What happens if you enter a limit order at a certain price – then the market moves dramatically away from that price? How are trade prices established in that case? More importantly, do market makers see your limit order – and are you vulnerable as a result?

I got this very interesting series of questions from a TradeKing client who goes by the username “buynhold” in the Trader Network. He offers this scenario as an example: “Say I sold an XYZ AA option for $1, then entered a buy-to-close order for $.50 limit. There was major news overnight on the underlying, and the XYZ AA bid and ask fell to $.05 and $.15. Would I buy at $.50, or $.15, and how is that decided? Does the market maker see my $.50 limit order?”

Let’s tackle the first part of the question first. If the opening quote for buying (the ask) was at .15, the exchange is supposed to fill your order at .15 or the best available price at that time the order is presented. This scenario in which the ask is so much lower than the limit usually only happens on the open (obviously), or when a stock is halted during the trading day and then reopens. If XYZ AA opened with the ask at .70, and then the option price went straight down in price, it’d take out your limit on the way down and you would most likely receive a fill at your limit price.

Now for the second part of your question, about what kind of public visibility your limit order may’ve had. If your buy-to-close was a Good-Till-Canceled (GTC) order and has been in there awhile, market makers know that your order is there. It will sit in the exchange’s order book displayed to everyone at the exchange until the order is filled or canceled. It makes sense when you think about it: if market markets can’t see your order, they can’t trade with it. That’s the entire job of a market marker, to provide liquidity.

Is there any way you can hold your cards closer to your vest? At TradeKing you could enter a contingent order instead – just login, go to Trading, choose the security you’re trading, then select “Contingent Order” from the “Advanced Orders”  pulldown menu. Here’s what you’ll get:



Contingent orders are held by the TradeKing platform and don’t get sent to the floor until the contingency you set is met. In your example, you could’ve sent a limit order, buy to close @ .50 if the ask of the option contract is less then or equal to .50. In that case, the exchange would not see the order until the contingency was met and the limit order was actually sent to the exchange.

Notice I said a “limit order to buy to close at .50”; most traders will still send a limit order to the floor after the contingency is met if they’re worried more about the price of the fill than the execution. I should mention it’s possible to enter a contingency order and have a market order sent to the exchange.  

However, there’s a point to consider: if your order is not on the floor it cannot be displayed to the rest of the world if your limit happens to be the best market at the time. Imagine the overnight news had swung the market to, say, .40 x .60 instead of .05 x .15. If you had entered that contingent order to buy to close at .50, if the ask is less than or equal to .50, your order would not be displayed until the ask clears .50 and the order actually gets sent to the floor. If it were in the exchange’s order book, on the other hand, the bid would adjust from .40 (the market maker’s best “buy” price) up to meet your limit, .50. You would actually see the quote displayed as .50 x .60.

The explanation behind displaying your limit order boils down to this: why should someone wanting to sell the option receive .40 from a market marker, when a public customer is willing to give them .50 for it? Obviously, if the floor doesn’t see the order it cannot display it. So whether you opt for visibility or not, as I always say: when it comes to options it’s all about the tradeoffs.  

Regards,
Brian Overby
TradeKing's Options Guy
www.tradeking.com

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I have found the contingent order method to be useful with options in some cases. Sometimes not being visible with your intentions, from a trading perspective anyway, is useful. There are also times when placing a limit order gets you a better than expected price if the spread between bid and ask is larger.

I had suspected the Limit order visibility scenario and began using contingent orders in some cases a month or so ago. As Brain states there are always trade-offs, but knowing the cause and effect of each is helpful when deciding what type of order to place.

Thanks Brian!

Brian, thanks for your insight, as always.

Corbin, what situations have you used a contingent order in?

Not necessarily something I can put my finger on, but there seem to be times when a limit order (which is visible to market makers) being in place can almost hold back a particular option. Haven't done the research to give a qualified opinion here, but just a pattern I picked up on and have started switching to contingent orders when I notice it.

Thanks for the comments gentlemen.

I personally like contingents as an alternative to stop orders. Stops are usually a protective order that gets you out when the trade is going against you. This is the type of order I really don’t like the market maker to see. This is because it is an order to close the trade at a worse price then the market is currently printing. So for stocks, but especially options I prefer to place a contingent order instead of a stop order.

Now, I say especially options because of the rules for stop orders on the floor. Pretended we are long an option and paid $5 for it, we say if the option goes to $3 we would like to get out and "stop" the pain. The floor says if you put a stop order in the stop price is triggered by the ask price or the last trade (no other alternatives offered by the exchanges). So the stop says if the ask prints at $3 or a trade occurs at $3 please make my order live. Now if that order is a market order one would expect to receive the current bid price on a market sell, which going to be below the $3 price for sure if the ask is the trigger. So you try to guess what the width of the bid/ask spread is and increase your stop price to make up for the spread thinking the ask will trigger your stop order, but then the last trade prints on a bid and that triggers the trade “early”. Seems odd but that is how they do it. Now with the contingent nobody sees it but the TK web site and also you can choose what you want to trigger the order (bid, ask or last) and when/if it gets triggered it comes to the marketplace looking like a “normal” market or limit order sent and has all the benefits of the auto execution systems of the exchanges.

Here is a link to a post I wrote a while back about the topic.
http://community.tradeking.com/members/optionsguy/blogs/7517-contingent-vs-stop-orders\\  

Regards
Brian (Og)