The Basics of Getting Fills in Fast-Moving Markets

11/09/2010 12:01 am EST

Focus: STRATEGIES

Dan Passarelli

Founder, Market Taker Mentoring, LLC

There is lots of talk about whether to use market orders or limit orders when entering options trades. To be sure, each has its own advantages and disadvantages. Let’s take a look at each order type and then discuss a happy medium that is a sort of combination between the two: Entering orders through the market.

Market Orders

Market orders are orders that execute at the best available price. Market buy orders execute on the disseminated offer. Market sell orders execute on the disseminated bid. One of the major benefits of trading market orders is that you know you’re going to be filled, but the major detriment is that you can’t be sure at which price.

Many traders who’ve been burned by market orders subscribe to the conspiracy theory that those evil market makers are somehow waving their magic wand and moving the market at the very moment little old you enters your trade. Having been a market maker for many years, I will tell you that this is not the case. With electronic trading, market makers don’t even see the order until they trade it. It’s not possible to have any foul play.

What I think has lead to this conspiracy theory is that sometimes the market happens to move adversely right when a trade enters the market. This doesn’t happen all the time, but when it does, traders remember it. For this reason, sometimes a limit order can be better.

Limit Orders

Limit orders are orders that only execute if it is possible to execute at the stated limit price. A limit bid will trade only if an offer is low enough to match. A limit offer will trade only with a high enough market bid.

The obvious advantage here is that traders know what price they are getting. They can’t be filled worse than their limit. Because of this peace of mind, many traders prefer to use limit orders instead of market orders.

But there is a disadvantage to limit orders. In those times when the market moves the wrong way, limit orders may not trade. If the market starts moving rapidly, limit order traders may miss an opportunity to get in or out of a trade. They may have to “chase” the offer (or bid) and may end up ultimately getting filled at a much worse price.

Through the Market

There is a happy medium—a sort of best of both worlds—that traders can use. In fast markets where there is risk of the market moving away from a limit price (risk of limit orders) but also the risk of a market order getting filled at an unacceptably bad price, traders can enter a limit order through the market. That is to say traders can enter bids above the current market offer, or enter offers below the current market bid.

If a trader enters a bid with a limit price above the market offer, the trade will fill at the market offer that is showing. For example, imagine the market is 4.90 bid, offered at 5.00. A trader enters a 5.40 bid. If the market doesn’t move, the trade will fill at 5.00—the offer that is showing. If, however, the market rises a tick, up to 5.10 offer, that will be the execution price. If the market rises so much that the offer is above the traders bid, say, 5.50 offer, the trade will not execute.

Use It in Fast Markets

This is a combination of a market and a limit order. Because orders fill at the best available market price, the order is effectively a market order as long as the offer is below the bid—in this case, below 5.40. Above the trader’s bid, it will be a resting limit order. This technique is used in fast markets by savvy traders who need to get filled, but who have a limit regarding what they will pay. It is used to prescribe a market order with a worse-case scenario limit.

By Dan Passarelli of MarketTaker.com

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