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Lesson 5 - Types of Options Orders

by Uncle Bob Williams

While we are discussing Options pricing and negotiating price, we will proceed now to consider the types of Options Orders - we will continue the description of the 2 last columns (Vol and Open Interest) in the Options Chain that follows.

There are only 2 kinds of Options orders:

We will discuss some of the different types of conditional Options orders, but no matter how sophisticated those orders sound, it is critical to understand that there are only 2 kinds of orders: Market Orders and Limit Orders.

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Market Order:

If we place a Market Order, we are guaranteed to be filled for the QUANTITY of Contracts we want to trade, but we are not guaranteed what price we will pay.

Example: If we buy the 510 Google CALL Option with a Market Order, we would be guaranteed to be able to buy as much as we wanted, and we would have to pay the full ASK price—$5.20 per share in our example.

In general we will pay the BID or the ASK price, but the Market Maker is not forced to give us those prices. We can pay more than the BID or ASK price, which is rare, but the Market Maker can't really take advantage of us because we can complain if something wasn't done correctly.

The key to remember:

Market Orders: guarantee QUANTITY, not price.

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Limit Order:

If we place a Limit Order, we are guaranteed to be filled for the PRICE we want, but there is no guarantee on the quantity. In fact, they don't have to sell us anything.

Example: If we buy the 510 Google CALL Option with a Limit Order, we can set the Limit of what we want to pay at $5.10 per share. The Market Maker can only sell to us if he is willing to meet our price of $5.10 per share or give us a better price. (In Options with a lot of trading activity it is possible to get a better price than our Limit price, but it's not usual.)

With a Limit Order, we are not guaranteed any quantity. For example, we may want to purchase 10 contracts of this Option, and the Market Maker may decide to only sell us 1 contract for $5.10 per share.

The key to remember:

Limit Orders: guarantee PRICE, not quantity.

Remember: those are the 2 Options orders we can place. All the other 'order types' are conditions for placing a Market Order or a Limit Order.

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"Spread Orders"

Most of the orders we will make trading the strategies in Uncle Bob's Money are "spread" orders, which means we can place a 'net' order for 2 or more positions at one time.

For example, we will make a CONDOR Spread on our fictitious Acme Company which is currently trading at $50 per share.

The Condor Spread is made up of these 2 trades: We sell one CALL Contract, and then we buy one CALL Contract further away from the current underlying price, as follows:

SELL 1 | ACME | JUNE | 55 | CALL | Bid = $1.40, Ask = $1.60, Mark (mid price between the Bid and Ask = $1.50)

BUY 1 | ACME | JUNE | 57 | CALL | Bid = $0.95, Ask = $1.05, Mark (mid price between the Bid and Ask = $1.00)

We could try to trade each contract independently, but the price of the underlying may change these Options prices while we are trying to get filled on these two trades. This could potentially create a nerve-wracking situation of getting our trades filled quickly so that we don't lose money. Instead, we can trade with a calm and cool head, and we can guarantee how much profit we will make if we put in a "Spread" order.

In this case, we enter ONE order to:

SELL 1 | ACME | JUNE | 55 | CALL

and

BUY 1 | ACME | JUNE | 57 | CALL

The price we will start to negotiate on this trade is $0.50 per share.

We calculated the $0.50 Net Amount by looking at:

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The Mark (mid price) of the 55 CALL = $1.50
MINUS
The Mark (mid price) of the 57 CALL = $1.00
EQUALS
$0.50 NET if we can make both trades simultaneously.
(With a CONDOR, we will get PAID that $0.50 per share as soon as we make this trade. How cool is that! -- But there is risk, and we will explain more in greater detail later.)

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With this "Spread" order, we don't have any worries or problems if the price of the Underlying and the Options change while we are making the trade. The Market Makers can accept my "spread" with the Net amount, or not. If our spread doesn't get filled, we can cancel the Spread order, and replace it with a new one. In the case above, we could duplicate the same order and put in a Net amount of $0.45 per share - and again wait a few minutes to see if our offer will get filled.

When our order does get filled, we just locked in the amount that we wanted to make on this specific trade and we did it without any pressure or panic to get our order filled.

Spread orders are also critical when we don't get our order filled. Let's say for example, that the minimum profit we would be willing to take on the Spread above was $0.45 per share. If we cannot get that Spread order filled, then we know to walk away from this trade. We would not cancel and change our order to $0.40 per share, because we know in advance that $0.40 per share is not enough profit on this trade for the amount of risk involved. If we think back to our Insurance example, if someone wanted to buy Car Insurance from us, we would know how much to charge for the premium for that specific risk, and we won't take less than that amount because we know statistically if we take less money on the premium, we will lose money. The same is true here with these Spread Orders. The Uncle Bob's Money Trade Finder will show us the most Optimum trades, and we also have specific guidelines for those trades. We will show you where the boundaries are for specific trades so that we consistently make trades where the probabilities and levels of risk stay in our favor.

