Limit Orders vs. Market Orders

How much of a better price can I expect to get with limit orders? I
just started trading US options, but am based in Australia. I generally
don't watch the market – and work off yesterday's closing bid/ask
prices.

NK

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I assume that you enter a limit order based on what you noted the night before.  If you enter 'market orders' please don't do that. 

When trading options, entering such an order is an invitation to receive a terrible fill, and there is little chance that you will get a fair price. 

Entering a market order at the opening is much worse.  It's difficult to imagine being so desperate to get a fill that you are willing to enter a market order at the opening of trading.

If you want to trade the opening, limit orders are mandatory.

'Yesterday's closing bid/ask prices' are almost always bad.  By that I mean they no longer represent the true market the following morning.  Why?

  • Many times the market makers widen the bid/ask spread just before the closing bell

  • If the stock price changes overnight – a common situation – so will option prices
  • If implied volatility changes overnight – and that happens frequently enough that it's a major factor in option pricing – then the option prices may be significantly different the next morning


If a market is very tight, such as 1.20 bid; 1.25 ask then paying the offer is fine and will not cost you anything.  But enter a limit order to pay $1.25 – do not enter a market order.

If a market is wide such as 2.30 bid 2.60 asked, it's extremely likely you can buy at 2.55 and I'd estimate the chances of getting filled by bidding 2.50 are at least 50%.

Obviously this is going to depend on liquidity – but most markets are wide for a reason   Foolish investors enter market orders or orders to buy at the ask price (when markets are wide).  There is no reason for market makers to offer to sell at lower prices when people are willing to pay higher prices.

I suggest you begin by looking at the mid-point between the bid and ask prices.  Then enter your bid 10 cents above (or your offer, 10 cents below) that midpoint.  If you are quickly filled, then the next time you trade the options for that underlying asset, try entering the order 5 cents away from the midpoint. 

If you are not filled when 10 cents away, then try 15 cents next time.  This is truly a trial and error process.  Conditions change and sometimes it's very easy to buy and sell options at favorable prices, and at other times, it's difficult.

I understand that the problem is you cannot see 'current' markets when you enter an order.  That's not a good thing.  Is there any way to be awake when the markets open (or perhaps near the market's closing time) – long enough to enter orders that you decided to enter the night before?

If not – perhaps you can make an arrangement with your broker – I'm sure they would charge a higher commission – to do as I suggest.  The broker can enter the order for the option you want to trade, at a price that is 10 cents above the midpoint when the market settles down – say about 15 minutes after the opening.

The bottom line answer is that you can do enough better by using limit orders to make it worthwhile.  Enough better to lose a night's sleep?  Probably not – but that depends on how many contracts you trade.

Please let me know if any of this proves to be helpful to you.

552


4 Responses to Limit Orders vs. Market Orders

  1. NK 12/16/2009 at 6:19 AM #

    Thanks Mark. An insightful answer. I always use a limit order, but I just wasn’t sure how much more I could get. Its definitely harder getting a good feel for it being unable to watch the current markets.
    I will try to spend a couple of nights watching the first 1/2 hour of the opening & closing activity – My trades from the past months seem to get filled around opening. I should be able to get a better idea then.

  2. Mark Wolfinger 12/16/2009 at 8:05 AM #

    Your current plan will be okay – part of the time.
    But there are enough days when the opening is far different from the previous night’s close that it’s worth doing as you suggest above.

  3. Mac 12/16/2009 at 10:08 AM #

    You noted that market makers frequently widen the bid/ask spread near closing. Why at that time?

  4. Mark Wolfinger 12/16/2009 at 10:42 AM #

    If, via an electronic trade that occurs right before the market closes – the MM gets filled on an order that’s more than just a few contracts, there may not be any opportunity to hedge the trade. Thus, to offset that risk, they look for better prices.
    I don’t know for a fact that that’s the reason, but if I were to widen my markets, that would be my reason (if I were still a market maker).