If you're an options trader, you could be making a big mistake…
It's one that could cost you A LOT of money. And there's a simple way to avoid it.
Let me explain…
When buying and selling options through your broker, you have two choices in how to make the trade.
The first is a limit order. Buying an option using a limit order means your buy order will only be filled at or below the price you enter as your limit. For example, if you set a limit order to buy call options for $2, your order will only be filled if you can buy the calls for $2 or less.
Selling an option with a limit order means your sell order will only be filled if you can collect at least the price you enter as the limit. For example, if you set a limit order to sell call options for $2, your order will only be filled if you can collect at least $2.
So with limit orders, you run the risk of not being able to get into or out of a trade right away. But it's much better than the alternative…
You see, the other option is a market order. In theory, buying an option using a market order means your buy order will be filled as quickly as possible at the best available price. Selling an option using a market order means your sell order will be filled as quickly as possible at the best available price.
Like I said, that's how a market order is supposed to work, in theory. In reality, using a market order – even in the most liquid environment – is like flashing $100 bills and singing “I'm in the money” while you're strolling down the most dangerous streets of Compton, Detroit, or Baltimore at two o'clock in the morning.
You are going to get ripped off!
You see, when we buy or sell options, options market-maker firms are often the ones selling them to us and buying them from us.
An options market maker is a firm that stands ready to buy and sell options on a regular and continuous basis at a publicly quoted price. Market makers keep the markets flowing.
Options market makers make money by profiting on the bid-offer spread of options (the difference between the prices at which a market maker buys and sells a security). For example, if a market maker buys a call option for $1.90 and is willing to sell it for $2, the bid-offer spread is $0.10. The larger that market makers can make this spread, the more they will profit. And that's what's so dangerous about market orders.
I used to consult with one of the country's largest options market-maker firms. Many of the guys at the firm would sit at the bar after a long day in the pits and tell stories about how they screwed someone who entered a market order on a large block of options.
They'd see the market order hit the screen and all of them would instantly pull their bids and offers from the market. Then they'd discuss at what price to execute the ticket and how they would divide up the trade. Finally, they'd fill the ticket at an obscene price – maybe 20% away from the previous price – and then get back to trading as usual.
That same routine occurs with small orders, too – especially right at the opening of the market.
Yes, that's collusion. Yes, that's a prohibited practice. And, yes, there are rules against it. But there are also rules against driving more than 65 miles per hour on most of this nation's freeways. Yet nearly everyone does it.
To see how damaging this can be to your trading account, let's look at an example. Let's say some call options are trading at $1.90 bid and $2 ask. If you use a limit order to buy two call options at $2, it will get filled for $2 or less, assuming the price doesn't change in the few seconds it takes your broker to submit your order ticket. Since each call option covers 100 shares, and you're buying two, it will cost you $400 or less.
But let's say you use a market order. Thanks to some market-maker collusion, you end up buying the calls for $2.40 – 20% higher than the last trading price. Now, it'll cost you $480. You'll also likely end up the subject of one of the stories shared at the bar later that night.
The same holds true for selling options. In the above example, you can use a limit order to sell your two calls at $1.90. Again, as long as the price doesn't change within a few seconds, you're going to get the order filled at $1.90 or more. So you'll collect at least $380 on your two calls.
But let's say you use a market order. The market makers step away from their bids, only to come back with a bid that's 20% less than the previous price. So instead of selling your calls for $1.90, you end up selling them for $1.52. Now, you only collect $304 on your two calls.
Even if market orders always worked like they should, you'd still run the risk of buying or selling for a price drastically different from what you intended – especially in volatile markets.
So for your own sake, NEVER use market orders when trading options. Only use limit orders. Yes, you risk not being able to get into or out of the trade right away. But most of the time (probably all of the time) even if you have to move your limit order down or up in order to get an execution, you're still going to be better off than if you had sent a market order to the options pit.
Best regards and good trading,
[Essay originally published by Stansberry Research.]
P.S. Starting this week, I’ll be answering some of the most frequently asked questions about options trading to hit my inbox. If you have a question about options, whether you’re a beginner or a veteran, be sure to send it right here.