Trade Entry & Execution

Is the stock price or the option price used as the trigger to set a stop-loss order on an option position?

It is a matter of personal preference. Most exchanges allow stop-loss orders in options. However, many brokerage firms do not allow them for various reasons.

Stop-loss orders attempt to limit losses on an investment once that investment goes a certain amount in the wrong direction. Generally, most people who set stop-loss orders use the actual price of the investment (in this case the option price) for the trigger to decide to liquidate a losing position.

On the other hand, some investors use options to execute a strategy based on technical analysis of the underlying stock. For example, an investor might believe that a certain chart pattern in a stock means the stock is due for a rally. To monetize that opinion, the investor buys calls. They may then believe that if the stock instead drops to a certain price, it no longer warrants a bullish opinion, and they would not want to own calls anymore. In this case, the investor might prefer to use the stock price as the trigger for the stop-loss order.

Check with your broker to see if they accept these types of orders. Once triggered, the stop order can be of two different types: a market order or a limit order. Make this decision based personal preferences. There is no better or worse choice.

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When executing a buy-write order(s), does there need to be two orders executed at the ask price?

The short answer is an unequivocal maybe. It's possible that with a multi-part order (such as a buy-write) that the options part of the trade might occur at the ask price, but there is no guarantee. When traders enter buy-writes, they usually enter them on a single ticket, for a net debit. In this case, the prices received for the call and paid for the stock matter only in the sense that the net dollars spent should not exceed the (debit) limit. For further information regarding buy-writes, review our online Covered Calls class.

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Who sets the width between the bid-ask on the options exchanges?

Basically, anyone who trades that product plays a role in the market width. However, there are rules on each exchange regarding the maximum width that quotes may be. The maximum bid-ask differentials are the same at exchanges that trade options. There are occasions and market situations on the various trading floors that may necessitate modification or waiver of the maximum bid-ask differentials.

The U.S. exchanges that list options have rules that specify the maximum bid-ask differentials in option contracts. The members of these exchanges are obligated, under normal circumstances, to honor their displayed quote for a minimum number of contracts. The number of contracts can vary, depending on the stock or index in question, but it is usually at least 10 contracts and in many circumstances could be 20, 50 or even 250 contracts.

In general, the market or displayed bid/ask spread could be composed of any variety of participants including market makers, institutional investors or private investors.

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How does open interest affect my order? Should there be a certain amount of open interest to execute the trade?

It is unlikely that open interest will affect execution of your order. Open interest is simply the number of outstanding contracts. It expands and contracts as investors and traders open and close positions. If you enter a market sell order, you will be filled at the best available bid price. If the quantity at that bid price is less than your order size, then you'll sell the number of contracts on that bid and the balance of your order at the next-best bid price, and so on.

If you believe the market would have problems digesting a certain quantity of contracts, it might be appropriate to spread that quantity out over the course of the trading day. If you're worried about the price you will receive upon entering a market order, consider using a limit order, where the limit is the lowest price you will accept.

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Does it make a difference what kind of order I enter during volatile market conditions?

During times of extreme market volatility, it is imperative for investors and their brokers to understand fully the risks of entering market orders. A market order is more time-sensitive than price-sensitive. If an investor enters an order at-the-market, especially a large order, there may be a chance that the market for that security will change quickly once they submit the order to the marketplace.

Furthermore, use extreme caution when entering market orders prior to the opening or closing of the markets. Understand the parameters of the orders you submit and invest, as prices can change rapidly in today's market.

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