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The Problem With Option Limit Orders.

Posted by Pete Stolcers on November 15, 2010

Option Trading Question

Today Don G. states, “I don’t like to place market orders because I always seem to pay more than I should. However, when I place a limit order I rarely get filled unless the stock moves against me in a big way. What can I do?”

Option Trading Answer

This problem is very common and it has to do with the poor liquidity in many option markets. In particular, option series where less than 100 contracts have traded for the day. These bids and offers are a mile wide and they are being put up by an auto quote system that belongs to a Specialist/DPM. There are a handful of firms with deep pockets that provide this function and each stock is assigned to a member by the exchange. If it’s ill liquid, “you’ll take what you get and like it”.

Here’s an example. Recently, I put out a report to purchase the July 95 puts on a stock for $1.50. The stock was at $97.50 and the option market was $1.30 x $1.50. That was a big $.20 “edge” (15%+) and I was willing to give it up on a stock that had already traded 1M shares (very liquid). We got filled on a few options and then the Market Makers bumped up the offer to $1.55 without the stock moving. The stock did drop to $97 and the options were out of range for a while. As subscribers placed their $1.50 limits, they were in the “book” where everyone could see their bid. The stock rallied to $98, $.50 higher than when the options were $1.30 x $1.50 and we could not get filled. The market was $1.50 x $1.55 (our bid). The options were sitting there and the Market Maker was leaning on our bid as long as possible. When the stock finally got to an unbearable level where the trade was too good to pass up, they took us out. While this was happening all of the other exchanges had market’s of $1.30 x $1.55. They never locked with our bid to forced a fill. That is because the auto quotes are based on where the other Specialist quotes are when there is a public order. Sound unfair? It is. Right after we got filled the market went $1.20 x $1.40.

So how do you get around this? You cancel your order. If the Specialist/DPM knows that the order is not “dead meat”, and they can’t lean on it, they will be more likely to fill it when it is at a “fair” price knowing that you might go to another exchange. This means you have to cancel and re-enter it.The other way to correct the problem is to route the order to another exchange. Go from one to another and shop the order. You’d be surprised at the fills you can get. The final solution… trade the stock. Don’t give up all of your edge to the Specialist. If that solution doesn’t work for you, don’t do the trade. You need to be in a fair marketplace, not somewhere where you are going to get raped coming and going.

If an option is ill liquid and you want to try and shave a dime off of a $.30 wide market, you can try, but don’t leave the order out there. Cancel it if you are not filled right away. If the stock moves and your price has “come in” grab it. On ill liquid options your chance of getting a fill between the bid/ask is slim.

In a liquid stock you have a chance of trading against someone other than the Specialist and the markets are much tighter. You might even get filled between the bid/ask.

If you’ve had similar issues, share your experience and I’ll try to coach you on how to “work” the order.

Option Trading Comments

  • On 10/28, cy said:

    i’m trying to establish a position in a very illiquid option.  it’s so illiquid in fact that I’m the only one in it!  Every time I place an order, it is partially filled then the price is bumped up.  My orders alone have caused the price to double from $.40 to $.80.  The b/a started at --/$.40, now it is
    my bid/$.80
    Am I better off placing one large order or several smaller orders spread out?  How can I avoid having my own orders drive the price up?

  • On 10/28, cy said:

    one more question relating to my previous one:
    At some point, if the MM keeps raising the ask price of my calls at the $15 strike price, they would theoretically become more expensive than the calls at the $12.50 strike price.  This is obviously impossible and he would instead raise the price of the entire call chain.  but I’m starting to wonder if there’s a limit to how high he’ll raise these prices (since he’ll have to raise the other prices as well) just to satisfy my orders thus risking losing any potentially interested buyers at the other strike prices.
    i hope that made sense!

  • On 04/07, Pk said:

    One way to get around the market makers seeing your limit order in their book is to use conditional orders to create a “virtual” limit order. These are now offered by most online brokerages. For example, the b/a is .70 - .90 on your long put which you want to buy at .60. Instead of creating a limit order to buy at .60 which will tip off the MM, you can place a conditional order with your broker like this: When the ask goes to .60 or below, place a limit order to buy at .60. This hides your intention from the MM until it is too late for at least a partial fill. Best results are on low volume orders which don’t exceed the average ask volume.

  • On 04/08, Pete Stolcers said:

    That is an excellent point and I use conditional orders in my trading. Another advantage to conditional orders is the ability to based them on the underlying stock. Decsions should be based on technical support and resistance levels for the stock, not the price of the option.

  • On 04/08, Pk said:

    I think that both the technicals and the price of the option are important for just the reason that you brought up earlier: the market makers like to play games with pricing when they have a persistent order in their book. By using a conditional order, you can ensure that you get filled at a price you predetermine is appropriate for a given level of the underlying.

    I know my broker hides this type of conditional from the MM, but are there any brokers or types of conditionals that get passed directly to the MM?

  • On 04/09, Pete Stolcers said:

    Brokerage firms leave conditional orders on their servers until the condition is met, then they route the order.

  • On 04/18, delbertino said:

    I have placed a limit order at bid and I’m allowed .05 increments between bid of .05 and ask of .10; I’m in no hurry and I don’t know enough to worry. I appreciate the ‘splaniations’ a ‘whole’ bunch. Thanx; newbie sickie

  • On 04/18, delbertino said:

    Thanx for the help in limit orders. I just placed a limit order at .05 between .05 and .10. Thanx; I’ll know what to expect.

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