Trading options using market orders

Mark,

I learned something interesting today when taking a loss on a paper-traded position. It was a debit put spread in which the underlying never quite moved into profitable territory and, it being the eve of expiration, I submitted an order to close the position at market open on expiration Friday. (I don’t have time during the day to adjust my positions.)

There was considerable wiggle room in today’s closing bid/ask spread, and I wondered where I should set my limit order to close. Then I realized that, if I really need to get out of this position tomorrow, I probably don’t have the luxury of setting a limit order! So I decided to submit a market order instead.

This was a situation that I really hadn’t foreseen. Just as a trader shouldn’t feel compelled to hold a profitable position until expiration, he/she should be careful about waiting too long before closing a losing position. It would probably have been worth it to give up hope a day earlier and have more flexibility when exiting the trade. I definitely need to put more thought into my trading plan!

Cheers,
RD

***

When trading options there are some things that must never be done – unless you truly prefer to lose money. At the top of the list is to never (under no circumstances) enter a market order at the opening of trading. Note: If you have a margin call and your broker enters that market order for you, there is nothing you can do – except to plead for five minutes to make the trade on your own.

A market order at the opening is a plea

“Please take as much money from me as is legally possible. And if it’s a spread order, please do that twice. In fact, if I am selling a credit spread, please make me pay a cash debit to exit. If it’s a debit spread, please, please make me pay more than the maximum value of the spread to get out of this trade. Thank you.”

If you have a job where you cannot take a five minute break – fifteen minutes after the market opens – that is truly a difficult situation. However, it is just one more reason not to carry risky positions.

There is another lesson in this scenario, and your comment makes it clear that you either don’t see it – or don’t agree:

It doesn’t matter whether it’s a winning position or a losing position. Your entry price was long ago and is no longer relevant. You must concentrate on the current price of the spread, market conditions, and risk vs. reward. You should be able to determine whether holding this position is a good or poor idea, and it has nothing to do with its status as a winner/loser. When it’s time to exit, exit.

One more point: Execution prices in paper-trading accounts tend to be removed from reality. It’s still worthwhile to practice the trades and risk management, but profit/loss is not going to be realistic.

934

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6 Responses to Trading options using market orders

  1. Libor 03/25/2011 at 8:33 AM #

    Mark,

    I have recently met with same type of problem on paper-trading account when trading options. Actually it was even worse than described here. I cannot get fill on regular limit order therefore I entered substantially lower limit price then market was traded at that time (something like 10% below market) to ensure I will be matched (both bid/offer were there and updating). I did not get fill either for an hour. That was time I have decided to go for market order just to see what is there and If I can close position. I have entered market order 2 hours before market closes and did not get fill for rest of day even bid/offer was updating on-line!

    I know another platform where you can get fill for the best price every time. If you trade spread then better then mid-price is not problem to get either. This has obviously a big impact on P&L because you can get out “cheap” from losing trade and earn “fat” profit on winning one no matter what available volume.

    It looks to me paper account is not realistic to be used for option trading unless someone wants to practice with trading environment. Feature and/or stock trading is much better on sim.

    • Mark D Wolfinger 03/25/2011 at 9:29 AM #

      Hello Libor,

      I would complain to the broker that their paper-trading platform failed to execute a market order for more than two hours. That’s disgraceful.

      I know that thinkorswim often provides ‘better than possible’ fills. This is at least a price nearer to reality than not being able to get filled at all. Don’t forget, for record-keeping purposes, you do not have to use the paper-traded execution price. It’s more work, but worth the effort if you want good records. When just testing the broker’s trading platform, then fill prices are not a concern.

      I have come to the same conclusion, however, the paper trader does still get a chance to practice managing a position – and in making decisions. If price execution is corrected from absurdity to a decent estimate, then paper trading serves its purpose.

      Thanks for sharing

      • Wayne 03/25/2011 at 11:46 AM #

        Hi Mark and all,
        I want to respond to the “better-than-possible fills” in many paper trading accounts. I remember in some older posts, Mark, or some other readers were asking which brokers’ paper trading looks more like reality.
        I can tell you that I have optionshouse. So far, it’s pretty realistic. What I always do is to test adjustment strategies for IC by buying debit spread, same month, different month, different width, opening and closing the debit spread before and after opening and closing the “troubled” call or put side of the IC. I experimented with many many scenarios.
        Then about how “real” their paper trading is to reality; well, today I set my limit price to close the “troubled” call side at 4.38, while it is showing the limit debit currently at 4.90. The result: it didn’t get filled; the paper trading doesn’t easily “give” it to me.
        While not recommending this broker to anyone, I see the value of paper trading as Mark said, “the paper trader still gets a chance to practice managing a position – and in making decisions”.
        Wayne

        • Mark D Wolfinger 03/25/2011 at 12:04 PM #

          Wayne,

          I tried OH paper account and could not get filled in this scenario:
          Bid: 1.10
          Ask 4.20
          I tried to sell at $1.15 and could not get filled. That is not realistic. But it is also only a single example.

          Thanks for sharing.

  2. Bob V 03/27/2011 at 12:16 AM #

    Mark,

    Great post, as I was not aware of “Rule #1”.

    I have a few questions related to the post:
    1) Can you provide some insights as to what happens during the first fifteen minutes after the opening that puts a market order at such a disadvantage?

    2) Does “Rule #1” also apply to limit orders?

    3) Does “Rule #1” apply as you approach the end of the trading day (i.e. stay away from market orders within fifteen minutes of the close)?

    Thanks,
    Bob V

    • Mark D Wolfinger 03/27/2011 at 8:04 AM #

      Bob,
      It’s not that anything special happens during the first 15 minutes. Three or four minutes may be enough time to avoid the opening situation. I chose 15 as an arbitrary period of time to allow the order flow to settle down to ‘normal.’

      Years ago, the option markets were fair – buy and sell orders were matched. Then the imbalance was determined – and a single opening price was set for each specific option series. To get that price, the market makers made their markets, brokers worked their customer orders (limit and market) and supply and demand set the opening price. Although it was not guaranteed that 100% of all orders would trade at that single opening price, that was the goal, and it happened almost all the time.

      Can you imagine how long that would take today – with so many different options trading – and options on so many more stocks? It would take hours.

      Today trading is electronic and orders are filled quickly. There is no time to get quotes and set an ‘opening price.’ When a market order enters the arena, I don’t know the exact process (I’ve been away from the floor for 11 years), but there is no attempt to ‘match it with another market order to give each person a good execution. The buy order pays the offer and the sell order sells at the bid. That encourages market makers (those in the pit or represented b computer) to set wide bid ask spreads.

      And why shouldn’t they? If I know you are going to pay whatever I ask (if my asking price is lower than everyone else) why wouldn’t I ask for a high price? It would not be my fault that the person entering the order is doing something utterly foolish.

      That’s why market orders are ridiculous. And the extreme volume of simultaneous buyers and sellers only occurs at the opening. Throughout the day, order flow is more orderly – even when volume is high. Reason: Orders get filled quickly and do got get stacked into a big pile.

      Limit orders are different. Surely you knew that before asking. How can you be hurt with a limit order? You may miss an opportunity to buy at your limit price when people are selling below that price, but you will never pay above your price. There is just too much trading for the system to sort the limit orders and match them with the sellers.

      The close is different. It is not a problem, or at least it never used to be a problem.

      The reason why the opening is different is that there is a huge volume of accumulated buyers and sellers trying to be filled at the same time. Computers fill orders, and they do it quickly. I suggest avoiding that game, and that includes avoiding a margin call that your broker demands be filled at the opening..

      Regards