Optimal Limit Order Choice

Abstract

We describe a method for investors to optimally choose whether to place a market or a limit order, and at what price to place a limit order. We base our analysis on a risk averse investor's expected utility maximization, and allow for a continuum of investor information, risk aversion, and security characteristics. We show that the choice of optimal market or limit order can be analyzed in a mean-variance framework and combined with the entire portfolio rebalancing problem. Using NYSE trade order and quote (TORQ) data from 1990, we demonstrate how investors could empirically evaluate limit order trading strategies. We estimate the parameters in our theoretical model and use them to find optimal limit order discounts under a variety of scenarios. We find some evidence that investors' order placement strategies are consistent with our theories.

The algorithms described herein are patented under US Patent No. 6,493,682.

Keywords: limit orders, microstructure, portfolio trading

JEL Classification: D4