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Limit Order Diligence
The Smart Profits Report: Issue #258
Thursday, November 10, 2005
Limit Order Diligence - How to Limit Your “Excitement” for Winning Trades
By Karim Rahemtulla
Chairman, Mt. Vernon Research
Whenever I issue an alert for my options trading services, I expect my readers to get excited. After all, if I’m not excited about a pick, I won’t write about it.
So, what makes me excited? A great market position for a company… an excellent price… a healthy profit target… and a chance to use limit orders.
But one of the most important factors is liquidity: “Can we get in and out with reasonable ease at the prices we want?”
If the answer is no, then I will not issue a pick, no matter how attractive. It makes absolutely no sense to “push” or influence the price of an option or stock, because at that point, the trades are artificial.
Today, I want to show you why it’s important to get the right price on every trade.
Three Reasons to Use a Limit Order
Regardless of the option, any short-term buying will have some influence on its price. If the market for a certain option has been inactive, any amount of activity will cause the price to move. But because there are six active options exchanges, not all of them list every option. So, there must be at least four exchanges that trade the option before I issue an alert. Further, each exchange posts the quantities available for buying and selling at various prices. If this “size” is not substantial, then it will not pass muster.
Finally, realizing that short-term buying will cause some movement, I allow a nickel or a dime either way when I make a recommendation. That is enough. Yet, there are still people who insist on paying more than the limit orders, and place market orders. How do I know? Because I watch the prices, and there are always trades beyond the limit price. This means that someone is too eager, too excited to wait to get into a play.
And here’s why trading this way can lose you money…
First, when I choose an option, I test its price against the options pricing model that I use. This model is pretty accurate at determining what the option “should be” trading for. If there is a big difference, I will wait before putting out the alert… or not put it out at all. The options market makers use similar models to determine prices, but they must also account for supply and demand - which is why I will allow some leeway.
Second, options are a decaying asset. If you do not understand this, you should not be trading them. Every day, an option loses some time value. This means that in the absence of any underlying movement in the price of a share, the option will lose value slightly each day.
Third, I can count on one hand the number of times the price of an option that I recommended went straight up or down (depending on whether I went long or short) and NEVER looked back. Stocks trade up and down, and so do options. When a stock goes up, an option will usually follow. The same is true on the way down.
Don’t Be An Eager Beaver
Your job is to be patient and to get filled at or below your limit order’s price. If you are patient, this will usually happen within a few days. I have seen this hundreds of times. What you should NEVER do is place a market order, unless you just want it in the worst way, or want to get rid of it in the worst way.
Instead, what you should always do is place a limit order and monitor it carefully. If the shares move lower, and the options do not follow, then REMOVE the order and wait until the option falls. If you leave a limit order in “good ’til cancel” status, the market maker will actually fill you at your price, and if the shares are falling, drop the price right after you are filled. He knows that the price of an option should change depending on the price of the shares - so should you.
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Today’s Smart Profits Cribsheet
- For more on getting the best deal on your options orders, see Smart Profits #212: Beating the Market Makers on Price. And speaking of price, check out Smart Profits #186: A Free Tool for Finding the Best Options Bargains.
- Lee Lowell, our Commodities Options Specialist, shows you how to get paid to wait for the stocks on your buy list to come down in price - Smart Profits #184, Getting Paid to Place Limit Orders On Your Favorite Stock.
- Check out the Smart Profits Glossary for up to date definitions on terminology found in this article like “limit order” or “decaying asset.”
Good trading,
Karim
Related Articles:
- Liquidity & Limit Orders - An Options Balancing Act
- Limit Order vs. Naked Puts - Getting Paid to Place Them on Your Favorite Stock
- How the Market Makers Lose: Uneven Trades and Open Positions
