Why We Always Have to Use Limit Orders in Options Trading
A few weeks ago, we discussed how a stop-loss order works and why they’re so important. While a stop-loss is a key piece to risk management, some investors may not prefer to have a “hard” stop-loss. That is, a stop-loss order that is placed with a broker. Others prefer to monitor the position and, if they have the discipline, use a mental stop-loss. Today though, we’re taking a closer look at the limit order. The limit order is a vital piece to investors — especially options traders.
Why do limit orders matter so much? It ensures we get our best price or better.
How does this work? When we set a limit order to buy a stock or option, it’s telling our broker that that price is the very least they can execute the trade at. In other words, do the trade for $XX or better. For instance, if we’re buying shares of ABC and use a limit order of $50, we’re telling the broker that unless he can execute the trade for $50 or better (meaning $50 or less), then he can’t execute it. In other words, we will never pay more than $50.
The opposite is true if we’re looking to sell. If we have a sell limit order of $75, the broker will not execute the trade unless he can sell the securities for $75 or more.
This may seem like a minor piece of the puzzle. And when considering how many factors go into finding the perfect trade, a limit order really is a minor piece of the puzzle. But it’s also vital. Like a spark plug in an engine, it’s not a complicated or overwhelmingly exciting component to the automobile. But without it, we wouldn’t get very far.
Limit orders are vital components to our trade setups because we can base the risk/reward around a specific price. For instance, If we buy a call option using a $1.00 limit order, with the target of it rallying to $1.20, we can calculate the 20% return. We know the return will be 20% (or better, if we get in at under $1.00) if we use the $1.00 limit order. If we use a market order and it fills us at $1.10 though, our returns are suddenly halved to 10%.
Because of the limit order, we can put together complex spreads and know exactly what we are paying for them before we enter the trade. Thus we can calculate the risk/reward before entering the trade as well. That’s counter to buying with a market order, where we find out our cost basis after the trade is executed.
Options Trading and the Limit Order
Limit orders are very important when it comes to options trading. That’s true for a few reasons, the first of which is liquidity. When liquidity is low, we can get some terribly wide spreads, meaning the bid/ask is wide. Remember, if we’re selling, our price will be closer to the bid and if we’re buying it will be closer to the ask. With market orders, we are generally filled at the bid or ask; depending on if we are buying or selling.
On tight spreads — say $2.26/$2.28 — we’re not too worried about the price. But on wide spreads — say, $2.25/$2.55 — using a market order just doesn’t work.
Why? Because if we’re looking to buy that particular option and we use a market order, the broker will execute at $2.55 — right at the ask. That leaves us long the option at $2.55, which will immediately be valued at the midpoint, or $2.40 in this case. In other words, we’re instantly sitting on a 5.8% loss simply because of our entry.
The limit order can prevent that, at least by telling the broker what we’re willing to pay. The other reason limit orders matter? Spreads. If we put in a market order on a bear put spread — simultaneously buying one put and selling a lower priced put — we will get executed for both strikes at the market price. I can’t emphasize enough how catastrophic this can be for our returns. If we give up, say $0.50 on a total spread because we used a market order, we could easily wipe out all or most of the potential gains.
When using 3- or 4-legged spreads, the importance of a limit order remains high as well.
All About Risk/Reward
When we see a stock trading with a spread of $57.88/$57.90 and we’re looking to buy, throwing out a market order may seem like a non-issue. In most cases, it likely isn’t an issue. But when it comes to options, a market order can be the difference between a good trade and a bad one.
Just a moment ago, we said using a market order can severely crimp our profit outlook for the trade. That is, when we pay the market price (and thus almost always a higher price) we have less room for profit. While that’s certainly true, we face a double-negative as well. While there’s less profit on the table, there’s also more risk.
Think about it. If we buy a $50/$55 bull call spread for $3.00 at the market rather than $2.50 with a limit, we just reduced our probabilities for success. Rather than potentially gaining $2.50 in profit (a 100% gain, excluding commissions), our maximum profit is now just $2.00 (or 66% excluding commissions). Lower reward would be acceptable if we had lower risk. But the opposite is true in this case. By paying a $3.00 debit for the spread, we’re now risking $300. That’s a 20% increase on the $250 risk we would have by using the limit order.
A higher risk and lower reward? That’s the complete opposite strategy that every investor is after. It also goes completely against what Option Party tries to do. By using probabilities and filters, we can pinpoint the very best trade for all sorts of investors. That, of course, is predicated on the fundamentals of trading. One of which is getting the order ticket correct.
In that case, it almost always involves using a limit order.