How and When to Use Market Orders on Options Trades

05/22/2015 8:00 am EST

Focus: OPTIONS

When it comes to index options, the spreads are often so wide that a market order may incur too much cost, so Andrew Falde of SMB Training Blog highlights two things he likes to do to reduce this cost while not limiting his ability to automatically defend a trade.

Limiting risk is critical to the long-term success of your trading.

Every strategy has a downside. Every trade is subject to having you on the wrong side of a big move.

It’s important to have a plan to keep that risk in check.

Some options strategies have built in risk, meaning there is no way to lose more than you planned (such as vertical spreads, butterflies, etc.).

Some trades have much more risk than you’d like to experience. These may be trades like a high probability credit spread, iron condor, or short straddle/strangle.

You have a plan to manage these trades, but maybe something happens when you aren’t at your machine. Or maybe you want to be proactive about defending the trade at a certain level.

Index options have a particular challenge when it relates to risk management. The spreads are often so wide that a market order may incur too much cost, especially in a fast moving market where the pressure on the trade could make that cost even higher.

There are two things that I like to do to reduce this cost while not limiting my ability to automatically defend a trade.

1) Use condition orders on the underlying. This allows you to define the point that you would manage the trade based on the underlying market rather than the options pricing. Options prices can be very erratic. If you use the price of the options to trigger a stop, then you could be stopped out based on a lack of liquidity rather than the actual performance of the underlying. Many platforms allow you to link your options trade to the conditions of the underlying which will be more reliable.

2) Use a correlated and more liquid instrument. I tend to use IWM options and /TF futures to defend RUT options trades if I need to do something quickly. It’s much safer to short futures, Sell IWM calls or Buy IWM puts using a market order than it is to buy RUT puts using a market order.

All that said…if the market is calm and you have the time to take the adjustment with RUT limit orders, then that is the lowest cost solution.

Andrew Falde, Contributor, SMB Training Blog

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