Online brokers have many advantages over their brick-and-mortar competitors. Real-time quotes online mean you don’t have to call to learn what’s happening in the market. With this, one of the most powerful things you can do is work your orders— especially option orders—to get better execution prices.
Online trading gives you the ability to see the bid/ask for an option and enter a limit order with a price that falls between the bid and ask. A limit order specifies that you will only accept an execution at your limit price or better, but it does not guarantee a fill. The idea of working a limit order between the bid and ask is like negotiating. You try to get the trader on the other end to give a little bit if you’ll give a little bit on your end.
Working an order between the bid and ask can also be seen as a form of price discovery, an attempt to determine the exact price at which the other trader is willing to buy or sell to you. In other words, there is a bid/ask price that is broadcast to the world, and when less knowledgeable retail traders execute orders, they give up a large amount of slippage. But if you use the tools available, you can work orders and discover a higher bid and lower ask than what’s shown.
This is easy today when using real-time quotes, electronic order entry, and penny price increments. Let’s say you’re long 1,000 shares of XYZ, and you want to sell 10 covered calls against them. If the options in XYZ trade in pennies, you might see a bid/ask for the call you want to sell at $1.50/$1.54. The bid price is $1.50, and you could sell 10 calls at that price.
The problem with doing that is you are giving up about .02 in slippage. That’s the difference between the execution price and fair value of the option, which is close to the average of the bid and ask prices. In this example, fair value would be about $1.52, the average of $1.50 and $1.54. The difference between $1.52 (fair value) and $1.50 (my execution price) is .02, and on 10 calls, that equates to $20. Then, instead of selling the calls at $1.50, you enter a limit order to sell two options at $1.52, the fair value. Why only two contracts instead of the full 10? You want to feel out the market. When you’re trying to get the best price, you don’t want to enter a limit order between the bid/ask and be filled immediately on all your contracts.
If you enter a smaller quantity and are filled immediately, you know what price you can execute the rest of your calls at, but you can work the order at a higher limit price to see whether you can get a better fill.
So you enter an order to sell two at $1.52. Assuming the stock price doesn’t change, if you don’t get filled after a few minutes, cancel your first order and submit a new one to sell two at $1.51. Maybe you’ll get filled at $1.51—or maybe not. If not, you know that to get a fill, you’ll have to go down to $1.50. But if you sell the two at $1.51, you might guess that you can sell the rest of your calls at $1.51, so maybe you enter an order to sell eight at $1.52. If you don’t get filled at $1.52, you can take the limit down to $1.51 with the hope of it getting completely filled. It’s important to trade with an online broker who does not charge for canceling orders. Some do, and when you’re working and canceling orders, you don’t want to incur hidden charges.
Learning how to execute trades is more of an art than a science, and you’ll get more skilled at it the more you practice. The better you can work an order to get a better execution price, the more money you’ll save over time. That can do a lot to reduce your trading costs and may even tip the balance between a losing and winning strategy.
— By Tom Preston
Tom Preston is a founding partner of thinkorswim and the chief architect of its trading platform. He holds multiple degrees, including an M.B.A in finance and statistics from the University of Chicago.
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