The order you enter should reflect your trading strategy, not just be placed to effect the trade. For example, if you are entering a trade in leisurely fashion, you might want to put a tight limit on the order; after all, you’re not in a hurry. But if a trade is hurting you and you want out immediately, you would use a market order to get the fastest fill possible on the order and avoid the risk that the market will trade through your order and either not be filled or be filled at a less advantageous price. When your order is executed, it has been “filled” in trading parlance, and the price at which it was executed is known as the “fill” obtained.
Market Order – an instruction to buy or sell the stock or options at the best market price available at the moment. Market makers are required to take market orders, but not limit orders. Thus a market order will definitely be filled, but you cannot be sure of the price, since market orders generally are filled in the order entered. Market orders can stack up, especially at the open, and your order must get in line.
Prices will vary with current conditions, and these conditions are not always reflected on your computer screen. The actual fill you get may be better or worse than expected. A market order guarantees execution, but not price. Market orders are for when execution – getting in or, more usually, getting out -is more important than the price.
Example: If you want to buy 500 shares of DELL when the current market is 20.05 x 20.09, you expect to pay $20.09. But as market makers fill orders for the number of shares specified in their posted offers, the offer may go up or down. Thus you could pay more, or less, for the stock.
Limit Order – sets a price restriction on your transaction. You indicate that you are only willing to buy or sell stock or options (or even a combination order of stocks and options) at a certain price, or better. Your order is not filled unless the security trades at that level. There is never a guarantee that your limit order will be executed at your limit price, or at all. The order will be filled if it is the next in line for execution and there are securities available at your price to fill or partially fill your order. It does eliminate the risk that your order will be filled at a price worse than you expected; though the security can move adversely after the order is filled! The limit order guarantees price, but not execution.
Example: If you enter a limit order to buy DELL at $20.05 (you are offering to buy DELL at this price) when the inside quote is 20.05 x 20.09, your order will not fill immediately. Only if someone offers the stock at your price will you get filled at 20.05, assuming your order is next in line for execution. If more buyers enter the trading area and drive up the stock price, your order will not be filled.
Be aware that many brokerage firms impose an additional cost for entering a limit order. However, the cost – if any – should be nominal. Getting a better fill of even $0.05 on a trade will more than pay for any extra cost associated with the limit order. The larger firms often are the worst offenders here.
Stop Order – this is a contingent order to buy or sell a security at a price level you specify (the “stop” or “trigger” price). Once the security has reached this price, a stop order becomes a market order and gets in line to be filled as any other market order. There are sell stops and buy stops.
A sell stop is generally used by one who owns a security and wants to sell out if the security’s price starts to drop. The trigger price placed on the stop order must be below the current bid price of the security. The sell stop is frequently known as a “stop loss” order (a term the SEC, Nasdaq and exchanges don’t like, since it does not necessarily stop a loss and implies more protection than it sometimes provides). The sell stop is a short order that is essentially protective in nature. They can be particularly important in fast-moving markets and for times when you are unable to watch the security and react when the stop level is reached. Note that watching a position without entering a stop order is known as using a “mental stop“. Stocks for covered call trades are discussed below under Contingent Orders.
Example: You buy 500 shares of DELL at $20.10 per share. To limit your loss in the event of a pullback, you enter a sell stop order at $19.60; if DELL trades at 19.60 your sell stop becomes a market order and the market maker or specialist will sell it at the market bid price. Stop orders in volatile issues will not guarantee an execution at or near the trigger price. Once triggered, they are competing with existing incoming market orders. Suppose DELL gets hit by bad news after the bell, trades down all night and gaps down to $15 on the open? Your 19.60 stop order becomes a market order, but in this situation you might not even get $15 for it.
A buy stop is used by one who expects the security to advance. The order fills if the market price touches or goes above the buy stop price. This order is used to try and guarantee a profit, since the expectation is that the order will be triggered as the security’s price advances above the buy stop. It does not always work out like this, of course. The price can touch or rise briefly above the stop price and then retreat. The trigger price specified for a buy must be above the current asking price.
