One thing I take for granted these days that a lot of newbie traders may not fully understand is the different order types that are available through your online brokerage. I just checked on Interactive Brokers, and they have OVER 50 DIFFERENT order types. Needless to say that is probably a little overwhelming for people who are new to the game.
Beginners need to understand the fundamentals of placing options trades before they can start looking at different strategies. It is important to build a solid base knowledge before risking real money. Mistakes due to putting in an incorrect trade order can be very costly and are easily avoided. Here is a brief explanation of some of the basic option orders types.
Market – Will trade at the current price. A Market order is an order to buy or sell at the market bid or offer price. A market order may increase the likelihood of a fill and the speed of execution, but unlike the Limit order a Market order provides no price protection and may fill at a price far lower/higher than the current displayed bid/ask.
Limit – An order to buy or sell at a specified price or better. A limit order ensures that if the order fills, it will not fill at a price less favorable than your limit price, but it does not guarantee a fill.
Stop – A stop order is a market order that does not get submitted until a specified stop trigger price is hit. A Stop order is an instruction to submit a buy or sell market order if and when the user-specified stop trigger price is attained or penetrated. A Stop order is not guaranteed a specific execution price and may execute significantly away from its stop price. A Sell Stop order is always placed below the current market price and is typically used to limit a loss or protect a profit on a long stock position. A Buy Stop order is always placed above the current market price. It is typically used to limit a loss or help protect a profit on a short sale.
Stop Limit – As above but submitted as a limit order rather than a market order. A Stop Limit order instruct the system to submit a buy or sell limit order when the user-specified stop trigger price is hit. The order has two components: the stop price and the limit price. When a trade has occurred at or through the stop price, the order becomes executable and enters the market as a limit order at the limit price. A Stop Limit eliminates the price risk associated with a stop order where the execution price cannot be guaranteed, but exposes the investor to the risk that the order may never fill even if the stop price is reached. The investor could “miss the market” altogether.
Trailing Stop – A Trailing stop order moves with the market price, trailing it by a specified amount or percentage. A market order is submitted when the direction of the move changes and your stop price is triggered. A sell trailing stop order sets the stop price at a fixed amount below the market price with an attached “trailing” amount. As the market price rises, the stop price rises by the trail amount, but if the stock price falls, the stop loss price doesn’t change, and a market order is submitted when the stop price is hit. This technique is designed to allow an investor to specify a limit on the maximum possible loss, without setting a limit on the maximum possible gain. “Buy” trailing stop orders are the mirror image of sell trailing stop orders, and are most appropriate for use in falling markets.
Trailing Stop Limit – As above but submitted as a limit order rather than a market order when the stop price is triggered. A trailing stop limit order is designed to allow an investor to specify a limit on the maximum possible loss, without setting a limit on the maximum possible gain. A SELL trailing stop limit moves with the market price, and continually recalculates the stop trigger price at a fixed amount below the market price, based on the user-defined “trailing” amount. The limit order price is also continually recalculated based on the limit offset. As the market price rises, both the stop price and the limit price rise by the trail amount and limit offset respectively, but if the stock price falls, the stop price remains unchanged, and when the stop price is hit a limit order is submitted at the last calculated limit price. A “Buy” trailing stop limit order is the mirror image of a sell trailing stop limit, and is generally used in falling markets.
Happy Trading!
