Hello, everyone. In my recent series about LEAPS (which starts here), I got a great question from WallStreetKing about stop orders. You can read our full exchange on post 2 in the LEAPS series, but the whole discussion got me thinking about stop orders and how a contingent order can work as a good alternative. They may look alike on the surface, but do have some key differences. This post will discuss how to use a contingent order as a “stop” type order and the good and the bad points differentiating each.

A few quick points before we dive in. Remember: stop orders can be entered on stocks or options, but for simplicity’s sake in this post we’ll address just the options side of things. Let’s also assume that we’re long an option and the risk is if the option decreases in price, so the protective order is to sell and close the position. Some traders like to sell options initially, and in that case the risk is if the option increases in price, so the protective order would be to buy and close the position. The following discussion applies to both scenarios, but we’ll just be exploring the long option position in our examples, again for simplicity. Finally, I’ll be describing order routing differences between the two order types, and I can’t guarantee every brokerage’s routing process works the way I describe. I can only speak for the TradeKing and what I know of the majority of brokers.

Without further ado, then…

First things first: what’s a stop order?

You’ve probably been told before to “set your stops” every time you enter a new position. Simply put, stop orders help you either protect profits or limit losses on positions you’re already holding. (Their full name, “stop-loss orders”, can help you remember that.) If you buy an option at 5, you might want to set a stop order below that price – say, 3.50 – to limit your potential losses.

In general here is how a stop order works. They come in two flavors: stop-limit and just regular stop orders. When your position trades at or through your stop price, regular stop orders get activated as market orders, seeking the best available market price. Stop-limit orders get activated the same way, but once activated they automatically send a limit order to the floor seeking to execute only if that limit price is met. A stop-limit order is more exacting, but also more finicky – if the stock or option is moving fast, it can easily blow through your stop and your limit prices without getting filled at all. With a regular stop order, a market order is sent to the floor and will get the next available price, so you will in all likelihood get filled - but with no guarantee what that price may be.

Entering a stop or stop-limit order is pretty straightforward at TK. Take a look at the third column in our order entry screen – you just enter your stop price and / or limit price in the spaces provided.

…and what’s a contingent order?

A contingent order sounds similar: you set up a contingency, something that needs to happen to trigger your order to activate. Just like a stop order, that contingency can be that the option trades at or through a certain price you specify. An example here would be if you bought an option at $5 and, contingent on the price of the option reaching $3.50, you’d send a sell to close order to the floor. This contingent order can be sent as a market or a limit order, just as with the stop order.

Here’s a look at our contingent order entry screen at TradeKing; you can access it from your TK account at Trading > Options, then choose “Contingent Orders” from the Advanced Order types pulldown at the bottom of the screen.

Differences between the two

Even though the two order types are similar in concept, there are important differences in routing and what value (Bid, Ask, or Last) triggers the trade. Stop orders are typically sent to one exchange immediately and stored on their books until your stop price is activated on that floor. This means your order is only being worked on one option exchange and the floor sees your order right away, i.e. before activation. Contingent orders, on the other hand, sit on TradeKing’s servers until activated, at which point they’re sent to the broader marketplace. That means when contingent orders are activated, TradeKing’s electronic order-routing systems give market orders the full potential benefits of automated routing, including National Best Bid or Offer (NBBO) guarantees. With a contingent order all the marketplace sees is a market order to sell your long options; those floor brokers have no idea the order was initially placed with a contingency. In short, with contingent orders you receive all the benefits of electronic order routing  and keep your hand secret until you’re ready to move; with stop orders, you generally don’t get either of those benefits.

The next point of differentiation is flexibility. With sell stop orders (emphasis on sell), the rules of the option exchanges state that the stop price is triggered if the ASK or the LAST trade touches that price. That means either a printed trade or a printed ask price sends the sell order to the floor. Not only is this is a little counterintuitive – in what other scenario is a sell order keyed off the ask? -  it also makes choosing your stop price difficult.

It’s super-common for beginning option traders to assume the bid triggers their stop order; again, because it’s a sell stop and the bid is traditionally the selling price. The exchanges decided to use the ask or last because they were concerned that a market maker might see your sell stop order (since it is on the exchange already) and lower his or her bid to the stop price, only to trigger the order. By contrast, you don’t have this same worry with TK’s contingent orders, because the market maker doesn’t have that order info in advance and therefore can’t be tempted. TradeKing’s order entry screen for contingent orders lets you choose between BID, ASK or LAST trade to trigger your contingency.

A final word to the wise…

Any discussion on contingent or stop orders isn’t complete without mentioning this caveat: they do not provide much protection if the market is closed or trading is halted during the day. It the stock gaps the downside "protective" order will most likely trigger, but who knows what the next available price will be.  The only true day and night protect is to use other options positions to hedge and design strategies where the risk is limited and known from the get-go.

Regards,
Brian (Og)

[image: Ready set go by downing.amanda on flickr]

Options involve risk and are not suitable for all investors. Please read Characteristics and Risks of Standardized Options.

While implied volatility represents the consensus of the marketplace as to the future level of stock price volatility or probability of reaching a specific price point there is no guarantee that this forecast will be correct.

Any strategies discussed or securities mentioned, are strictly for illustrative and educational purposes only and are not to be construed as an endorsement, recommendation, or solicitation to buy or sell securities.