One disadvantage of the stop order is that it’s not guaranteed to fill at the order price specified. Once the stop order has been triggered, it turns into a market order, which is filled at market. The fill gotten may be lower than specified by a sell stop, or higher than specified in a buy stop.
Stops set too tight: If the stop is set too tight – too close to the current price action – a brief oscillation in the price could activate the order and sell you out of the position.
Example: If DELL, now at $20, tends to fluctuate down to the $19.50 level in intra-day trading, a sell stop set above 19.50 could easily be activated to cause a needless loss.
Stop Limit Order – essentially the same as a stop order with one major exception: once triggered, it becomes a limit order, not a market order. That is, the trigger price becomes the new limit price for your order. This order gives the trader far more control, but the disadvantage is that there’s no guarantee of getting filled. Because it transforms into a limit order and offers little real protective power, the stop limit is not used where an immediate exit is needed. It also is chancy to use the stop limit where price is moving fast. A stop limit should be used only to try to realize a better price, not as a stop loss.
Example: Rambus (RMBS) is trading at $39 and a stop-limit order is entered to buy with the stop price at $40 and the limit price at $41.25. If RMBS moves above the $40 stop price, the order is activated and turns into a limit order. As long as the order can be filled under the $41.25 limit, then the trade will be filled. If the stock moves above $41.25 before the stock can be bought, the order will not fill.
Many brokers also allow entry of a trailing stop order; instead of a stop price, a stop parameter is used, creating a moving or “trailing” activation price. The stop parameter can be entered in points or by percentage. The trailing stop is not commonly used in covered call writing.
After a stock split or a stock dividend payout, the price on all buy limit orders and the trigger price on all stop orders and stop limit orders is proportionally adjusted. This can affect covered call orders, as well, where the price of the underlying is adjusted.
Just as the type of order must be specified, you must specify its duration: how long the order is to be good. Not all brokers offer all durations of orders, but these are the most common durations:
Day Order – is good through the end of the trading day on which it is entered. It automatically expires at the day’s close unless filled. If unfilled, you must enter the order again the next day. If you don’t specify otherwise, an order will be treated as a day order. All market orders are good for the Day only.
Good until Canceled (GTC) – means that the order remains active until it executes, is canceled, or expires. The expiration date for all GTC open orders is the last trading day of the next month after the order has been placed. For example, a GTC order placed on March 12th, left unfilled and un-canceled, would be canceled automatically on April 30th, if not earlier. GTC cannot be used for market orders.
Good through Date (GTD) – means that the order remains active through the date specified by the trade until it executes, is canceled, or expires. It cannot last longer than a GTC order. GTD cannot be used for market orders.
Contingent orders, in which the execution of a leg of a spread or combination trade is contingent on another transaction, are made for covered call and spread writing. In fact, it would be difficult without them. Entering a stop order on a covered call would be impossible without them.
One Triggers Other (OTO) – allows you to enter an initial order and place a second order contingent upon the fill of the first order. For example, this order structure is used to place a stop order on a covered call; if the stock falls to a certain level, it triggers the repurchase of the call and the sale of the stock.
One Cancels Other (OCO) – allows the simultaneous entry of two orders, and when one is filled, the other is canceled. The two orders have to be expressly linked together as OCO. For example, a trader long DELL shares could enter an OCO order including a sell stop order (to protect against loss) and a buy stop limit order to add to an improving trade. If the stock drops, it will trigger the sell stop, which cancels the buy stop limit order.
Combination (combo) orders – these are linked orders in which the broker must execute the entire order simultaneously, or not at all. Good examples are covered call writes and spread orders. Note that this is essentially a variant of the old fill-or-kill order, which specified that the entire order had to be executed or not at all.
There are other types of contingent orders, but these are the ones that concern covered call writers and spread traders.
Orders in Covered Call Trades
The OTO and combination orders – if permitted by your broker – have profound applications in covered call writing, as we will see in a subsequent article. For example, the OTO order can be used in the covered call trade as a stop order. An OTO order can be placed that orders the broker, if the stock falls to a certain price, to repurchase the calls and sell the stock. This is important, because a stop order cannot be entered on a combination position, since the stock stop order goes to Nasdaq or the exchange and the option stop order goes to the options exchange. Only your broker can effectively process an order that acts as a stop on the entire position.
