Futures For YouQ&A
Futures For YouInside The Futures World
Want to find out how the futures markets really work? Carley Garner is the senior strategist for DeCarley Trading, a division of Zaner Group, where she also works as a broker. She authors widely distributed e-newsletters; for your free subscription, visit www.DeCarleyTrading.com. Her books, Currency Trading in the Forex and Futures Markets, A Trader’s First Book on Commodities, and Commodity Options, were published by FT Press. To submit a question, post your question at https://Message-Boards.Traders.com. Answers will be posted there, and selected questions will appear in a future issue of S&C.
PLACING STOP ORDERS
Is it possible to place a stop order on an option?
As with option trading platforms, futures exchanges do not accept stop orders on electronically placed options. Some open outcry execution brokers might be willing to take the order by phone for execution in the trading pit, but in general, stop orders on options are a thing of the past. That said, even if it were possible to place stop orders on options, it isn’t generally a good idea.
On the surface, having the ability to define approximate risk via stop order placement, similar to the way a futures trader does, is an appealing idea. Nonetheless, whether you are trading long or short options, the practice works much better in theory than it does in reality.
By definition, a stop order becomes a market order once the stated price becomes part of the bid/ask spread (bid is defined as the price at which you can sell, and ask is defined as the price at which you can buy). In other words, the order is elected once the price of the option, as determined by the spread between the bid and ask, reaches the stop price. Upon election of the stop order, the trade is executed at the best possible price available.
Exchanges do not accept stop orders on options because they are prone to excessive slippage. For instance, crude oil options rarely have market makers during the overnight session. As a result, the bid and ask of any particular option represents only those orders being worked by retail traders; in many instances, the spread between the prices can be excessive. During such off-market hours, it is not uncommon to see the spread between bid and ask in multiple dollars in premium (thousands in price).
To illustrate, imagine a trader who is short a June crude oil $120 call from a price of $0.40 (or $400) and is interested in exiting the option, should the value double in price. The trader might assume that placing a stop order at $0.80 would accomplish the goal; after all, such an order is an instruction to buy the option back at the market once $0.80 falls within the bid and the ask prices. The fallacy of this assumption lies in the fact that there are certain scenarios, such as the overnight session, or prior to major economic or EIA announcements, in which the bid/ask spread can temporarily balloon to ridiculous levels. It is not impossible for a stop order of $0.80 to be filled higher without the futures price ever moving adversely to the trade.
If no market makers are present, it might be possible to see an option valued near $0.40 be bid at $0.10 and offered at $1.60 without any meaningful change in the price of the underlying futures contract. Here, the spread between the prices represents $1,500 to a trader and would result in a stop order placed on the option to be filled at the market ($1.60) or a loss of $1,200 (($1.60 – $0.40) x $10). Simply put, this trader would have sustained a substantial loss in a trade that had not gone against him, nor given him any reason to exit the market.
Had the same trader bought the $120 call rather than sold it, he might have believed that placing a stop order at $0.20 would limit his risk to $200 (($0.40 – $0.20) x $10) on the trade but would likely discover a premature exit at a much lower price. Either would be expensive lessons to a trader. As a result, the exchanges have a policy of rejecting stop orders to save inexperienced traders from themselves.
In conclusion, don’t be discouraged when you place a stop order on an option, only to immediately receive a rejection notice; instead, you should sigh in relief.
*There is substantial risk in trading options and futures. It is not suitable for everyone.