Types of Options Orders

| December 6, 2011 | 0 Comments

Before you begin placing orders through your broker to trade options, you need to first understand the various types of orders that are available to you. You can be absolutely right about the overall market trend, your chosen option strategy, the direction of the underlying security, and the pricing of the option, but if you make a mistake in the type of order used you could end up paying a higher price (in the case of a buy order), receiving a lower price (in the case of a sell order), or even missing out entirely on a profitable opportunity. If you want to make money trading options, especially over the long-term, you cannot afford to rack up losses or miss out on profitable trades because you used the wrong type of order.

There are many types of orders available for trading options, but not all of them are acceptable on all exchanges or at every brokerage firm. You should check with your broker for the most recent information about which orders are acceptable.

Types of Option Orders – Orders That Specify The Action To Be Taken

The following terms are used when entering an order to buy or sell an option to describe the action an investor intends to take with the order. These terms are divided into two categories: opening transactions and closing transactions. An opening transaction is the initial transaction to buy or sell and is used to establish a new position or increase an existing position. A closing transaction is used to exit or reduce an existing position. Opening buys are usually followed by closing sales; opening sells usually precede closing buy trades. One of these terms must be specified when entering an order to buy or sell an option for it to be accepted by the broker.

Buy To Open

This term is used to establish a new long position in an option or to add to a long position that already exists in your account. For example, if you want to go long the Jul 35 call option on Microsoft, you would specify “Buy To Open” in your order. Similarly, if you are already long a MSFT Jul 35 call option and want to buy more of these contracts, you would specify “Buy To Open”. This term should not be confused with “Buy To Close”, which is explained below.

Sell To Close

This term is used to exit or reduce a long position that you have already established in an option. For example, if you are long the MSFT Jul 35 call option in your account and you want to sell it, you would specify “Sell To Close” in your order. Take note that if you establish an option position with “Buy To Open”, you will exit that position with an order specifying “Sell To close”. This term should not be confused with “Sell To Open”, which is explained below.

Sell To Open

This term is used to establish a new short position in an option or to add to a short position that you already have in your account. For example, if you want to go short the MSFT Jul 35 call option (sell the option even though you don’t own it in your account), you would specify “Sell To Open” in your order. Similarly, if you already have a short position in the MSFT Jul 35 call option and wish to increase that position, you would enter an order specifying “Sell To Open”. This term should not be confused with “Sell To Close”, which is explained above.

Buy To Close

This term is used to exit or reduce a short position that you have already established in an option. For example, if want to exit or reduce a short position that you established by selling to open the MSFT Jul 35 call option, you would specify “Buy To Close” in your order. Take note that if you establish an option position with “Sell To Open”, you will exit that position with an order specifying “Buy To Close”. This term should not be confused with “Buy To Open”, which is explained above.

Types Of Option Orders – Contingent Orders

There are many advanced option trading strategies that require a combination of different options. For example, a Bull Spread is established by buying a call option at a certain strike price and simultaneously selling a call option on the same underlying security at a higher strike price. Most brokers now offer two types of combination orders that make it easier for the option trader to establish these advanced option positions.

One-Triggers-Other (OTO)

An OTO order allows you to enter an initial order and then place a second order that is contingent upon execution of the first order. There are many uses for OTO orders. Here are a few common positons that can be conveniently established using OTO orders:

(1) Leg into a covered call

  • (a) First Order – buy a stock at a limit price
  • (b) OTO Order – sell a call against the stock you just purchased

(2) Use proceeds from a sale

  • (a) First Order – sell an option that you are long at a limit price
  • (b) OTO Order – use sale proceeds to buy a different option contract

(3) Leg into a call spread

  • (a) First Order – buy a call at a limit price
  • (b) OTO Order – sell a call at a limit price

One-Cancels-Other (OCO)

An OCO order simultaneously cancels an open order with the execution of another order. OCO orders are used primarily as an exit strategy to protect gains or to avoid losses. Here are two scenarios of how an OCO order can be used to conveniently manage the risk/reward parameters of an option position.

(1) Price of Option Decreases – a sell stop order placed below the current price of the option executes to limit or avoid a loss and a sell limit order placed above the current price is simultaneously cancelled.

(2) Price of Option Increases – a sell limit order placed above the current price of the option is executed to capture the gain and the sell stop order placed below the current price is simulatneously cancelled.

