Option Market vs. Limit Orders

Published on: Jun 09 2016 by John Critchley

Use options market orders at your own peril

 

By: John J. Critchley, Jr.

Senior Options Specialist/ Option Principal

My old friends on the floor of the option exchanges may not like me saying this, but one of the biggest mistakes new option traders make when they are first starting out is using market orders to execute their option trades.  Why? If you want to trade options that are lacking liquidity, it may have a very wide bid/ask spread and you may get an unexpected surprise when you receive an execution report showing an execution price away from the stated market. 

Many retail may also not know this little known fact:  If you enter an options market order pre-market, you are not guaranteed the NBBO (National Best Bid & Offer).  The market order will be routed to one of the 12 exchanges who will execute the order at a price that is up to the market maker’s discretion.   To combat this, SogoTrade does not allow market orders to be entered pre –market. However, if a customer enters a market order immediately following the opening and before all the options marketplaces have opened in the particular option, you still may encounter an unexpected fill price. Bottom Line: Be careful with option market orders.

You may think the options market is the same as the stock market, but that is certainly not the case.

The smartest method to employ to execute option orders as a new option trader is to trade limit orders. If you are trying to put on a position as quickly as possible, simply put a limit buy at the ask or a limit sell at the bid. This enables you to get filled at what basically is the market, but it won’t allow any funny business from the market makers.

If you like trade but are in no hurry to get your orders executed, an even better execution strategy is to simply put a limit order at the mid price. This is the halfway point between the bid/ask spread.

Also, low volume on either the underlying or its options can be a contributory factor in these wide bid/ask spreads. The market makers don’t want to be caught by surprise by an avalanche of electronic orders that may occur before an outsized move in the underlying, so they give themselves more maneuverability or space by making wider bid/ask spreads.

Let me throw in one disclaimer- There are times in which market orders are certainly justified. If you encounter a turbulent or fast moving market and your position is rapidly going against you, it may make sense to liquidate via market orders to avoid further losses.

To be fair, I must also point out that bid/ask spreads are narrower now than they have been in the past due to the proliferation of option exchanges, the emergence and dominance of electronic trading  traders competing for retail option order flow and the emergence of $1 and now 1/2 strikes, 0.01 price increments, etc.  However, even with all these customer friendly pricing developments in the options marketplace, the bid/ask spread on an equity or ETF option can still fluctuate from a few cents to a couple dollars.

 

Let’s look at a simple example.  The market in the CMG Jun 10 2016 427.5 calls is  $2.10- $2.60.

The theoretical fair value or bid/ask average is $2.10+$2.60/2 = $2.35   If you enter a market order to buy at $2.60 or a sell order at $2.10, you are giving up $.25 in edge or profit potential.  That makes the trade a 9.6% loser right out of the gate.  Instead, try putting a limit order at $2.35 and see if you get filled.  If you don’t after a reasonable amount of time, increase the bid or lower the offer by at least the minimum increment (in this case, $.05).   Believe me- nine out of ten times, you are much more likely in an example above to get filled on a limit price below the ask or above the bid.

 

Remember this key point:  As a retail options trader, it’s in your best interest to narrow the spreads as much as possible.  To attempt to accomplish this, try mid-market limit orders.

Conclusion: It’s important to remember that you don’t always have to pay the offer or sell the bid when you trade options. This is especially true when the spread between the bid/ask is large, you can more often than not get filled at a limit price that is much closer to the option’s true value.

Stay tuned and profitable…..

 

We are not liable for any trading decisions made by any reader. NO advice is given or implied. The information offered in  this article is for demonstration purposes ONLY and should not to be either construed as an offer or considered to be a recommendation to buy or sell any options .

Your use of this information is entirely at your own risk. It is your sole responsibility to evaluate the accuracy, completeness and usefulness of the information. You must assess the risk of any trade with a professional broker, or financial planner, and make your own independent decisions regarding any trades mentioned herein. This is not a solicitation to buy or sell any options, or to purchase or sell any credit spreads. Trading options only carries a high degree of risk, is not suitable for all traders/investors, and you may lose all of your premium money invested in the options. If you have never traded options before, we strongly recommend that you read a little background information made available by the government. Only you can determine what level of risk is appropriate for you. Also, prior to buying or selling an option, a person must receive a copy of Characteristics and Risks of Standardized Options.

Past performances DO NOT guarantee future results. Please consult with your own independent tax, business and financial advisors with respect to any trade. We will NOT be responsible for the consequences of anyone acting on this purely demonstration material.

 

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