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Variations of the Limit and Market Orders: Stop, Stop Limit, Trail Stop, Trail Stop Limit:

Remember, there are only 2 types of orders: Market and Limit orders. These other variations—Stop, Stop Limit, Trail Stop, and Trail Stop Limit—are not different kinds of orders. Instead, they are triggers that indicate when our Market or Limit order will be placed.

STOP
A Stop order is a MARKET order that has a price trigger that will make our order live.
For example, if someone decided to do a Covered Call on Acme Company from our examples above:
=> Acme underlying is currently trading at $50 per share.
=> They previously SOLD 1 | ACME | JUNE | 53 | CALL |
=> They can put in a "STOP" order if the price of Acme gets too high. In this case the Stop order might be: If the Mark price of Acme reaches $53, then place this MARKET order: BUY 1 | ACME | JUNE | 53 | CALL
This will close out their short CALL position.

NOTE: A Stop order is a MARKET order, so we will pay full price. We are guaranteed to get filled for as many contracts as we want, but we are not guaranteed which price we will pay. But, don't write off Stop orders. Stop orders are very helpful when we set a conditional order. If we aren't able to monitoring our Options positions all the time that the Market is open, we will want to use Stop orders to protect against a major loss. If the market makes a fast drop, we could be exposed to a large loss, and while it is true that we will pay a high price to exit our positions, it is better to pay a high price to exit than to experience a massive loss.

STOP LIMIT
A Stop Limit order has a price trigger that will make the order live - just like the Stop order. However, it becomes a LIMIT order when it is live and there is no guarantee that it will get filled.
From the example above, the person may decide they are only willing to cash out of their Covered Call if they can get a certain price; otherwise they are willing to leave it.
=> Acme underlying is currently trading at $50 per share.
=> They previously SOLD 1 | ACME | JUNE | 53 | CALL |
=> They can put in a "STOP LIMIT" order if the price of Acme gets too high. In this case the Stop Limit order might be: If the Mark price of Acme reaches $53, then place this LIMIT order: BUY 1 | ACME | JUNE | 53 | CALL | Limit Price = $1.50 per share.
If this order is filled, it will close out their short CALL position. With the Stop Limit order, the person is able to say how much they are willing to pay. It's like saying, "take this or leave it". The market can accept their Limit price or leave it.

NOTE: Since it is a LIMIT order, there is no guarantee that the order will be filled, so it's very important to place Limit orders only when we can afford to let the order expire without being filled. If the Market makes a fast drop, and we want to exit our positions, the Limit order won't necessarily help us. We may not get filled, we won't know what the actual pricing will be in that situation, and additionally when the market is dropping fast, the Options pricing changes very quickly and the Market Makers will not generally fill a Limit order unless the price is as the same as or close to the Market price.

NOTE: It is possible to set conditional orders in a series so that we can do some small amount of automated negotiation if the market pricing changes. However, this is an advanced topic we will discuss later.

TRAIL STOP
A Trail Stop order is a Market order that goes into effect after a specific price change has occurred. The idea behind a Trail Stop is that you want to maximize your profits if a Stock price rises, but cash out before the price drops down too much. If we owned Acme Company and the price of the stock keeps going up, we can make a Trail Stop order like this: If the price of Acme reaches $53, then place a Market Order to sell if the price drops down $1.00 per share. With a Trail Stop, if the price of Acme keeps going up, the Stop order will only be activated when the price of the stock drops $1.00. If the price keeps climbing to $57, and then drops down to $56, the Stop order (Market Order to Sell) will be placed into the market and we are going to lock in close to $6 in profit.


Trail Stop orders can also be placed on Options, and we can use the Bid price of the Option as the trigger for the Stop order (Market Order to sell).

NOTE: A Trail Stop is still a Market Order. What makes it different is the trigger for when that order is placed.

TRAIL STOP LIMIT
A Trail Stop Limit is a Limit order that goes into effect after a specific price change has occurred. It is the same as a Trail Stop, except that the order that gets triggered is a LIMIT order, and there is no guarantee that our order will be filled.

NOTE: With a Limit order we are guaranteed on the price, but we are not guaranteed on the quantity.

NOTE: Generally, it is possible to get better trade Fills at the end of the day rather than in the middle of the day.

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Order Expiration:

When we place an Options order, we can specify if the order will only be active for that Day or if it will be "Good 'til Cancelled" (GTC).

Day Order
Day Orders are only good for that day, and will expire when the Options trading day ends if they are not filled.

NOTE: If we are trying to negotiate on price, we should use Day Orders. Day Orders seem to get more attention from the Market Makers than Good 'til Cancelled orders do.