The combination limit order is used on entry or exit of a combination position such as a covered call or collar (covered call plus a long put). The order is to place or close the entire position at a specified debit (entry) or credit (closing) amount, which is the amount of the limit order.
The “Show or Fill” Rule
All customer orders placed are shown in the systems where they are entered (Nasdaq, NYSE, CBOE, etc.). A buy or sell order is considered “published” if it shows as a bid or asked quotation visible to all specialists or market makers. Following some extensive litigation in the late 1990s, the SEC adopted a set of rules including Rule 11Ac1-4 (the Customer Limit Order Display rule) under the Securities Exchange Act of 1934, though it is known in the industry as the show or fill rule. This rule provides that if a customer enters a buy or sell order that would improve the bid or offer of a security, the market maker or exchange specialist must publish the quotation, in which case it becomes the high bid or low asked price. An order improves the market when it is in the “middle” between the inside quotes.
For example, if the inside quotes on the current 80 Call option are 4.25 by 4.60 (a $0.35 spread), a buy order higher than 4.25 would improve the bid price, and a sell order lower than 4.60 would improve the asked price. Suppose you wanted to buy the 80 Call but did want to pay the $4.60 asked price; you might enter an order to buy the calls at $4.45. This is a limit order, which market makers are not required to fill. But the show or fill rule requires that your $4.45 buy order be published by the market maker as the new high bid price, which means that the published inside quotes will now change to 4.45 x 4.60. If someone else puts in a new sell order at $4.50, the inside quotes will narrow even further, to 4.45 x 4.50. Prior to the show or fill rule, the market maker did not have to publish the order, leaving the bid and asked prices unchanged; even though the order was in the system, and all market makers could see it.
Because the CBOE and other option exchanges typically require that a published bid or offer quotation be good for at least 10 contracts, the market maker could be obligated to sell 10 contracts of the 80 Call at the $4.45 price. If your order is for only a few contracts, the market maker may consider it less troublesome to simply fill your order at $4.45 rather than publish it as the new high bid quotation.
This is particularly the case when the market for the calls is not very liquid and the market maker does not want to sell more contracts than you are looking to buy. If your order is for 10 contracts or more, however, the market maker will not feel as pressured to fill your order. This works as well on the sell side, of course. If you are filled at $4.45, as in our example above, you have beaten the $4.60 market asked price by $0.15, which is a great result. If the premium was only, say, $0.90 to begin with, the added $0.15 improves the premium by almost 17% – these nickels and dimes add up.
Using the show or fill rule, it is often possible to get a better fill on orders, particularly where only a few contracts are involved. However, it makes sense to try getting a better fill on every order, even if for a larger number of contracts. Now you know how. This works for stocks and options both.
There are some exceptions to the show or fill rule. Obviously, the order need not be published if it is filled, though it will immediately show as the last sale price. In fact, where prices are stable and you see an abnormally high transaction price that occurred in the “middle” it often indicates that an order was filled to avoid showing it, which is nice to know. In addition, the order need not be published if it is an “all or none” order (meaning the entire order must be filled, or none of it), if it is for less than 100 shares, and in certain other circumstances.
You do run the risk of having only part of the order filled and requiring more than one transaction to complete the order, but on orders of a few contracts this does not happen too often. The market makers often prefer to move your troublesome order out of their tidy little market.
Market makers are required to comply with the show or fill rule for stocks, options and other securities. Many brokerages also act as market makers and, somehow, never get around to popularizing the use of this SEC rule. Go figure.
Warren Buffett eloquently and accurately observed that the market, like the Lord, helps those who help themselves. But unlike the Lord, the market does not forgive those who know not what they do. The show or fill rule illustrates this adage, as do many other things in this article. Ultimately, patience and discipline will take you to consistent success in any investing or trading endeavor. But at no point along the way does ignorance improve your results.
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