In this article, we discuss the general order types that traders can implement for their option trades. This article will cover:
- Market orders
- Limit orders
- Stop loss orders
- Stop loss market orders
- Stop loss limit orders
A market order is an order that allows a trader to buy or sell an options contract at the current market price. Your orders are filled instantly because you accept the prices that the market quotes you. If you are an options buyer, your market order is filled at the ask price. If you are an options seller, your market order is filled at the bid price.
A market order should only be used when you urgently need to make a trade. When the underlying security makes a quick move, you may want to use a market order to fill the trade as quickly as possible.
An example of a market order is when you tell your broker “Buy 100 shares of microsoft”. Since it is a market order, you accept the price at which the order is filled. If the price of the security is volatile, you may be filled at a very high price.
As such, the disadvantage to using the market order is paying a high price for the option.The market makers will want to earn the maximum from a bid-ask spread of an options contract. This is especially so if the options contract is thinly traded. Very often, if you can wait, you can place a limit order and wait for your trade to be filled. Key in that order and wait for the market makers to accept “your price”.
A limit order sets a price that the trader is willing to buy or sell at. Hence, in a limit order, a trader has more control over the price that he buys or sells. After all, a trader would want to buy at the lowest price possible and sell at the highest price possible.
A trader is initiating a short position on an options contract places a limit order of $1. He is actually telling the market that he will only accept that order if he manages to get a price of $1 or more.
When a trader is initiating a long position places a limit order of $1, he is telling the market to accept that order only if the trade can be filled at $1 or less.
The disadvantage to having a limit order is that the order may not be filled. In a situation where you are day trading and can be in and out of a trade in minutes, in anticipation of a major price move of the underlying security, a limit order may not be as useful because it may not be filled.
Stop Loss Order
A stop loss order is an order that is executed to help the trade limit his losses. When the underlying security price moves against a trader, a stop loss order is executed immediately, thereby closing his positions and limiting his losses. The stop loss order will only be executed when the underlying security reaches a price specified by the trader.
Let us examine an example here.
Trader A initiates a long position on a ABC January call options contract with a strike price of $10. He bought the options contract at a price of $2. He then places a stop loss order at $1.50. In the event that the market price of the underlying security turns against him, the stop loss order would be filled at $1.50. The stop loss is a conditional order. It will only be filled at a specific price stated by the trader.
There are two types of stop loss orders. You have stop loss market orders and you have stop loss limit orders.
Stop loss market orders
Stop loss market orders are also known as stop market orders or stop orders. A stop order is only executed if a specified price is reached or breached.
A buy stop order limits the losses on a short position. A buy stop order is placed at a price above the market price at which the option was sold.
A sell stop order does the opposite. It is placed with the intention of limiting losses on a long position and it is placed at a price below the market price at which it was bought.
The disadvantage of using a stop loss market order is that the your order may not be executed at your desired price. Your order will be filled at market prices which may cause you to incur a larger loss than originally expected. In a volatile market, you can expect your stop loss market orders to be filled at undesirable prices. To avoid that, use a stop loss limit order.
Stop loss limit orders
A stop loss limit order is also known as a stop limit order. It is essentially a limit order that is placed to limit losses and is executed only when a specified price is reached or breached. The advantage of using a stop limit order is that you get your desired price or better. The disadvantage of using a stop limit order is that your order may not be executed at all when the price of the underlying security is volatile.