Betraying Your Price
Firms are very clever in their ability to extract willingness to pay information from customers. For example, brokerage firms likely use price discrimination to maximize the number of orders on which they receive commission. They do so by allowing clients to place “limit orders.” A limit order asks the broker to buy so many shares of a stock, on behalf of the client, at no more than a particular price. Limit orders are convenient in that they allow the client to opt out of an order should a share price rise dramatically before a buy order is executed. This is especially useful if the client possesses a limited amount of tradable funds. However, limit orders can hurt the client in that they ask him to express his spot willingness to pay for shares of the stock. The broker can (and likely does) use this information to maximize the number of commissioned trades he can execute.
For example, suppose that a stock begins the day at a price of $1.01 and rises steadily throughout the day to a closing price of $1.10. A brokerage firm has 10 limit orders, each of which asks to buy one share of the stock. One order places an upper-limit of $1.01 on the purchase price. Another order places an upper-limit of $1.02. This pattern continues such that there is one order at each of the following limits: $1.01, $1.02, $1.03,…, $1.10. Suppose that trading for this stock opens at $1.01 a share, and the brokerage has an opportunity to fill one of the orders at this price (Assume that the market for this particular stock is thin or low-volume in nature.). Which order will the broker fill first? Will he choose randomly? Will he fill the first order placed? A price-discriminating broker who wishes to fill the most commissioned orders will begin with the $1.01 limit order. Such a broker will do so because he may be able to fill any of the other orders at a later time should the share price subsequently rise. However, he does not have this luxury with respect to the $1.01 limit order. If he does not execute this order in the first round of trading and the share price then goes up, the order will go unfilled. Thus, one might pay a hidden cost for the convenience of a limit order. Market orders, on the other hand, are less convenient but betray no information to the broker as to one’s spot willingness to pay for a particular share of stock.
-SS
