Using Limit vs. Market Orders

Improve Option Trading Efficiency

Order Types
Market order vs. limit order. Public Domain

As a new option trader, you may believe that your only objective is earning a profit. It may surprise you to learn that option trading is not always about profits because options can be used to hedge (reduce the risk of owning) an already existing investment.

It must be obvious that one of the ways to generate a profit is to buy your options at the best (lowest) possible price, and to sell your options (and other assets, such as stock) at the best (highest) possible price.

Even though this basic trading concept is obvious to all traders, much of the time an inexperienced trader is so anxious to make a trade that he/she enters the wrong type of order (a market order) through his/her broker. 

Exchange Trading

Every exchange has members — regardless of the specific asset being traded — who "make markets." In other words, those members always publish a "bid price" and an "ask price." The combination of those two prices is known as "the market" and represents prices at which you can immediately buy or sell options, stocks, commodities etc. Please remember that those prices are established to allow the people who publish those prices to buy or sell the options at an attractive price.

The bid is the price that members (called market makers) are willing to pay for the asset that you sell. Simultaneously, the "ask price," is the price that you are requested to pay when buying an asset.

When you enter a "market order," you are virtually certain to pay the ask price when buying options and to sell the bid price when selling options. Too many new traders believe that they are required to trade at those prices. However, that is a myth. Instead of entering a market order, I suggest that you always enter a "limit order" instead.

 

When you shop at a retail store (as we all do), the price is not negotiable. It is the ask price and you are forced to pay that price if you want to buy the specific item at that time. Sometimes it pays to wait because the store may provide a discounted price (i.e. put the item on sale) in the near future. 

Note that options may be thought of as going on sale when implied volatility declines. 

Market Order

A market order is no better than a request that some random trader (the person on the other side of your trade) take some of your money — without so much as a 'thank you." Why is that true? Because a market order is one that must be filled as quickly as possible. No negotiation takes place. With computers running the trading world, the only way to get an immediate execution of your order is for the system to match your buy order with an existing offer to sell the specific option (or any other asset) that you want to buy. Sure, the system finds the lowest published price that is available, but that price is going to be the ask price that you saw when entering the order.

For those of you who remember that trading was not always done via computers: Some years ago, your order was represented by a real person who entered the trading pit, announced the option he/she wanted to buy, and was greeted with a bunch of verbal bids and offers.

The broker than would counter the offers with a slightly lower price — giving the pit traders the opportunity to sell at that price. If no one made the sale, the broker then filled the market order by paying the ask price. NOTE: The broker did not take much time doing this because the order was a market order — and that did not give the broker the authority to take much time in negotiating for a better price. But, at least there was a chance for a better fill. That is no longer the case when the order is executed via computers.

Your order is executed quickly. However, it is possible for the market to change just as you click to send in the order. In other words, the fill may occur at a slightly lower price than anticipated when buying, and it is equally possible that you pay a bit more than expected.

This is how the system works and no one is cheating the customer. Market orders are filled at the best possible available ask price — when the order hits the marketplace — and that ask price changes from time to time. 

You may ask, what is wrong with that? Isn't the ask price the lowest price at which the option can be bought, as the instant that the order arrives in the marketplace? The answer is that there is plenty wrong with that because the bid/ask quote that you see on your computer screen is known as the published bid/ask price. It is also referred to as the outside market. And that published market is frequently quite different from the true market.

Unless the bid/ask quote is very tight (i.e., $0.01 or $0.02 wide), there is almost always someone who is willing to sell options at a price that is lower than the advertised asking price. And that price represents the true asking price. If you wonder why that seller does not advertise his/her intentions, there are two good reasons:

  • Too many people enter market orders and pay the higher price. If the market maker can get a higher price simply by not disclosing his/her true selling price, why wouldn't he/she bother to advertise? There is nothing unethical about asking for a higher price when willing to accept a lower price. This occurs all the time in flea markets, small retail stores, and in outdoor markets around the world. Bargaining is expected, and you can do the very same thing — by using a limit order — when trading.
  • If one seller announces a willingness to sell at a lower price, that works well when that person is the only seller. However, too often that seller will be joined by others who are also willing to trade at the reduced price — making it far more competitive. The seller has a better chance to wait until his/her computer sees a bid price that he is willing to hit, and then hitting the sell button.

Note that the wider the bid ask spread (i.e., instead of .31 bid// .33 ask, the market is .29 bid//.35 ask) the greater the chances that you can sell above the bid and buy below the ask.

The only time that it is appropriate to enter a market order occurs when it is essential that you make the trade immediately. And there is almost never any good reason to do that.

Limit Order

A limit order is one that establishes a maximum purchase price or minimum selling price. Instead of your order being filled at the best available price, your order is filled if and only if it can be filled at your limit price, or better. 

Let's see how this works. Let's say that you want to buy some XYZ Dec 16, 2016, ​50 calls. NOTE: This call option gives its owner the right to buy 100 shares of the underlying asset (XYZ stock) at the strike price ($50 per share) at any time before the options expire (shortly after the close of trading on Dec 16, 2016.)

The market is $1.00 bid and $1.20 ask.

  • If you enter a market order, you will buy your calls at $1.20 ($120 per contract) each.
  • If you enter a limit order with a limit price of $1.20, you will buy the calls at $1.20. NOTE: IF willing to pay $1.20, it is better to enter a limit order of $1.20 rather than a market order — just in case the $1.20 ask price disappears temporarily for a few seconds and is replaced with a higher offer. The $1.20 limit price prevents your getting caught in that type of trap.
  • If you enter an order with a limit price of $1.15, you may not buy the calls. However, if you do buy them, the price will be $1.15 or less.
  • If your $1.15 bid is not filled quickly, there is nothing wrong with changing the bid to $1.20. but, by entering a limit order at a lower price you give yourself the chance to save some money on the trade. In my opinion, when the market is $1.00 to $1.20, there is a very good chance that one of the market makers will be willing to sell the calls at $1.15. This is not always going to be true, but you have nothing to lose in trying to buy cheaper (or sell higher). The cash saved is probably more than enough to pay your broker's commission.

Keep in mind that this idea will prove beneficial often enough that every trader should adopt this idea. Remember, if you decide that (using the above example) $1.15 is all you want to pay, then enter the order and do not raise your bid.

If you are willing to pay $1.20, and if the bid/ask spread is more than 5-cents wide, it pays to try to get your order filled at a better price. In the example, you could begin with a bid of $1.10, hoping for the best. Then, after 15 seconds, I suggest raising the bid to $1.15. After another minute or so, you have a choice. If you need this trade because of an existing position, then by all means bid that $1.20. Don't be stubborn when the trade is required to hedge some existing portfolio risk. But if this is a new position, you will have to decide between being stubborn and paying a price that you are truly willing to pay.

The point of this discussion is that it is foolish to enter market orders when trading options. This is especially true when the options are in their opening rotation at the start of the trading day — because buy and sell orders are filled haphazardly when the markets are busy. In earlier times there was a "one-price" opening where all orders were filled at the same price during the opening rotation. However, that is one more innovative trading idea that disappeared when computers replaced live traders.