The Limits of Market Orders

 

Date: 7/13/2021
Author: Chris Hood

 


Be sure to check out new episodes of my video podcast each week, where my ace pupil Brian Jones and I talk the ins and outs of options trading- and give you insights and strategy that you can immediately put to work for you in the markets.


If you’ve ever wondered about the difference between market (MKT) and limit (LMT) orders, you aren’t alone.

It’s one of the most common beginner questions.

What’s the difference, and when is each appropriate?

Trading options (and stocks) is much like an auction.

For every buyer, there must be a seller. Likewise, you can’t sell an option if there’s no one on the other end to buy it.

Take a look at the options chain for any underlying stock, and you can see the market price, abbreviated MARK, as well as the BID and ASK prices.

The bid price is what buyers are willing to accept, and the ask price is what sellers are willing to pay. So the mark will be somewhere between the two.

The difference between the two is known as the bid-ask spread.

Let’s look at an example.

At the time I’m writing this, SPY is trading at 436.73.

This index is highly liquid, meaning there are numerous buyers and sellers in the market.

Should you want to place a bullish, directional trade and buy the Nov 19th, 2021 417 call, you’ll see that the bid is 29.51 per contract and the ask is 29.84 with a 29.68 mid-point price.

There are lots of buyers and sellers here, with the open interest at 1,833.

This is a relatively tight spread, meaning if you want to get in at the midpoint, your order will most likely fill quickly at the price you want.

Set your order at BUY LMIT @29.68, and it shouldn’t take long for you to hear that “ding.”

You’re in the trade.

Setting LMT orders is essential. If you place a MKT order to buy, the options exchange will just fill your order at the ask price.

MKT orders tend to make you overpay, and when you overpay, you make less money – sometimes none at all.

In options trading, LMT orders are critical.

Sudden changes in stock price or volatility might cause your order to fill at a price far higher than what you saw when you sent the order.

If your order doesn’t fill right away, just be patient and let the price come to you.

A few hours have passed, and you’ve not gotten filled. So you have a couple of choices.

Change the LMT order by one or two cents or just pass on the trade.

Keep in mind that it’s far better to let the price come to you than chase it. If the entry isn’t optimal, keep the stock on your watchlist and wait for a better entry.

On some less liquid stocks, the bid-ask spread may be vast, so LMT orders become even more important.

For instance, IDRV, a self-driving and electric vehicle ETF, is a current market megatrend.

It’s currently trading at 49.69. Assume you were bullish on the stock and decided to buy a 44.00 strike call for Dec 17th, 2021.

Here the open interest is only five – not much trading going on.

The bid is 4.60, and the ask is 8.10.

That’s a spread of three dollars and a half compared to the thirty-three cents of SPY.

You’re probably not going to get filled at an optimal price, and if you entered an MKT order, you’d be paying dearly.

So LMT orders for both opening new trades and closing winners are necessary.

Is there ever a time to use a MKT order?

Yes…When you want out of a losing trade immediately.

If a trade is going against your position and you want to close it right away, then a MKT order gets you the quickest fill.

Waiting on a LMT order that might not get filled can lose you even more money.

It’s like being picky about the color of the parachute when your plane is crashing. Just grab the nearest chute and jump.

So let’s summarize.

When you open a new trade or want to take profits, then set LMT orders. NEVER use MKT orders.

Your goal is to get the best price and the most profit.

When you close a loser, don’t risk not getting a fill. Instead, get out quick at the MKT price.

Simple concepts, but ones that will make a massive difference in your P/L.

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