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Describe and compare the various order types used in trading.

FRM® Part I · Financial Markets and Products · Futures Markets · FRM1.FM.7.e

The idea

Order types specify how and when a trade is executed. A market order is filled immediately at the best available price, so execution is certain but the price is not. A limit order sets the worst acceptable price, which is the limit or lower for a buy and the limit or higher for a sell. So the price is controlled, but execution is not guaranteed. A stop order, or stop-loss, becomes a market order once the market trades at the stop level. A sell stop sits below the market to protect a long, and a buy stop sits above it to protect a short. A stop-limit becomes a limit order once triggered and may go unfilled in a gap. A market-if-touched order becomes a market order when a favourable level is touched. Exam trap: a stop fills at the next available price, not at the stop price.

A practice question

From the question bank, with the reason each wrong option is wrong.

Which description matches a market order?

  1. An order to trade at once at the best available price. - correct
  2. An order to buy or sell only at a specified price or better, so that the price is controlled.Why not: Describes a limit order, which controls price but not execution.
  3. An order that becomes active only when the market trades at a specified trigger price, and not before.Why not: Describes a stop order, which is dormant until the trigger is reached.
  4. An order to trade at the end of the session at the settlement price, whatever the level of the market.Why not: Describes a market-on-close type order, not a standard market order.

A market order gets executed immediately at the best available price, so execution is certain but the fill price is not.

A harder one

A trader is short futures from 50.00 and wants to cap the loss if the price rises to 53.00. The market is at 50.00. Which order is appropriate?

  1. A sell stop at 53.00Why not: Uses the wrong side; closing a short requires a purchase, not a sale.
  2. A buy stop at 53.00 - correct
  3. A buy limit at 53.00Why not: A buy limit at 53.00 is marketable now and would fill immediately at about 50.00 instead of waiting for 53.00.
  4. A sell limit at 53.00Why not: Wrong side again; it would not close the short position.

To close a short, the trader needs a buy order that activates when the price rises to 53.00: a buy stop. It becomes a market order when 53.00 trades.

The hardest tier

With the best offers at 50.40 for 6 contracts and 50.60 for 4 contracts, a trader enters a buy limit order for 10 contracts at 52.00. What is the average fill price?

  1. 52.00Why not: Assumes a limit order is filled at the limit price, which is only the worst acceptable price.
  2. 50.48 - correct
  3. 50.40Why not: Assumes all 10 contracts fill at the best offer, though only 6 are available there.
  4. 50.50Why not: Takes a simple average of the two prices instead of weighting by quantity (6 and 4).

A marketable limit order executes against available offers at or below the limit: (6 x 50.40 + 4 x 50.60) / 10 = 50.48. The limit only sets the worst acceptable price.

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