An Integrated Model of Market and Limit Orders
Craig W. Holden
Indiana University - Kelley School of Business - Department of Finance
We develop an integrated model in which a risk neutral informed trader optimally chooses any combination of: a market buy (MB), a market sell (MS), a limit but (LB) including the optimal limit buy price, and limit sell (LS) including the optimal limit sell price. With minimal distributional assumptions, we are able to characterize the informed trader's optimal strategy. We find that the informed trader sometimes chooses to submit market orders when the terminal value is inside the bid-ask spread. We also show that there is a mutually beneficial interaction between opposite order types. For example any time the terminal value is above the bid, a combined MB-LS is more profitable than a MB only. The limit order may trade against the market order, but this interaction eliminates some or all of the states in which the market order would have experienced a loss. Adding specific distributional assumptions, we obtain an analytic solution and explore the comparative statics of the informed trader's limit price strategy.
JEL Classification: D40, D82, G12, G14
Date posted: January 12, 1995
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