Types Of Option Orders – Orders That Specify Price For Execution

The following terms are used when placing an order to buy or sell an option for both opening transactions and closing transactions. These terms provide instructions to the broker as to what price you are willing to pay (buy order) or receive (sell order) at execution. It is important to understand what these terms mean and the potential advantages and disadvantages of each before you begin trading options.

Market Order

A market order is an order to buy or sell an option at the best price available at the time the order is executed. Market orders must be executed immediately and take precedence over all other types of orders. Generally speaking, market orders to buy are executed at the ask price and market orders to sell are executed at the bid price. However, if the option you wish to buy or sell is not liquid and has a wide spread between the bid and ask price, you may end up paying a significantly higher price than the quoted ask price (in the case of a buy order) or receiving a significantly lower price (in the case of a sell order) than the quoted bid price. Essentially, the main advantage of a market order is that it will be executed immediately and you will know right away if you bought or sold the option. The main disadvantage is that you will not know for certain at the time you place the order the exact price you will pay or receive.

Market prices could move substantially higher or lower between the time a market order is entered and the time it is executed in the market. This is especially true during times of high market volatility or unusually heavy volume. Orders made outside of standard market hours may also experience wide price fluctuations.

Limit Order

A limit order is an order to buy or sell an option at a specified price called the limit. There are two types of limit orders: (1) an order to buy an option with a restriction on the maximum price a buyer is willing to pay, and (2) an order to sell an option with a restriction on the minimum price the seller is willing to receive. Limit orders can be executed at a better price than the limit price – a lower price for buyers and a higher price for sellers. However, there is no guarantee of an execution with a limit order as there is with a market order. Even if the price of the option trades at your limit price or a better price there is no guarantee that your order will be executed. Limit orders are entered into the order book in the order they are received. It is possible that some orders at a given price may not be filled due to orders that were placed earlier. Limit orders should be used only if you have the patience to wait for the option to trade at a specific price.

Stop Order

A stop order specifies a price – the stop price – at which the order is to be triggered (not executed). Once triggered, a stop order immediately converts to a market order and is executed at the next available price. That price could be higher, lower, or equal to the stop price. A stop order is triggered when the bid is equal to or less than the specified stop price or when the ask price is equal to or higher than the specified stop price. Stop orders are used most often to protect gains or to help protect against potential losses.

There are two types of stop orders: (1) buy stop order, and (2) sell stop order. A buy stop is set at a price higher than the current market price of the option. Traders use buy stop orders when they believe a an option will continue to rise in price once it trades at or through the stop price. For example, if the current price of the Exxon Mobile (XOM) Jul 100 call option is $3, a trader might believe that the price will continue to rise once it trades at or higher than $4. To take advantage of this expected price movement, the trader might place a buy stop order at $4. If the option trades at or higher than $4, the buy stop order will convert to a market order and execute at the next available price.

A sell stop is set at a price lower than the current market price of the option. Traders use sell stops to protect a gain or to protect against further loss. For example, if the current price of the Coca Cola (KO) Jul 50 call option is $3, a trader might place a sell stop order at $2. If the price of the option trades at or below $2, the sell stop order will convert immediately to a market order and the floor broker will execute the order as soon as possible. The trader, however, is not guaranteed that the order will be executed right at $2. If the option price is falling fast, the order might be executed at a price below $2.

Stop Limit Order

A stop limit order is an order to buy or sell an option at a specified limit price once the option has traded at or through a specified stop price. Unlike a stop order, a stop limit order specifies two prices, which may or may not be the same: (1) the stop price at which the order will be triggered (not executed), and (2) the limit price at which the order may be executed. When a stop limit order is triggered it converts into a limit order and will be executed only when the limit price is reached. A sell stop limit order is triggered when the bid is equal to or less than the specified stop price; a buy stop limit order is triggered when the ask price is equal to or higher than the specified stop price.

Similar to a straight limit order, there is no guarantee that a stop limit order will be executed once its triggered. The option price may trade through the limit price before the order can be filled. For example, let’s assume that the Intel OCT 25 call option is trading at $3 and you place a sell stop limit order at $2 stop, $2 limit. If the option’s bid price were to hit $2, your order might be filled at $2 or better depending on market conditions. However, the order would not be filled if the option traded through the specified limit price of $2 and traded down immediately to $1.90, $1.80, $1.70, and so on.

