Last week, I introduced you to different order types for placing trades in your broker’s system, which can help you avoid getting your “face ripped off” by a market maker.
Today, I’ll demonstrate how I think you should use different order types for different situations.
Before doing that, though, it’s important to understand the way brokers provide quotes…
Whenever you look at an option on the chain, there will always be a “last” price the option traded at, along with a “bid” price and an “ask” price.
It’s generally safe to ignore the last price. That could be old data. Even if that trade happened just a few seconds ago, it reflects the past and we have to trade in the present. That’s why it’s key to focus on the bid and ask prices.
The bid will always be less than the ask — it represents the price a market maker has bid to buy the option. This is the price you can sell at with a market order.
The ask is the price a market maker is willing to sell at. That’s the price you will receive on an order to buy at the market.
A market order will usually be executed near the bid or ask, depending on if it’s a sell or buy order, respectively. Still, prices can change quickly, so it’s common to see the price on a buy order to be a few cents, or more, above the ask price. Or for a sell order to be executed a few cents below the bid price.
Despite this pitfall, market orders can still be useful.
I use market orders when the stock or ETF I’m trading has high volume. In high-volume assets like these, market orders tend to give you entries you would expect. So in general, if you want to buy an option on a stock in the S&P 500, a market order can be used.
When selling, a market order should always be considered. While you might not wind up with the best price, a market order ensures you will get out of the trade, and that is the goal when trying to close a position.
Using another order type could get you a few extra cents, but the one time it isn’t executed could cost you hundreds of dollars or much more. From a risk-reward perspective, I prefer market orders for closing positions.
Another useful order type is the limit order. This is used to avoid overpaying. For example, you could set a limit to buy just below the ask price. That would get you into the trade at a more favorable price. Another popular limit price is the midpoint of the bid and ask. These orders are often filled quickly.
When trading options on stocks with high volume, you should use limit orders to open positions.
You may have noticed I mentioned the volume of the stock rather than the volume of the option. There’s a technical reason for that, based on something called put-call parity.
That’s a story for another day, but for now, it’s important to know you can exit an option position using market orders, and enter using limit orders, as long as the underlying stock’s volume is high.
The last order type I sometimes use is the stop-limit. This is an order to buy with a stop price above the current ask price and a limit above that. This ensures the market is moving in your desired direction before entering the trade.
Stop-limit orders can be useful before the market opens. They let you place an order to participate in big moves without having to follow the market open.
Each order has pros and cons. But as we can see, each one is best suited to specific scenarios.
When trying to open a position before the open, I like stop-limit orders. During the day, a limit order or market order works well. Market orders should be used only when the difference between the bid and ask is small, just a few cents.
For selling, I like market orders for how quickly they get you out of the trade. You can use limit orders, but they need to be checked on. If it doesn’t fill quickly, it could be best to use a market order to get out of the position.
Next week, we’ll continue with this series of options fundamentals, and move on to some more advanced trading concepts.
Michael Carr, CMT, CFTe
Editor, One Trade
Chart of the Day:
Bitcoin Season Stalling?
(Click here to view larger image.)
A couple weeks back, in the latest Crypto Claptrap video with Chris, I proclaimed, “It’s Bitcoin Season!”
At the time, bitcoin was trading hands at just north of $57k. I anticipated bitcoin would essentially lead the market higher and leave most alts in the dust from then until the end of the year.
While it should come as little surprise to any experienced trader, the market didn’t do exactly what I thought it would. In fact, some altcoins have approached and even surpassed their previous highs, while bitcoin has tacked on roughly 10% and just briefly put in new highs before losing some ground.
That’s why we’re looking at the ETH/BTC ratio chart today, which plots the performance of alt-king ETH against BTC.
As you can see from the green circle at right, this ratio pair is breaking out of a monthslong downtrend. The ratio retested the breakout in the past few days, and the gains ETH has made against BTC appear to be holding.
So what does this mean for our expectations of the final leg of the crypto bull market? I have two thoughts.
One, it certainly complicates things. If bitcoin were to follow the script it has in previous bull runs, we would be seeing BTC make consistent new highs for a sustained period of time while alts lagged behind. Instead, we’re seeing a tug of war, where alts are attracting capital at a similar rate to bitcoin.
That makes it potentially harder to tell when the time to rotate from bitcoin to alts will come… if it does indeed play out that way this cycle.
But on a more positive note, this sort of combative trade action could potentially lengthen the market cycle even further. We’re currently in the longest crypto bull cycle on record, and there’s weight to the idea that the cycles are lengthening over time.
To have these slow grinds upward, spread across all crypto assets, seems healthier in my view. The less that people pile into one asset, rapidly spurring its price rise, the less likely we are to see the blow-off tops that tend to end crypto bull cycles for several years.
If and when we start seeing daily moves of $10k or more in bitcoin, while altcoins lie dormant, that will suggest this cycle will end like the others: a blow-off top in bitcoin followed by a brief but even bigger blow-off top in alts, before the bear market begins.
Managing Editor, True Options Masters