Options FAQ: Trade Entry & Execution

by The Options Industry Council | April 13, 2011 5:24 pm

Trade Entry & Execution Questions

Trade Entry & Execution Answers

Q: I want to set a stop-loss order on my option position. Should I use the stock price or the option price as the “trigger” to set the stop-loss order?

A: It is a matter of personal preference. Most exchanges allow stop-loss orders in options; however, most brokerage firms do not allow them for various reasons. Stop-loss orders are a way of attempting to limit your losses on an investment once that investment goes a certain amount in the “wrong” direction. Generally, most people who set stop-loss orders use the actual price of the investment (in this case the option price) for the “trigger” which decides when to liquidate a losing position. On the other hand, some people use options to execute a strategy based on technical analysis of the underlying stock. For example, an investor might feel that a certain chart pattern in a stock makes him believe that the stock is due for a rally. To “monetize” that opinion, the investor buys calls. He may then believe that if the stock instead drops to a certain price, that bullish opinion is no longer warranted, and he would not want to be “long” anymore. In this case, the investor might prefer to use the stock price as the trigger for the stop-loss order. As always, check with your broker to see if he accepts these types of orders. Once “triggered,” the stop order can be of two different types: a market order or a limit order. This is another decision for you. Again, personal preferences would rule; there is no better or worse choice.

 

Q: Where can I find information about how orders are routed on the exchanges:

A: Information about order routing can be found at the following sites:

 

Q: Is it true that when executing buy-write order(s), there needs to be two orders and that both are executed at the ASK price?

A: The short answer is an unequivocal “maybe.” It’s possible that with a multi-part order (such as a buy-write) that the options part of the trade MIGHT occur at the ask price, but there is no guarantee. When traders enter buy-writes, they are usually entered on a single ticket, for a “Net Debit.” In this case, the prices received for the call, and paid for the stock matter only in the sense that the net dollars spent should not exceed the (debit) limit. For further information regarding buy-writes, review our online Covered Calls class.

 

Q: Who sets the width between the bid-ask on the options exchanges?

A: Basically, anyone who trades does! However, there are rules on each exchange regarding the maximum width that those quotes may be. Generally speaking, the maximum bid/ask differentials are the same at the exchanges that trade options. Please be aware that there are occasions and market situations on the various trading floors that may necessitate the maximum bid ask differentials can be modified or waived.

The 6 US options exchanges that list options have rules that specify the maximum bid ask differentials in option contracts. The members of these exchanges are obligated, under normal circumstances, to honor their displayed quote for a minimum number of contracts. The number of contracts can vary, depending on the stock or index in question, but it is usually at least 10 contracts, and in many circumstances could be 20, 50 or even 250 contracts!

For example, if a stock offered 8 different strikes per month, you could say that there are 64 different contracts available (8 calls, 8 puts and four expiration months)!

You quickly realize the amount of capital these ladies and gentleman are willing to risk at any time. Then, multiply this number of strikes by 10 (most of these specialists/market makers work between 10-15 different stocks) and you can see the daunting task these traders have.

 

Q: How does open interest affect my order? Should there be a certain amount of open interest to execute the trade? If not, what is open interest telling us? I have 8,500 shares of XYZ. If I were to write 85 contracts, do I get filled at the bid or ask?

A: I doubt that open interest will have any affect on the execution of your order. Open interest is simply the number of outstanding contracts; it expands and contracts as investors and traders open and close positions. If you enter a market sell order, you will be filled at the best available bid price – if the quantity at that bid price is less than your order size, then you’ll sell the number of contracts on that bid and the balance of your order at the next-best bid price, and so on and so forth.

The impact of selling 85 call contracts will probably have a similar effect to that of selling 8,500 shares, so if you feel the market would have problems digesting that many shares then it might be appropriate to spread that quantity out over the course of the trading day. In any case, if you’re worried about the price you would receive upon entering a market order, you might consider the use of a limit order, where the limit is the lowest price you would be willing to accept.

 

Q: When I enter an order in volatile market conditions, does it make a difference what kind of order I enter?

A: During times of extreme market volatility, it is imperative for investors and their brokers to fully understand the risks of entering market orders. A market order is more time sensitive than price sensitive. If one enters an order “at the market”, especially a large order, there may be a chance that the market for that security will change quickly once that order is submitted to the market place. Furthermore, use extreme caution when entering market orders prior to the opening of the markets or after the markets close. As prices can change rapidly, especially in today’s market, understand the parameters of the orders you are submitting and invest accordingly.

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