Limit versus Market orders: Rookie Mistake #1

Published on: Feb 11 2013 by John Critchley

 

Today’s Topic:  The use of Limit orders versus Market orders in Options.

This is by far one of the biggest mistakes new option traders make when they are first start trading options.  We have addressed this issue many times in our Options Boot Camp Podcast. Check it out here:  http://www.sogotrade.com/s1/Education/htm-en-us/podcast/sogopodcast.html

Remember, the option marketplace is different from the equity marketplace. When you view an options chain, you may see options trading in penny or nickel increments, but remember that option contracts are standardized for 100 shares. You may see the bid and the ask has only a difference of .05 to .25, but the 100 shares leverage means the bid/ask spread is much wider than on first glance.

If the options you are trading have low liquidity, it can have a very wide bid/ask spread.   This lack of liquidity means it’s very important to get the best fills you can.

The best method to use as a new option trader is to trade limit orders. If you need to get a filled right away, simply put a limit buy at the ask or a limit sell at the bid. This way you will get filled at what effectively is the market, but it won’t allow for any fills dramatically away from the ‘fair’ market price.

If you like a trade but are in no rush to get filled, then simply put a limit order at the mid price or bid/ask average.  This is the halfway point between the bid/ask spread.

There are times in which market orders are completely justified. If a market is very liquid like the $SPY or $QQQQ, then it may make sense to use market orders. Also, if a market is moving quickly and your position is getting out of control, it may make sense to liquidate immediately to avoid further losses.

The bid/ask spread on an underlying instrument option can differ from a few pennies to a many dollars in today’s marketplace. In general, these spreads are tighter than in the past due to the proliferation of exchanges and competition for customer option order flow.  This is great news for the retail customer.  Let’s take advantage of these circumstances and not whittle away money through the unnecessary use of market orders.

It’s important to remember that you don’t always have to pay the offer or sell the bid when you trade options. Especially when the spread between the bid/ask is wide, you can quite often successfully “work” a limit order that is much closer to the option’s true value.

What is an options true value?  Simple: take the mid-price between the bid & ask as the “fair value” for the option.

Basic Example:

Market is  $4.00 Bid   – $ 4.50 Ask

In this example, the fair value is$ 4.25, if you pay the ask or sell the bid, you’re giving up about 5.5% “edge” on both sides of the trade to the market makers. For any retail options customer, it is always best to narrow the spreads as much as possible.

Let me share a little secret:  In today’s option marketplace with so much competition for option volume, with strikes in ½ dollar intervals and prices in penny increments, you are  more likely than not to get filled on a limit order below the ask or above the bid.

I want to make sure there is no misunderstanding of what I am saying:

If you need to close a position immediately then the use of market order may be appropriate.  If not, then try using limit orders.  You may save yourself some money.

 

Trade smart…..

 

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One Comment to “Limit versus Market orders: Rookie Mistake #1”

  1. John Critchley says:

    Please feel free to discuss. use what type of order is in your comfort zone, but remember a market order can be filled at a price away from the market at the opening.

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