Types Of Option Orders – Order Conditions That Specify Timing For Execution

In addition to the type of order, traders are able to choose certain conditions that will affect the price of the trade: (1) Time Conditions, and (2) Execution Conditions. While certain conditions may offer an effective strategy in one situation, they may be less effective in another situation. It is important to understand how each of the several different time and execution conditions can affect the execution of the trade before you place conditions on your orders.

Time Conditions

The time condition specified in an order dictates when the order expires. Depending on the type of order placed, you may usually choose from two alternative time conditions: (1) Day Order, and (2) Good-Til-Canceled Order (GTC).

Day Order

A day order is valid for the current trading day only and will expire at the end of the trading session if it has not been executed. Day orders placed after the market has closed are usually treated as day orders for the next regular trading session. Day order is typically the default time condition used if the order does not specify one.

Good-Til-Canceled Order (GTC)

A GTC order remains valid for an extended period of time (the exact time frame varies from broker to broker) or until it is executed or canceled. For example, let’s assume that you place an order to buy 1 IBM OCT 100 call option at $4 limit, GTC. The order may be executed the day it is placed if the limit is reached and the order is filled. If it is not filled on the day its placed, the order remains open for some period of time established by the brokerage firm and may be executed anytime prior to that date unless you request cancellation of the order prior to execution. It is important to note that a GTC order may be filled in one trading session or over multiple trading sessions. Orders filled over multiple trading sessions will usually generate increased commission costs depending on the broker.

Execution Conditions

There are several different execution conditions that can be used depending on your investment objectives. These conditions can be used, for example, to test the market or to place a large order without negatively affecting the price. The following are the most commonly used execution conditions.

All Or None (AON)

This condition directs the floor broker or market maker to execute the entire order at one time – or not at all. The main advantage of using this condition is that your order must be filled entirely at one time rather than over multiple trading sessions. This condition helps you contain trading costs since it ensures that you will be charged only one commission upon execution. Orders that are filled in parts over multiple trading sessions will usually generate multiple commission charges.

There are a couple of disadvantages to using the AON condition. First, it restricts the floor broker’s or market maker’s flexibility in executing the order. This could result in delay of execution which might cause you to miss the market entirely if there are not enough contracts to fill the order. In addition, AON orders are subordinate to limit orders placed without conditions and must wait in line behind them.

Immediate Or Cancel (IOC)

An immediate or cancel condition requires the floor broker or market maker to fill as much of the order as possible immediately and then to cancel the order for any remaining portion. This condition may not be available under all market conditions depending on the broker. An IOC condition can be useful to test the market for interest at a particular price. If the order is filled, you will know right away that there is interest at that price. While IOC is not as restrictive as AON, orders with IOC conditions are not entered into the floor broker’s order book and may not be executed at all if the specified price is not reached.

Fill-Or-Kill (FOK)

The FOK order condition is a combination of the IOC and AON conditions. An FOK order is canceled if it cannot be filled immediately in its entirety. Like the IOC condition, FOK can be used to test the market at a specific time and price. However, the more restrictive nature of this condition makes it even less likely that it will be executed at all.

Market Not Held

A market not held order gives the floor broker discretion with regard to the time and price at which the order is executed. Although the floor broker is allowed to use limited discretion in executing this type of order, he will not be held responsible for the final outcome. This type of order can be an effective way to get a better price in situations where a market order would be less effective. For example, if you place a market order to buy a large quantity of contracts in an illiquid option, you might end up having your order filled in part with each lot purchased at a higher price than the prior lot. By using a market not held order instead, you would give the floor broker time to work the order for you – break the large order up into several smaller orders – which could allow you to get your order filled at a lower average price.

Market-On-Close

A market-on-close condition instructs the floor broker or market maker to execute the order at the option’s closing price or as near to it as possible. This order condition can be useful when you expect the price of an option to rise or fall at or near the close of trading. It can also be effective if you’ve tried a limit order during the trading session that did not get filled and you want to ensure that it is executed before the close. The disadvantage of using a market-on-close condition is that the execution price is not certain and you may not necessarily get the closing price. These orders must be received or canceled at least 20 minutes before the standard market closes.

Category: Options Trading Basics

About the Author ()

Marcus Haber is the co-editor of Options Trading Research and boasts well over a decade of real-life options experience. Learning from some of the biggest names in the business, Marcus has served as an Options Strategist for a number of firms and was also appointed to the Options Advsiory Board with Pershing, a branch of the Bank of New York.

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