Option Limit Orders vs. Market Orders

Topic: Limit Orders vs. Market Orders on Options

Dear Options Trading FAQ:

Here is my first option question for this great option trading resource:

Up to now, I have always had my option trades executed as market orders. Is there anyway to get a price between the bid and ask? I am comfortable using limit orders when trading stocks on the NASDAQ to get a price between the bid and the ask, but with high volatility in the option markets I hesitate to use limit orders.

Any ideas? Thanks,

"Sick of the Spread"

Dear Sick of Options (I hope you feel better after reading this answer):

Like you, most professional traders use market orders. This is the only order that guarantees an execution in a fast moving market. If you are watching the market tick by tick and are sure of wanting to jump on an emerging trend, do use a market order.

The popular psychology is to avoid market orders, however. There are a few factors behind this. Some feel that a market order gives the floor a license to steal, while others don't want to pay the going price in any situation. These traders may feel secure only when placing a buy order on or below the bid.

But here is a question: When the price does go down to your limit, don't you think it'll continue lower? Oh, I see, the market will dip down for you to get in at a great price and then rocket up to that wonderful profit you envision ;) Seriously, some nervous buyers go so far as to continually lower their bids when the option starts coming their way. (In the order room, that is called "going the wrong way") Perhaps subconsciously, these traders realize that if the option goes down to your price, you really don't want it!

As for my own option trading, I now force myself to use market orders after too much frustration with unexecuted limit orders. In the old days, I , too, was uncomfortable with "paying up" for an option - especially when it starts trading at higher prices (After all I've been watching it trade for hours at the lower levels). But how many times have I missed on a limit order and watched the option fly away in price never to return? Too many to count. However I do notice an alarming correlation: When I miss with a limit, the trade would have turned out a big winner, but when I jump in with a market order, the price promptly turns around - leaving me with having paid the high option contract price of the day! Why is that?

Anyhow, folks, here is my recommendation on the matter. In a flat, ranging, lazy type of market, you may, if you wish, use buy limit orders at the bid or in between the bid and the ask. There will probably be several chances to get an execution on your options. Asking your broker to "book" an OEX or SPX option order may increase your probability of execution, by the way.

In an emerging trend market, try to use market orders if you think the breakout is for real. If it really is a legitimate move, the "higher" price you pay will seem like a bargain before long. You'll be ahead of all those who were unwilling to pay up on the initial move and be better off psychologically to withstand the inevitable pull-back. Speaking of psychology, one trick super-traders use is to commit to trends in set lots. Buy the first bunch of option contracts on the initial movement, the second on confirmation that it is a real move, and another on the retracement. If the first lot turns out bad, you'll have only committed a small portion of your wad.

Here's a tip that we like to mention to our option clients: Use an "Or Better" order. I'll devote a future letter to that subject, but here is the essence of it. An option is quoted 1 1/16 to 1 1/8 and starts to move up quickly. You don't want to use a market order (maybe you need to cap the amount of funds committed to this position) but you don't want to miss the opportunity either. So, being the savvy Options Trading FAQ reader that you are, you enter a limit order at 1 1/4 or better. That is, you'll accept a price as high as 1 1/4 but hopefully the execution will come back at a lower price. You are giving some room for a fill but at the same time limiting the maximum price possible. A good compromise when trading options.

Thanks for a stimulating question. As order entry preferences are highly personal, I expect quite a response from the readership on this subject. We'd all love to hear stories about types of orders used and why one likes them.

PS - You should really also consider the trading volume in the option. If it's a thinly traded option you should most likely consider a market order, this is because it's unlikely your order will be taken out by paper on the other side. It will only be filled if the market moves. On the other hand in the OEX, you have a good chance of being filled against paper with the market not moving at all. Then again the OEX moves around more as well, but it is the most liquid options pit in the world. Again, though if you are trying to fill as back month OEX option the trading volume will be low, and it will be unlikely your order will be filled with another customer order. So in addition to trend analysis, consider option volume analysis as well in your decision.

Good luck and trade well! Remember, an educated options trader is the best options trader. Browse these books books on trading options.

Tags: Options Trading, Options Broker, Options Order

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