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Options University’s Options 101 - Part 51

Filed Under Beginner Options Trading 

Stop Limit Orders
A stop limit order is an extension of a stop order. The difference is that stop limit orders convert to a limit order, which means your shares will be sold only if the limit price or higher can be hit and guarantee a price. But as with any limit order, if you guarantee the price, you cannot guarantee the fill.
 

Key Differences Between Stops and Stop Limits
 
Stop Orders become a live “market” order if stop price is triggered. Guarantees that the order will be filled but cannot guarantee the price.
 
Stop Limit Orders become a live “limit” order if stop price is triggered. Guarantees the price but cannot guarantee that the order will be filled.

In order to place a stop limit order, you must specify two prices. The first price is the stop price. Once you specify the stop price, you must then specify a stop limit price (which must be less than or equal to your stop price).
 
Let’s use the previous example but now apply a stop limit. Assume you purchased 200 MSFT at $36 and have now placed the following order:
 
Sell 200 MSFT at a stop price of $35 with a stop limit of $34.50.
 
Notice that two prices must be entered. The first price ($35) is the stop price. This just tells the computer when to activate the order. If the stock trades at $35 or below, the order will become activated and becomes a live limit order to sell 200 shares of MSFT at the stop limit price ($34.50) or higher. The stop limit price you enter (second price) you enter must be less than or equal to the first price. Many traders like to reduce the second price a bit to allow for some market fluctuations if the order is triggered.
 
Now let’s go back to your stop limit order and assume that MSFT opens at $27. The order is activated because the stock traded at or below $35. You now have a live limit order to sell at $34.50. Obviously, the order cannot be executed since you are requiring a price of $34.50 or higher. This shows that stop limit orders do not prevent losses any more than stop orders. However, stop limit orders will keep you from selling at prices you consider unfavorable.
 
Which should you use, stop or stop limits? That depends on the situation; you may find that you use both at different times. The one question you need to answer is this: If MSFT opens below your stop price do you want to sell the shares at any price? Is your goal to simply get rid of the shares regardless of price? If the answer is yes, then use a stop order. However, if there is a price at which you’d rather hold onto the shares rather than sell then use a stop limit order.
 
Option Stop Orders
The key point you want to understand with stop and stop limits when applied to options is that the orders are “triggered” if the asking price equals the stop price or lower. Option stop orders and stop limits are not based on the last trade. The reason is that it is possible to not have any trades on the option even if the stock’s price is falling. In other words, there might not be any activity and therefore no last trades. However, the bid price and asking prices on the options will definitely change in response to the falling stock price. That’s why the exchanges trigger stop and stop limit orders on the asking price for options and execute the orders on the bid price.
 
 
Limit Order Display Rule
In Chapter Two, we how the bid-ask spread near expiration can make a big difference on your profits, especially if the bid price falls below intrinsic value. In a similar fashion, the spreads at any time during the option’s life can have a dramatic negative impact on profitability even if the bid price represents the full intrinsic value. For example, assume a stock is trading for $51 and the $50 call is bidding $2 and asking $2.25. Both the bid and ask prices contain the $1 intrinsic value. However, if you were to buy at the asking price of $2.25 and immediately sell at the $2 bid price, you would instantly lose over 11% of your money just because of the spread. Many traders dream of making a quick 10% on their money but notice how the spread can quickly eat that away. The spread causes buyers to pay a higher price and sellers to receive a lower price than the theoretical fair value; it is a serious threat to profitability, especially when you consider the relatively low prices of options when compared to stocks.
 
But there is an effective way we can trade between the bid and ask to reduce this detrimental effect. The effectiveness of this technique hinges on an exchange rule called the Limit Order Display Rule. In order to understand how we can use this rule to our advantage, we must first understand how the quotation system works.
 
 
Understanding the Quote System
Let’s say you see an option with the following quote:
 
Bid: $2.00       Ask: $2.25
 
What exactly does this mean? We learned in the first chapter that the bid price represents the price at which you can sell while the asking price represents the price at which you can buy. In many ways, this is like the difference between retail and wholesale; you can buy this option for $2.25 but you can sell it for only $2.00.
 
While this is a correct interpretation of the bid and ask prices, it hides the source. Chapter One showed us that the bid price represents the highest bidder among a list of many bidders while the asking price (also called the offer price) is the lowest selling price among a list of many sellers. In order to understand this bid-ask interpretation better, it helps to see how option orders are accumulated by market makers. Whenever you submit an order to your broker, it is received by a market maker who will stack all orders according to price and time.
 
Here’s how the process works: Let’s assume the market is not open yet and the maker has no orders on the books. When orders are placed through the various brokerage firms, the market maker will accumulate them in a specific manner. Assume that the first order is an order to buy 5 contracts at a limit of $1.90. Because this is an order to buy, the market maker will list it under the “bid” column (remember, buyers place bids):
 
Bid
Ask
1.90 (5)
 
 
The number in parenthesis shows the number of contracts at that price. Assume that the next order is an order to buy 10 contracts at a limit of $2.00. Because this is another buy order, the market maker will place it under the “bid” column as well. However, this trader is considered a “stronger” buyer since his buy price is higher than the person at $1.90. The markets are only concerned with the highest bidder and lowest offer. Because of this, the market maker will place the order above the $1.90 price as follows:
 
Bid
Ask
2.00 (10)
 
1.90 (5)
 
 
Assume the next order is an order to sell 8 contracts at a limit of $2.35. Because this is a sell order, the computer will place it in the “ask” column (remember that sellers submit “asking” prices). As a matter of convention, asking prices are generally stacked on the top for reasons we will see shortly:
 
 
2.35 (8)
Bid
Ask
2.00 (10)
 
1.90 (5)
 
 
The next order is an order to sell 4 contracts at a limit of $2.25. This trader is considered a “stronger” seller since the selling price is less than the previous order at $2.35. Because of this, the market maker will place this order below the previous order:
 
 
2.35 (8)
 
2.25 (4)
Bid
Ask
2.00 (10)
 
1.90 (5)
 
 
Notice how the orders are being stacked. The bids are being stacked in descending order from strongest to weakest; that is, from highest to lowest. The sellers are stacked in ascending order from strongest to weakest; that is, from lowest to highest. Let’s say the next order is to buy 6 contracts at a limit of $1.95. This trader is the stronger than the buyer at $1.90 but not as strong as the one at $2.00, so that order will get placed between the two:
 
 
2.35 (8)
 
2.25 (4)
Bid
Ask
2.00 (10)
 
1.95 (6)
 
1.90 (5)
 
 
To finish the example, assume that the next order is to sell 2 contracts at a limit of $2.30. This trader is a stronger seller than the one at $2.35 but not as strong as the one at $2.25, so that order will get placed between those two:                            
 
 
2.35 (8)
 
2.30 (2)
 
2.25 (4)
Bid
Ask
2.00 (10)
 
1.95 (6)
 
1.90 (5)
 
 
 
To be continued…..
 

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