Ever been knocked off your feet? Well, if you don’t have a strong handle 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.
On the other hand, 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 option 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
This is arguably one of the most commonly placed types of option orders in options trading. A trader will use the buy to open order when he or she wants to buy a call or a put option, or a combination of both. These orders are commonly used when traders anticipate that particular options contracts will go up in value or when they would like to exercise the option in future.
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
The sell to open order is used when a trader wishes to open a trade by selling options e.g. naked calls or naked puts. If you feel that a particular options contract is set to fall in value and thus want to take advantage of that move, you may consider using a sell to open order to short sell that option. Conversely, you can use a sell to open order to write a put options contracts when anticipating that the price of the underlying security will go up. In such a case, you effectively go long the underlying security.
Going back 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 option order to use if you want to open a trade. The order is rather used to close a previously opened short options position. A 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’.
There are several circumstances under which a trader might choose to use a buy to close orders to exit their current position. For example, if the value of options contract they created has gone down, they may choose to buy back those options contracts using a buy to close order and consequently collect their profits at that point. Alternatively, if the underlying instruments have gone up in value, they may decide to cut their losses further by placing a buy to close order which will allow them to buy back the options contract.
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.
Essentially, you can use this type of order to realize profits after the value of options contracts you own goes up. Besides, the same order can also be used when seeking to dispose of any options contracts that are falling in value in a bid to cut losses.
Combining Different Orders
Where things become confusing for newcomers is when they have to use a combination of the above orders 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 or 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. One of the main advantages of using market orders is that you’ll often fill your order quite fast, sometimes even instantly. However, there’s a catch. Be ready to pay a little more especially if your order is large and the trading volume is thin.
With a limit order, the trader asks the broker only to buy or sell at below or at a certain price. This way, an order may never be executed at a price higher or lower than the investor’s limit price. One of the main advantages of using limit orders is that you are in more control of the price at which you trade your options. On the other hand, however, a failure by the underlying stock price to move at the desired pace may inhibit your order from getting filled as quickly as you’d like. This way, you may miss a chance to realize a profit.
Any thoughts on today’s post? Feel free to air them in the comment section below.
Guest Post by Marcus Holland of Option-Trading.com