The Limit Order Effect
Understanding the Behavior of Uninformed Investors
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Previous research on investor behavior and performance suggests that individual investors consistently make mistakes and lose money with their investment strategies, leading to a curious form of market inefficiency. New research offers an alternative explanation by studying the use of limit orders.
According to previous research, individual investors are very sensitive to market news and short-term returns; they tend to sell when share prices rise and buy when share prices fall. In addition, they trade against earnings surprises, selling shares of companies that release better than expected earnings news. In all these trades, investors lose money. The fact that investors systematically lose money contradicts theories of market efficiency.
In the study “The Limit Order Effect,” assistant professor of finance Juhani Linnainmaa analyzed how the use of limit orders alters previous assumptions about investor behavior.
When individuals want to buy shares of stock, they can use market orders or limit orders. A market order offers the benefit of immediate purchase, though the investor is likely to pay a higher price. If investors want to use a limit order, they will set a cap on the highest price they are willing to pay for a share as well as indicating when the limit order will expire. In order for limit orders to execute, the market price must fall to the limit order price.
“If you aren’t willing to pay the current market price for a stock, you submit a limit order and wait until someone is willing to sell,” said Linnainmaa. “Because prices are constantly changing, a limit order may get executed in five minutes, an hour, a day, a month, or not at all.”
As Linnainmaa explained, there may be individual investors who can afford to wait for a better price and opt to use limit orders. If a company announces unexpected news, other investors who monitor the market closely may submit market orders to take advantage of the now-stale limit orders (a limit order becomes stale when there is news about the company). The stale limit orders then execute. It will look as if limit order traders reacted to the news by trading in the wrong direction and losing money, with many individuals simultaneously making the same mistake. This can lead to false inferences about investors’ stock picking skills and timing.
A study that does not account for limit order investors’ passive reactions to news runs the risk of confusing the cause and effect of investor behavior. Linnainmaa calls this bias “the limit order effect.”
“The limit order effect suggests that many findings about investor behavior, including poor performance, can be explained as side effects of using limit orders,” says Linnainmaa.
Linnainmaa combined individual investors’ trading records with limit order data to examine the importance of the limit order effect. He found that stale limit orders significantly alter inferences about investor behavior. The limit order effect may be a simple, yet powerful, explanation for many findings about individual investors’ behavior and performance.
If investors use limit orders, they lose money when their limit orders get executed in response to news in the market,” says Linnainmaa. “In any trade that takes place, informed investors will win. However, uninformed investors don’t lose because they misinterpret information or because their behavioral biases generate systematically bad trades; they lose because they are uninformed.”
However, Linnainmaa noted, there is an upside to using limit orders.
“It should be kept in mind that individuals may still be doing the right thing by using limit orders,” said Linnainmaa. “If you use a market order, your immediate loss might be greater than what you would expect to lose to the informed investors if you submitted a limit order instead.”
The use of limit orders can lead to false conclusions about the performance of individual investors. It is the limit order traders who appear to possess poor stock-picking skills and who seem to misinterpret new information.
Widespread Use of Limit Orders
To study the limit order effect, Linnainmaa used data from the Helsinki Exchanges (HEX) from September 1998 to October 2001. Investor trading records were taken from all publicly traded Finnish stocks from the Finnish Central Securities Depository registry. Limit order data was obtained from the supervisory files of the exchange. Using these two data sets, it was possible to determine whether an investor used a market order or a limit order in 60 percent of all transactions.
Linnainmaa’s findings are not specific to the Finnish market. Data from the United States also indicates the widespread use of limit orders. Using data from a U.S. discount broker, Linnainmaa found that nearly three-quarters of the orders submitted by individual investors in the United States are limit orders. The magnitude of these numbers suggests that limit orders are likely to alter inferences about investor behavior in the United States.
Linnainmaa found that limit orders significantly contribute to irregularities in investor behavior. Traders with stale, unmonitored limit orders appear to possess poor stock picking skills and seem to misinterpret new information. In contrast, market order traders earn positive returns when reacting to new information.
Earnings announcements provide a trading opportunity for investors who closely monitor the market. If an investor reacts to new information before competitors, he or she can profit from all the limit orders between the current and post-announcement valuations. An earnings announcement renders all pre-announcement limit orders stale. If individuals have limit orders pending when the earnings announcement arrives, only the orders going “against” the news will execute.
Linnainmaa used data on earnings announcements released during regular trading hours to determine whether stale limit orders contributed to misinterpreting new information. He computed average trading gains for all executed orders around each announcement and found that the use of limit orders entirely explained the tendency to trade against firms’ earnings announcements.
Stale limit orders triggered after announcements performed very poorly and lost money. Individual investors who submitted market orders immediately after announcements, however, earned superior returns. These results contradict the perception that individuals always misinterpret new information. Individuals who make active decisions and submit market orders are interpreting new information accurately.
“A stale limit order does not reflect current market information,” said Linnainmaa. “Ideally, investors should withdraw limit orders as soon as there are changes in the market, but they rarely do. The problem is that individual investors don’t have the resources to constantly monitor the market, which places them at a disadvantage relative to institutional investors.”
Previous research also has suggested that individual investors consistently tilt their portfolios toward future losers and away from future winners, which suggests poor stock-picking skills. The stocks individual investors sell outperform the stocks they purchase. Linnainmaa found the subsequent performance of a trade depends on whether the individual used a market order or a limit order.
Individuals displayed poor stock-picking skills only when others traded against their limit orders. Market order traders did not exhibit systematically poor timing. Hence, individual investors do not lose money because they actively sell stocks that go up in value and sell stocks that subsequently fall. It is their passive behavior that generates the losses. Someone with better information can tell which limit order traders are offering to sell the stock at too low a price—or bidding too much for it—and takes advantage of these uninformed investors who find themselves on the wrong side of the market when that information is publicly revealed.
How does limit order use affect inferences about individual investors’ behavior? To address this question, Linnainmaa studied several behavioral patterns. For example, the tendency for investors to sell stocks with capital gains rather than capital losses from their portfolios is referred to as “the disposition effect.”
Linnainmaa found that limit orders significantly contribute to inferences about the disposition effect, with almost half the estimated disposition effect explained by limit orders.
Linnainmaa also studied how past stock returns affect investors’ buying and selling decisions. Previous research has suggested that investors follow “contrarian trading strategies.” Limit orders are always contrarian, since they execute only when the stock price moves against the order: A limit order to sell executes when the price goes up, while a limit order to buy executes when the price declines.
Linnainmaa found that limit orders account for all of the short-term contrarian behavior and one-quarter of long-term contrarian behavior. The lesson is that individual investors are not necessarily “swimming against the current” because their behavioral biases tell them to do so; their decision to trade against past returns is a consequence of their limit order use.
Support for Market Efficiency
“Finding that investors lose money because they are uninformed, and not because they systematically make bad decisions, is actually good news for those who believe in market efficiency,” said Linnainmaa. “Underperformance is a result of individual investors’ passive strategies—they lose money when new information arrives because they often can’t withdraw their limit orders in time. In the long run, limit order traders lose because investors with more precise information trade against them. Individual investors don’t have negative stock-picking skills, they lose because they are uninformed.”
Linnainmaa also urged a degree of caution for investors. “When choosing whether to use a limit order, investors need to consider whether they think the order will execute because an impatient investor is willing to pay that price, or if the limit order price is set so far below the market price that it can only execute if there is news. If I set the price too low, I can only lose. Either the stock goes up and my order doesn’t execute, or the order executes because my limit order gets stale and someone takes advantage of it. Either way, I would just regret the order, so it would be better to set a higher price.”