Always Use Limit Orders, Since Your Market Orders Just Become Bad Limit Orders Anyway

I don’t know how everyone else does this, but whenever I buy shares of an ETF for my portfolio, I always use a limit order. But it’s usually a “lazy” limit order, because I am just aiming to buy immediately at roughly the market price and the limit order is simply insurance against a flash crash or similar anomaly that happens rarely, but still happens. So I look at the bid/ask prices, and add some wiggle room, and submit a limit order good until the end of day.

I’ve read advice elsewhere to place a limit order at the midpoint between bid and ask, but that makes it so there is a good chance the order will not fill that day, and may never fill if the market keeps moving. I don’t want to keep chasing the market price and staring at the order book on a trading screen. I just want a fair fill, and I want it done. My holding period will be decades, so consistently investing in the market is the most important.

However, on newer trading apps like Robinhood, the default option is always a market order. With smartphone user interfaces, all it takes is a quick swipe and off it goes. Sometimes it takes a little hunting around to even find the limit order option.

It turns out, Robinhood actually agrees that market orders are dangerous. Behind the scenes, Robinhood and many other brokers do something called “order collaring” and quietly turn your market order into a limit order with a 5% margin. For example, if the stock is trading around $100 and you put in a market order (that says you’ll pay whatever the best price is that the moment, even if it is $5,000 or something, technically) into a limit order for $105 max. Matt Levine wrote Money Stuff column about order collaring (gift article) that points out that there are trading bots that specifically take advantage of these 5% collared orders, especially on more thinly-traded stocks.

Here’s how I imagine Robinhood’s thinking:

“We gotta keep things simple and fun for these newbie investors, so we will just let them do market orders with a single swipe, no entering numbers or doing math required! Hmm… but market orders are kinda stupid and dangerous. So… let’s actually make them a +/- 5% limit order so they can’t really hurt themselves so badly that they’ll get mad at us. If they are careless enough to do a market order, then they won’t notice a 5% bad fill but they might notice something worse.”

According to Vanguard, the median bid-ask spread for their popular Vanguard Total Stock Market ETF (VTI) is 0.01%. That means roughly 3 cents a share at the current price of ~$270. Here’s a screenshot from my order screen today. The bid might be $268.83 and the ask might be $268.86. Here, I might just put in a limit order at $270 so that even if the market moves up a little quickly, I still get my order filled. It filled at $268.93, and a few minutes later it was at $269.29.

Meanwhile, 5% of $270 is $13.50 per share. That’s a lot! 500 times the usual spread, and something is usually wrong if it’s that much off. I know that VTI is not thinly-traded, and 99.9% of the time, it won’t matter what you put in for your limit. But once in a while, it will matter, and it only takes an extra few seconds to place a limit order instead of a market order.

My guess is perhaps people think that putting in a limit order will actually encourage the market maker to take advantage of them? It’s like if you say “I’ll pay up to $5 for that Pepsi”, and someone will charge you exactly $5. It’s better just to do a market order and not “show your hand”? But this information about order collaring reaffirms that market orders aren’t any better because they just get turned into very loose limit orders anyway. The bots will still see you as a potential sucker. You might as well set a tighter limit yourself.