Ever been knocked off your feet?
Well, if you don’t have a strong handle on the different types of options orders it will happen soon. That’s why traders who migrate to options trading from the world of stock trading often find it very difficult to grasp immediately the types of orders that are available. With stocks, you can only do one of the two things: buy or sell.
With options, there are four major types of orders and two major ways of placing an order.
4 Types of Option Orders
The four types of options orders available for most traders are: buy to open, sell to open, buy to close, and sell to close. What makes it even more confusing for newcomers is that it is often necessary to combine more than one order type to set up a particular kind of trade, e.g. an options spread.
Buy to open. A trader will use this type of order when he or she wants to buy a call or a put option, or a combination of both. For example, if 3-month ATM call options for company ABC are trading at $2 and 3-month put options are selling for $1.90, a trader who wishes to set up a long straddle will buy to open calls at $2 and simultaneously buy to open puts at $1.90.
Sell to open. This is when a trader wishes to open a trade by selling options, e.g. naked calls or naked puts. Returning to the above example, the trader could set up a short straddle by selling to open calls at $2 each and selling to open puts at $1.90 each.
Buy to close. This is not the type of order to use if a trader wants to open a trade. This is rather used to close a previously opened short options position. The trader with the short straddle in the sell to the open example above would use a buy to close order to exit his position. Such a trader is therefore buying back the options he or she previously sold to close the trade, hence the term ‘buy to close’.
Sell to close. This should be easy to understand for most traders. It’s simply the way to close an existing long options position. A trader who previously used a buy to open order to enter a long straddle would, for example, use a sell to close order to close that position.
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Combining Different Orders
Where things become confusing for newcomers is when you have to use a combination of the above to enter a trade. To set up an iron butterfly, for example, a trader has to sell to open an ATM Call and an ATM Put and simultaneously buy to open an OTM call, and an OTM put.
What is useful here is to always take note of the part of the order that comes after ‘to’. When setting up a trade that should always be ‘open’, e.g. buy to open, sell to open and when closing a trade that should be ‘close’, e.g. sell to close, buy to close.
Market Orders and Limit Orders
As with stock trading, in options trading you also have the choice of using either market orders and limit orders.
A market order instructs the broker to buy or sell the options at the next market price. If the price suddenly gaps, this could mean getting filled at a really bad price – hence the increased margin requirements of such an order.
With a limit order, the trader asks the broker only to buy or sell at below or at a certain price. While this means less uncertainty, it could also mean that you could have an order sitting around that might not be filled and miss a great market move.
Guest Post by Marcus Holland of Option-Trading.com