1. Securities trading: Market and limit orders

Securities trading: Market and limit orders

After the liberalisation of the Indian economy about 25 years ago, a trading culture, from the perspective of financial markets, has taken deep roots in India.

New Delhi | Published: January 12, 2018 1:02 AM
Securities trading, market, limit orders, economy, stocks The system has to ensure that buyers are given access to the lowest prices on the sell side.

After the liberalisation of the Indian economy about 25 years ago, a trading culture, from the perspective of financial markets, has taken deep roots in India. These days it common to find a cross-section of residents, be they students, housewives, or professionals, showing a deep interest in securities trading.

When a person wishes to trade, the first step is to place an order. There are two basic types of orders, namely, market orders and limit orders. Other more complex order types exist, but will not be covered here. A person placing a market order merely indicates the quantity to be bought or sold. No price is too high for a buyer or too low for a seller. These traders are price takers. The quantity specified in such orders is termed as the order size. The other fundamental type of order is a limit order, where, as the name suggests, the trader specifies a price limit in addition to the quantity sought. If it is an order to buy a security, the limit will be a ceiling or an upper limit. Whereas if it is an order to sell a security the limit will be a floor or a lower limit.

The system has to ensure that buyers are given access to the lowest prices on the sell side, while sellers are given access to the highest prices on the buy side. Consequently limit orders which cannot be executed are stacked in the system using certain priority rules. Universal criterion is price priority. That is, on the buy side the higher the specified limit higher will be the priority accorded, whereas on the sell side the lower the specified limit, higher will be the priority. Thus, buy orders are arranged in descending order of price while sell orders are arranged in ascending order of price. This ensures that an incoming buy order is exposed to the lowest price on the sell side, while an incoming sell order is exposed to highest price on the buy side.

The next issue is what happens if two orders on the same side of the market have an identical price limit. This is where the secondary priority rule or time priority kicks in. That is, on both sides of the market in case of orders with an identical price limit, the earlier the receipt of the order, the greater is the priority accorded. In certain markets, order size or quantity specified is also used as an order ranking criterion. However in India this is not the practice.

While placing an order it is imperative to correctly and comprehensively identify the security. For equities it is fairly simple in most cases because the majority of companies will issue one category of shares. Thus, merely specifying the company name is adequate. There could be exceptions. For instance Tata Motors has two types of equity issues, ordinary shares and DVR shares.

The latter have differential voting rights and hence the name. While placing a futures order, in addition to the name of the company, the expiration month also needs to be specified. For instance, a trader may place an order for February 2018 contracts written on Tata Steel. An order to trade an options contract requires additional details to be specified. In addition to the underlying asset and the month of expiration, the trader needs to specify the exercise price, and whether he wants a call or a put option. For instance a trader may place a buy order for call options on Tata Steel expiring in February 2018 with an exercise price of Rs 600.

Sunil K Parameswaran is visiting faculty at various business schools including IIMs

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