Purchase 100 Quantity @ 101, this is lowest offer price, hence 100 Stocks will be bought and then my pending order will be 100 (since 100 Stocks are already purchased).
2. Purchase 100 Quantity @ 102, now this is the lowest offer price, hence 100 Stocks will be bought and my pending order is closed.

Usually the volume(Ask Volume and Offer Volume) being displayed are all Limit orders and not Market orders, Market orders are executed immediately.

This is just an example, However several transactions are executed within a second, hence we will get to know the exact value only after the order is completed(executed)