Good 'til Cancelled (GTC)
Good 'til Cancelled (GTC) are Limit orders that will continue to be valid until they are filled, until that Option has expired, or until that order has been live for too long. (IE: We can't place an order for an Option that expires a year from now and let it ride the entire year.)

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Advanced Order Sequences: (OCO) One Cancels Other, (OTO) One Triggers Other, First Triggers: OCO, and Blast All

(OCO) One Cancels Other
One Cancels Other allows us to place 2 or more trades into the market at the same time, and when one of the orders is filled, it will automatically cancel the other orders. This is an advanced technique where we may have a few different Options strategies that look good, but we are interested in only taking the one with the best pricing, so we can use (OCO) One Cancels Other to put all those strategies into the market at the same time, and the 'extras' will get cancelled as soon as one of the strategies is filled.
NOTE: It is possible that more than one order can be filled. When we place an OCO order, ALL the orders are LIVE and it is possible that more than one order can be filled before the other orders are cancelled.

(OTO) One Triggers Other
One Triggers Other allows us to place one or a sequence of trades to occur after a specific trade occurs. For example, we may have an order for a Condor Spread, which is one of the strategies we use at Uncle Bob's Money, and as soon as the Condor Spread is filled, the OTO order could automatically then place a Stop order to close the Condor Spread if the Market reaches a certain price.
In practice, we would more likely make the Condor trade actively, and then after it is filled at the best price we could get, we would then make a conditional order using a Stop order to limit our loss if the Market makes a big move.

First Triggers: OCO
First Triggers: OCO is very similar to the (OTO) One Triggers Other, except here it is given a special name because it is a more common special order and some Brokers have trade forms set up to make this type of order easy to put into their systems. From the example we used above with the Condor spread, we may want to have 2 conditional orders that will cancel the other if one is filled. We may want a conditional order like that above that will protect against a big loss if there is a massive Market move, and we may also want to put a conditional order on the other side that will close the position for you automatically when we have made a certain amount of profit.
For example, if we get a $1.00 Credit per share on the Condor trade, we may want to make a limit order of say $0.20 per share when the market price of the underlying reaches 10 points higher than it is now.

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In The Money

"IN THE MONEY" means that the Option has Intrinsic Value. For example, if Acme Company stock is trading at $55 per share, and we have a CALL Option at the $52 strike, our CALL Option is $3.00 IN THE MONEY. Right now, that CALL option has $3.00 of real value. If the Option Expires, we will get paid $3.00 per share for a cash settled Option, or if it's a stock settled Option that means we can buy the stock at $52 per share instead of $55. When trading stock settled Options, make sure to understand what happens at Expiration with the Broker: it's usually best to exercise the Option before expiration.

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Out of the Money

OUT OF THE MONEY means that our Option expired worthless. For example, if Acme Company stock is trading at $50 per share, and we have a CALL Option at the $52 strike, our CALL Option is OUT OF THE MONEY. There is no intrinsic value to the Option and if this is what happened at Expiration, then the Option would expire worthless.

It's important to mention here that even though an Option may be OUT OF THE MONEY, that Option may still have a lot of value prior to Expiration. This value is called "TIME PREMIUM". Time Premium is the value that the market gives to an Option because of the probability that it will go IN THE MONEY before Expiration.

For example, 2 of the strategies we use at Uncle Bob's Money—Condor and Double Diagonal—only utilize Options that are OUT OF THE MONEY.

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European & American Style Options

A European Style Option can only be Exercised immediately prior to the expiration. An American Style Option can be exercised at any time. Options on stocks are American Style Options, while Options on Indexes can be either European or American style.

In practical terms, it means that if we trade European Style Options, like the SPX (S&P 500), RUT (Russel 2000) or NDX (NASDAQ 100 INDEX) for example, we will never have an early exercise. With Options on Stocks or some Indexes that are American Style Options, it is possible to have an early Exercise, but it's not something to worry about.

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Early Exercise

Exercise means that the Option holder uses their right in the Option to buy or sell the stock at the strike price of the Option. An Early Exercise is where the Options holder will "exercise" their option prior to Expiration.

For example, if we have:

1 Contract | ACME | JUNE | 52 | CALL |

and the underlying price of Acme reaches $53, we can exercise our CALL option and purchase 100 shares of Acme for only $52 per share. Although some people do Exercise their Options, in practical terms it is much easier to just sell the Option. If we Exercised the CALL Option, we would purchase 100 shares of Acme for $52, then we can immediately sell those shares on the open Market for $53 per share, giving us a Net Profit of $1.00 per share or $100 Profit.

However, it is much more simple for us to sell the 52 Strike CALL Option. This CALL Option has $1.00 of Intrinsic Value, and may also have some Time Value. So, the market price of our CALL Option is at least $1.00 per share, so we can sell this Option for $1.00 per share, and we take in the same profit of $100, without all the added hassle of buying and selling the stock.

