Let me ask you something. You love that stock, currency pair, option, futures contract (whatever) right? You think its going to soar, correct? So then why are you buying it when it is going down? That is always the question that befuddled me whenever traders put in limit entry orders for their positions. Make no mistake about it, every time you buy on limit you are betting against the market. You are buying when prices are falling and selling when prices are rising.
Now I don’t know about you, but I am just not smart enough to perpetually bet against the market. Don’t get me wrong, the market is not infallible. There are plenty of times when the market is wrong. That’s what stops are for. But generally trading in the direction of the price flow is an effective strategy over time. My Tradestation is full of algos that turn conventional wisdom on its head by essentially buying highs and selling lows. That’s not so much fun when you encounter chop, but in the long run it generates alpha.
Let’s examine the limit order in more detail. There are essentially three scenarios that can occur when you place a limit order. One -- you are brilliant. You caught the bottom, nicked the top and got in at an excellent price and can now manage a trade with great risk/reward profile. Two, you were right on the overall direction of the instrument but because you tried to be cute with price you missed your entry and now watch wistfully as prices move away from you while you remain empty handed. Three -- you got your fill and now you wish you hadn’t as price continues in the opposite direction of your bet.
So in summary in two out of three cases you have a negative outcome. Now if you happen to be a superb market timer that may not matter, but if you are just an average Joe (and we all are) then your chances of execution are basically 33% on each scenario which means your chance of winning is only 33%. That’s why limit orders are a sucker’s bet. They play to our desire for a bargain, but in the end they cost much more than we think.