How to Use Contingent Orders When Trading Options

08/26/2009 12:01 am EST

Focus: OPTIONS

Puts, calls, spreads, straddles—when it comes to options trading, there's a lot of lingo to learn. But once you get the basics down, well, that's when the real fun begins.

We've covered many of the basic types of orders associated with options trading, but now it's time to get a little deeper into one type unique to options: The contingency order.

When you place an options order, you can choose to place contingencies on that order, meaning that the order will be filled only when a specific event has occurred.

A contingent order is simply a way to enter an order to buy an option, but instead of specifying the option price you want, you specify where you want the stock to trade before your option order is entered. With a contingent order, you peg your option buys and sells to where the stock or index is trading.

Here's an example. You are interested in buying call options on XYZ Corp. The stock has been in an uptrend, however, it recently had some profit taking and is currently trading at $47 per share. You decide on three-month-out call options at the $45 strike price.

You could enter a contingent order to buy these XYZ 45 calls when the stock hits $45, $46, or $48, or whatever price you choose. The point is, with a contingent order, you simply specify when you want to buy your options based on the price of the stock, not the price of the options.

Two Flavors for Your Orders: O.C.O. and O.T.O.

For most of the time that options have been available to trade, contingent orders have not been available to the individual investor. However, with the speed and convenience of the Internet, contingent orders are now available at most option brokerage firms.

Let's take a closer look at some of the most popular contingent orders:

Order Cancels Order (O.C.O.)

It depends on your brokerage firm whether you're allowed to place O.C.O. orders, but the ability to execute this kind of contingent order is getting more and more common.

An O.C.O. is the ability to place two orders at the same time. For example, let's say you own XYZ May 40 calls at $3.40, then you place an O.C.O. order that allows you to place a stop loss at, say, $1.50, while simultaneously placing a second limit order to sell XYZ May 40 calls at a price of, say, $7.

If the XYZ May 40 calls happen to zoom up and fill (sell) at $7, then that particular order would cancel the other (the other order being the "stop order" you had in place to sell the XYZ May 40 calls for $1.50.) So one order cancels another order, or O.C.O. Conversely, if you were to be stopped out of the trade at $1.50, the order to sell out at $7 would be immediately cancelled.

One Triggers the Other (O.T.O.)

O.T.O. orders (one triggers the other) involve two different trades that are based on each other. When trading, you could find yourself in a situation where you'd like the "fill" (or a completed trade) to signal the triggering of yet another trade. Here's a hypothetical example of how an O.T.O. contingent order works: A trendy clothing retailer seems to steam ahead in the quarter leading up to the back-to-school shopping season. You decide to pick out this hypothetical retailer, "ABC Clothing," and you determine that you want to buy in at around $29. Currently the stock is trading for $29.70 and we're in February. So you enter in a limit order to buy the April 30 calls when the stock hits $29.

Then, as part of this O.T.O., you specify that if your buy order gets filled, it will immediately trigger an order to sell your October 30 call options when ABC Clothing stock hits $34 per share (based on some past years of evaluation of what tends to happen to the stock during this time). Your buy order (when filled) "triggered" another order. In our hypothetical ABC Clothing example, it was an order to sell when a certain price was reached.

Contingent orders can be a great way to follow up on a specific set of market conditions. When used correctly, contingent orders can be an excellent tool for helping you maximize your options trading profits.

By Jim Woods, senior editor for OptionsZone.com

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