NOTE: Some Brokers have an additional fee to Exercise an Option, so the cost to Exercise can be higher than just buying and selling the stock.

Someone can only Exercise an Option that we hold if we SOLD that Option. With Options that we bought, WE have the right to Exercise.

So what happens if someone does Exercise an Option we are holding? Most of the time, this will only happen with Options that are IN THE MONEY, because to Exercise an Option that is OUT OF THE MONEY would be more expensive than just buying or selling the shares on the open Market.

Since an Option Exercise can seem scary at first, let's  carefully examine the different scenarios so we can take all the mystery out of Exercise.

Exercise of IN THE MONEY CALL: Underlying Price= $52 | We Sold 1 Contract | ACME | JUNE | 50 | CALL (Option price = $2.00 per share)
=> The CALL holder has the ability to purchase 100 shares of Acme at $50 per share from us.
=> From our position, the Exercise is almost the same as if we bought this Option which we had previously sold.
=> We will have to pay $2.00 per share to fill the difference in stock price between the Call price of $50 and the market price of $52.
=> We can immediately sell another Option for $2.00 to make up for that money that we just put out of pocket, and we are back to where we started before the Exercise.

NOTE: When the Option holder Exercises an Option, he loses any TIME VALUE that was in the Option. So, it is possible that we could make money on the Exercise. Let's say for example that the Option price above is actually $2.25 per share ($2.00 of Intrinsic Value, and $0.25 of Time Value).
When he Exercises the Option, we still need to come up with $2.00 ($200 for 1 Contract) to make up the difference between the Option Strike Price and the Market Price, but then we can immediately turn around and sell an Option for $2.25 which is $0.25 more than we just paid. We get $225 for the sale of the Option to put ourselves back to where we were - taking in an extra $25 for our efforts.

Exercise of IN THE MONEY PUT: Underlying Price= $48 | We Sold 1 Contract | ACME | JUNE | 50 | PUT (Option price = $2.00 per share)
=> The PUT holder has the ability to sell 100 shares of Acme at $50 per share from us.
=> From our position, the Exercise is almost the same as if we bought this Option which we had previously sold.
=> We will have to pay $2.00 per share to fill the difference in stock price between the PUT price of $50 and the market price of $48.
=> We can immediately sell another Option for $2.00 to make up for that money that we just put out of pocket, and we are back to where we started before the Exercise.

NOTE: Again, when the Option holder Exercises an Option he loses any TIME VALUE that was in the Option. So, it is possible that we could make money on the Exercise.

Exercise of OUT OF THE MONEY CALL: Underlying Price= $50 | We Sold 1 Contract | ACME | JUNE | 52 | CALL (Option price = $1.00 per share)
=> The CALL holder has the ability to purchase 100 shares of Acme at $52 per share from us. (That's $2.00 MORE than the Market price.)
=> We will buy the stock for $50 on the open Market, and we will get paid $52, giving us an immediate $2.00 per share profit. Nice!
=> We can then sell another Option for $1.00 to put us back to where we started before the Exercise of this Option, and we end up making $1.00 per share profit for our troubles.

Exercise of OUT OF THE MONEY PUT: Underlying Price= $50 | We Sold 1 Contract | ACME | JUNE | 48 | PUT (Option price = $1.00 per share)
=> The PUT holder has the ability to sell 100 shares of Acme at $48 per share from us.
=> We will have to buy the stock for $48 from him, and we can immediately turn around and sell those shares for $50 on the open Market. Giving us an immediate profit of $2.00 per share.
=> We can then sell another Option for $1.00 to put us back to where we started before the Exercise of this Option, and we end up making $1.00 per share profit for our troubles.

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Short / Long

Long

Long means that we bought an Option. If we buy 1 Contract | ACME | JUNE | 52 | CALL, then people use the term "We are LONG the Acme June 52 CALL".

Short

Short means that we sold an Option that we didn't own. If we sell 1 Contract | ACME | JUNE | 52 | CALL, then people use the term "We are SHORT the Acme June 52 CALL".

In the strategies that we use at Uncle Bob's Money, we will have both Short and Long positions which make up 'spreads'. Don't worry though; having a 'short' position in a Spread doesn't mean that we are facing an unlimited risk. With 2 of the strategies we use: Calendars and Butterfly trades, the maximum risk that we have is the amount of money that we pay for the spread: even if the world comes to an end. With an Iron Condor or Double Diagonal, the amount of risk we have from our 'short' positions is clearly defined and known BEFORE we make the trade.

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Number of Exchanges that an Option trades on.

The pricing on an Option, and the amount of negotiation that we can do, is strongly influenced by the number of Exchanges that Options on that Underlying (Symbol) trade on. For example, the SPX (S&P 500 Index) only trades on the CBOE Exchange, and so the Bid / Ask Price Spreads are wide and the amount of price flexibility is generally small.

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