Don’t Use a Market Order for Options Trading
Many investors are sabotaging their retirements unnecessarily – and for the life of me, I can’t figure out why.
One thing I will never understand about the market is why there should even be an option to place market orders on everyday trades. These orders get investors into more trouble than any other strategy when buying or selling stocks.
A market order allows you to buy a stock or option at the price it’s trading when your order is received. That might not hurt for a stock trading with penny spreads if the market isn’t moving fast.
But for Long-Term Equity Anticipation Securities (LEAPS) options that are trading with a huge spread, say at a $1.20 bid and $1.80 ask, you might be the unlucky investor to ring up $1.80 or more with a market order. Yet many investors still choose this over using a limit order or trying to buy in between.
A market order to buy means you want to buy at all costs.
But is that really what you want to do?
When you’re selling, the same rules apply. If you say “sell at the market,” you are saying “get me out at any cost.”
On a slow day, this may not be as bad. There might not be much movement in the share price. But when the stock begins to move, you’ll regret that market order more often than not.
The Wrong Time for a Market Order
Take Beyond Meat (Nasdaq: BYND), for example. Its shares have shown that they can move by $1 or $2 within milliseconds.
Do you really want to risk paying any price or selling for any price?
If you are going to use a market order, make sure it’s for a good reason.
For example, panic-selling on bad news may be the only way out of a stock when it’s dropping like a rock. You’ll get a horrible price, but you’ll probably escape better off than your neighbor.
Buying into a euphoric moment after discovering something that the market is just about to catch on to might also be worthwhile. A market order here will ensure that you get in even if the price starts moving.
However, for options, market orders are a no-no most of the time. This is because the options market is less liquid than the stock market, so oversized moves really don’t get much scrutiny.
Everyone, including the market makers and regulators, knows that options have big spreads. And they know that nonprofessionals will always pay up. After all, that’s how the market makers make the big money!
When you’re trading options, your first order should be less than halfway between the bid and offer. If that doesn’t work, inch your price up until you are filled.
The only time to use a market order with an option is when you have a tight spread and you can’t get filled on a limit order. In this case, you must take the additional step of finding out how many contracts are on the bid (if you’re selling) or on the ask (if you’re buying).
For example, if you are selling five contracts and there are only three contracts on the bid, you can guarantee that you will get shafted. The market maker can “move out of the way” for the balance, and you’ll get even less.
But if the bid is strong, let’s say 100 contracts, and you sell at market, chances are that you will get filled at the bid or higher. Then you can use a market order to try and get a better price if there is a good-sized spread.
Action Plan: Desperate times call for desperate measures, and those are the times for market orders. In most other situations, you’ll do best to use only limit orders. If you want more investment advice like this – and trades recommended in real time – then join me in The War Room today!
About Karim Rahemtulla
With more than 20 years of experience, Karim has mastered the subtle art of options trading. What we admire about him is his ability to score huge gains while minimizing the massive amount of risk that often comes with options. Beyond his expertise in options trading, he is also the author of the best-selling book Where in the World Should I Invest? He publishes weekly about smart speculation in his latest free e-letter, Trade of the Day.