Throughout Optionetics course manuals, articles and seminars, the need to manage risk is emphasized repeatedly. Yet with all of the repetition it's unlikely that the point is overstatedâmanaging risk is a critical component of longevity in the business. A key way to manage risk is to know the maximum loss acceptable for any position prior to establishing it, as well as the method used to exit the trade.
The order platforms and trading screens available today provide a variety of approaches to exit an option position. In addition to direct order placement for the specific option(s), the trader can also place contingent orders based upon the movement of the underlying security. Starting with basics this month, the March and April Hotline Help articles are intended to help you navigate some of these alternatives.
Option Order TypesâBasic Orders
Market & Limit Orders: When deciding which type of order to place a good thing to remember is that a Market Order will guarantee execution, but not the price of that execution. On the other hand, a Limit Order will guarantee price, but not an execution. Optionetics in general recommends using a Limit Order particularly for trade entry so you only establish positions that are within your trading allocations. However, if you need to guarantee an exit only a Market Order will accomplish that for you.
Fast Markets: Execution quality has improved considerably over the last decade, but there are some things a new trader could encounter that might throw a wrench in their trading. The first is "Fast Markets". A security can be deemed in a Fast Market when a very large volume of orders is flowing to the market for that security, volume is high and quotes & execution reports are delayed. Although technology has reduced the number of securities placed in Fast Markets by the exchange, traders must be aware that standard rules for execution are waived at this time.
An individual who places a market order to establish a new position may end up with an execution minutes after the order is placed when the price is significantly different. The resulting cost of the trade may be much more than the amount anticipated. In the event the individual has an existing position and must exit it, the market order may still be the best option, regardless of current conditions. While such an execution may result in a trade that exceeds the individual's risks, it is still better than risking even more money by holding onto a position that is moving against you.
Trader Driven Conditions: In addition to market conditions that affect the timing of order execution, the trader needs to consider other things that can impact the amount of time that passes between obtaining a quote and obtaining an order execution. The system in which the individual is using may be slow or too much time may be taken placing the order. Given the amount of bandwidth trading platforms use, a slow computer or slow connection could put you seconds behind live quotes. Simple human error on the trader's part could also impact actual execution prices versus those expected.
Using a market order to establish a position under such trader-driven conditions leaves the individual open to executions that exceed their intended trade value. An alternative order type many traders use to address this problem is a Limit Order that is Marketable. This means a limit order is placed above the asking price when buying or below the bid price when selling so that it is treated as a market order on the exchanges. If you place a limit order to buy option XYZ at $2.90 and the valid current ask is $2.80, rules dictate you should receive a fill at the $2.80 level.
Booked Order: In the past, the presence of six non-linked option exchanges resulted in best bids or best offers that represented orders that entered the market between the existing spread. Assume the current market for a security is bid at $1.25 and offer/ask at $1.35. If a new limit order to buy 5 contracts at $1.30 arrives at the Amex, the specialist could place this order in the "Order Book" making the new best bid reflected in the markets at $1.30. Prior to linkage, the only way to access this bid was by having a sell order routed to the Amex where the Order Book held the order to buy at $1.30. Once linkage evolved, any exchange had the ability to forward an order to the exchange where such best bid or offer contracts were booked; however executions were not guaranteed.
The negative impact of booked orders for retail traders has been reduced by both better access to quotes from different exchanges and the trader's ability to route orders to specific exchanges. Linkage and higher trading volume also minimize the impact of booked orders on trade executions, but currently they do remain a part of the options trading world.
Triggers for Option Stop Orders
There are two types of option stop orders, the plain stop order and the stop limit order. In each case a stop level for the security is identified and the order is triggered when a trade occurs at that level (equities, options) or the current market quote reaches the stop price (options). The first type of stop triggers a market order while the second triggers a limit order.
Option Distinction: Since option volume for a specific contract is much less then that of its underlying security, the option trader needs to pay more attention to the second trigger parameter: the quote trigger. It was my understanding that equities can also be triggered by the quote, but I came up short when trying to research the topic. I was only able to confirm the option quote distinction on the NYSE web site. The information provided in this section represents my knowledge of the topic up through 2003âcheck with your broker for clarification, but as far as I know the rules haven't changed.
A sell stop order is placed below the current market and is generally entered to protect the downside for an existing position. The stop price is identified and this level triggers a market order. If you're concerned about proper order entry when using the internet, have your broker on the line the first time or two you are placing such an order.
There are two ways the stop is triggered; via a trade execution in the market or through the current quote for the security. A sell stop order is triggered when the security trades at or below your stop price or if the ask reaches your stop. A buy stop order is triggered when the security trades at or above your stop or the bid reaches your stop. Since you sell on the bid and buy on the ask, option traders need to account for the bid-ask spread when determining their stop level. As a quick example, assume XYZ is an option with the following quote:
Bid: 1.40 x Ask 1.45
If you have a sell stop order in place at a level of 1.45, the current ask triggers this order and it is executed as a market order. In normal markets you should receive an execution at $1.45. This may be $0.05 less than you anticipated. An option trader needs to account for the quote spread since it's very common for the stop order to be triggered by the quote rather than a trade execution.
Equity Stop: In contrast, equity sell stops can also be triggered by the quote, in this case the bid not the offer (check with your brokerâI could not locate this distinction on the NYSE site). Assume ABC is a stock with the following quote:
Bid: 1.40 x Ask 1.45
A sell stop order at a level of $1.45 will not be triggered until ABC trades at or below 1.45 or the bid drops down to $1.45. If the latter happens, the stop triggers a market order which should be filled at $1.45 under normal conditions. Again, the greater volume associated with equities results in many stops triggered by actual trades rather than the quote.
Stop Limit Order: A stop limit order requires the trader to enter both a stop level and a limit level. Although this may seem a good way to address the spread issue, it may prevent the trader from exiting a position that is going against them. In the case of a sell order, execution relies on the option dropping, but staying within a certain level once it drops. That's an awful lot to expect from the markets. One scenario in which such an approach makes sense is if you are trading one or two contracts and the commission will exceed the price obtained if executed.
Rather than providing straight definitions, I hope this article provides some understanding of what you will experience in actual trading. There are times when different types of orders are appropriate, but the bottom line is that the trader needs to really understand the implications for any order they place. As mentioned previously, your broker should welcome a call to obtain clarification needed whether it's regarding exchange rules or proper order entry when using their trade platforms.
To see the previous articles in this series, please click here.
Clare White, CMT
Contributing Writer and Options Strategist
Optionetics.com ~ Your Options Education Site