Limit Order Discipline
The Smart Profits Report: Issue #285
Wednesday, February 22, 2006
Limit Order Discipline & Two Other Simple Rules For Making Money In Options
By Karim Rahemtulla
Chairman, Mt. Vernon Research
Recently, I have taken to reminding my trading service (LEAPS Option Trader) members about using limit orders for all of their trading. Here’s why: The options market is not nearly as liquid as the stock market. Options also trade in $0.05 increments under $3 and $0.10 increments above $3.
Options quotes are presented by several exchanges and the market makers at each exchange are supposed to make orderly markets in all the options listed. But, like small-cap stocks versus big-cap stocks, supply is only one side of the equation.
If demand is not there, the options market makers will have a field day. Sometimes, even with demand apparent, the market makers can ruin a nice profit or exacerbate a loss.
There are several things you can do to ensure that the price at which you are buying or selling is not exaggerated by the third parties. Let’s take a look…
Discipline Keeps the Market Makers In Check
1. Use limit orders. The first thing you must always do is to use limit orders, buying at or below the offer price. It’s normal human emotion to act quickly on an exciting idea. But most often, this will cost you more.
Understand that options are similar to stocks in one aspect: They are driven in the very short-term by supply and demand. Buying will cause the price to go up and selling will cause prices to go down. It sounds elementary, and it is. But, in practice, investors will still ignore this fact.
Aside from the above-mentioned characteristic common to stocks and options, everything else about options trading is different. Options lose value everyday regardless of the underlying share price. This is because of the time component of options. As decaying assets - options have an expiry date - each day that goes by, the option will lose value slightly as there is less time theoretically for the underlying shares to move in your direction.
Sometimes that decay will seem minimal or masked by upward moves in the share price, but believe me, decay is a fact of options investing. So, if you are hot for a trade, waiting a few days before buying may provide you with a lower entry point.
2. Get quotes from every exchange. The second thing you can do to ensure you’re getting the best deal, besides using limit orders, is to check the prices on all exchanges. This is really the first thing you should do. Exchanges are competitive and they will post prices that are similar, but not the same. Each market maker is driven by his/her own profit targets. Some may be happy with a couple of pennies, others may want more.
I have seen options trades go by in penny increments, even though the prices are quoted in 5-cent or 10-cent increments. You cannot put in an order in penny increments, but you can get filled below the offer or above the bid depending on how much the market maker wants your options, or wants to sell you his options.
Regardless, check each exchange for both price and volume. In my experience, the best execution comes from the International Securities Exchange. If you have the ability, you can also ask your broker to direct your trade to a particular exchange. In no event should you EVER use market orders for options. If you do, you are saying that you want to get filled at any price and are now subject to the whims of the market at that specific time. Limit orders will allow you to get the prices you want.
3. Practice patience. Finally, if you do not get filled, wait. Don’t chase the price. Invariably, in my experience I get filled at my price if I am willing to wait. At the time you put in your limit order, if it’s below the market, the market maker will rarely come to you. But, give him some time. If the shares are trading in a tight range, more often than not, I have found that I will get filled at my limit.
This is especially important when you consider that each nickel or dime difference in the price you pay or receive can amount to a gain of 10% or more because of the low prices of options.
In sum: Do not chase options, use limit orders, take your time, and understand that the guy on the other side is trying to make money off you. Treat options trading like any other shopping that you might do. Look for the best value, and if necessary, be willing to walk away and come back later.
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Today’s Smart Profits Cribsheet
- While we’re on the “best-prices” topic, be sure to check out Steve McDonald’s The Options Bid - The Bid, the Bid, Always the Bid in Smart Profits #279. Steve gives us the lowdown on watching the options bid prices and strategic disciplines, like using limit orders, that can increase your returns.
- You might also want to see his secret to picking option strike prices that have greater chances of making you money and turning your trading statements from deep red to shiny black in Smart Profits #276, Strike Prices - Increase Your Odds by 99%.
- Also, revisit Lee Lowell’s recent advice in his Option Chains - How To Pick Your Ideal Option if You’re Bullish on a Stock, Smart Profits #283, where he reviews how to use option chains in order to assess risk and make educated decisions in options trading.
Good Trading,
Karim
Related Articles:
- How to Limit Your “Excitement” for Winning Trades
- Liquidity & Limit Orders - An Options Balancing Act
- Getting Paid to Place Limit Orders On Your Favorite Stock
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