Limit Orders

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Limit Orders: Dodging The Market Maker’s Bullet & Side Stepping The Liquidity Trap

By Karim Rahemtulla, Advisory Panelist
Friday, February 2, 2007: Issue #392

Our goal here at Investment U is to show you how to “invest like a pro” so you can “make more money faster.”But if you want to realize an asset’s full moneymaking potential, there’s one key factor that you need to look at before you consider executing a trade.

It applies to both stocks and options – but with regard to options, it’s a question that attendees at conferences ask me all the time… “Are options liquid?”

The simple answer is: “Some are; some aren’t.” And you need to pay attention, because it makes a big difference to your results. Let’s see why this is the case – and how you can combat this using limit orders, so you don’t fall into the “liquidity trap.”

The “Liquidity Trap”: Two Reasons Why Options Don’t Follow Their Stock

When we talk about liquidity with regard to options, the ability to buy and sell an option at a fair price and reasonable spread is directly related to the trading activity of its underlying security. Nine times out of ten, if the security is “liquid” (i.e. traded frequently enough so that the price isn’t fundamentally affected), the option will be, too. This allows you to make your money from it faster.

For example, let’s say you’re bearish on the housing market, and want to buy put options on one of the homebuilders because you think an imminent rise in interest rates will negatively impact the stock.

You buy your put options, and are correct in your judgment. Interest rates do rise, and shares decline. But there’s a problem: Your put option doesn’t move in tandem with the shares. There can be two main reasons for this:

The option is one that not many investors know about, or own. So it’s thinly-traded, or “illiquid,” even though the underlying shares are liquid.

The underlying shares are extremely volatile. This results in a large spread between the bid price and the ask price. Beware of large spreads, because this is a sign that the option isn’t very liquid.

Dodge The Market Maker’s Bullet

Large spreads usually mean that the options market maker is glad to see you coming. When he does, he’ll tweak the price as high as possible – yet set it at a price where you’ll still be willing to enter the trade.

And it’s just when you want to exit the trade that the market maker has a big advantage. Illiquid options usually mean there are few other interested buyers and sellers. So if you’re keen to sell at any price, he feels your desperation and will aggressively move the bid price lower. Or you may see the dreaded “no bid.”

But there’s a way to combat wide spreads to ensure you don’t get burned. And you can do so using one of the most powerful weapons in your options investing arsenal – both offensively and defensively…

Take It To The Limit Order

The best way to avoid getting yourself into a situation like this is by using a limit order.

First and foremost, limit orders give you valuable protection when entering a trade. They ensure that if you get filled on your order, it will be at or below your set price – your limit price.

And if you don’t get filled? Don’t worry. By using good discipline and not chasing the price, it’s far better to miss a trade, rather than to pay so much that you have very little chance of profiting – even if you’re correct about the underlying stock.

Don’t get sucked into the trap of “playing index options.” Your sole aim is to make money. And if you don’t get filled on the entry, it’s likely that you wouldn’t have been able to exit gracefully, either.

Open And Close With A Limit Order

When the time comes for you to close your trade, use a limit order again. But be careful: Yes, you have to sell in order to make a profit. But you don’t want to risk not getting your order filled. So make sure you set your limit midway between the bid price and ask price. If the spread is wide, set your order slightly higher than the bid price.

If the spread is reasonable, set your limit order at the current bid price, just to ensure the market maker doesn’t start dropping his bid price as soon as you show up.

Even when I don’t see any obvious liquidity problems, I still use limit orders to get the best results.

For example, in one of my trading services, I recommended call options on a company, and used a strict limit order to buy the options at the current ask price. The reasoning wasn’t to slice a few cents off the price… it was because I wanted to avoid having the market maker step in and start raising it when he saw the volume of orders coming.

The strategy worked well. The issue was very liquid, with over 2,000 contracts offered at our limit price. So most readers were probably able to get filled at that price. But when you’ve got fewer contracts changing hands, using limit orders is even more important.

So avoid the “liquidity trap” and market maker manipulation… make sure you employ limit orders in your investment strategy today.

Good Trading,

Karim Rahemtulla