From Our April 2015 E-mail Archives: One of our traders had a simple question on the best way to do an order entry for a spread trade. Our Head Trader, Robb, replied to the question and showed that the answer is anything but simple.*
From: Shanti M.
Subject: Order Entry on a Bear Call Spread
Hi Robb,
What is the best way to do an order entry on a Bear Call Spread (buying and selling calls) when you want it to trigger on a breakout to the downside? This is for my virtual trade account. I have not figured out how to enter here apart from a market order, which can be dangerous. Thanks!
P.S. See you at the Maverick Trading New York Summit!!
Thank you again,
Shanti
-----Reply Message-----
Hi Shanti,
Your question is a very good question and I wish that I had a very simple answer for you. The biggest problem that you have already identified is that a market order is very dangerous to use – especially on an option combo where there is a wide bid/ask spread. So, here are some things you can do to try to control your entry:
- Use a Contingency Order and Only Trade Highly-Liquid Options: This is actually a great choice since it takes away a lot of the risk of those market orders.
For example, assume that you are attempting to enter a Facebook (Ticker: FB) 80/82 Bear Call Spread if/when the stock breaks below 81. In this case, it would actually be OK to use a contingency order to sell (enter) the Bear Call Spread at market since the bid/ask spread on the combo will be something like 1.00x1.02. As you can see, there will only be very reasonable 0.02 of “slippage” (i.e., $2.00 per contract).
- Use a Limit (LMT) Order Attached to Your Contingency Order: Let’s say that you are trying to enter the same FB 80/82 Bear Call Spread if/when the stock breaks below 81. This time, though, the options aren’t as liquid as you would like and there is a 0.25 bid/ask spread (something like 0.90x1.15 when the order triggers).
If you use a Market order and the “stock breaks below 81” contingency triggers, then you will be filled at 0.90, which is too low. If you used a LMT order of 1.00, then the lowest that you would sell (enter) the Bear Call Spread for is 1.00. Using this LMT order will ensure that you get at least the acceptable minimum credit that you are looking for. The downside to the LMT order is that you can end up not being filled and you end up with no position at all, especially if the stock keeps breaking down.
- Use a Stop Limit Order Directly on the Combo: This one takes the most amount of work, but will also likely be the most effective. With the other examples, you are using either a market or limit sell to open order contingent on the stock breaking below 81. So, all that is happening is that you have an order to sell to open the 80/82 spread that won’t go out to the market until the contingency is hit (stock below 81).
For this third method, you won’t have any contingency on the stock itself and will be completely based on the price of the combo (i.e., the FB 80/82 vertical spread). However, you will have to use your knowledge of the option Greeks to estimate what the price of the spread is likely to be when FB stock breaks below 81.
Let’s say that you are looking at this position when the stock is at 81.50 and want to enter the 80/82 Bear Call Spread if/when the stock breaks below 81. The current market price of the 80/82 combo is 1.25x1.45 at the combo and has a net Delta of 0.60. So, with a 0.50 move down in the underlying stock, we would assume that there would be a 0.30 (0.60 Delta X 0.50) change in the combo price (i.e., 0.95x1.15). So, we would basically put in an order directly on the combo itself at this level.
We would use a stop limit order with the stop being the trigger and the limit being the lowest price that we would pay. Thus, we could put in a Stop Limit order at 1.05 Stop (you will need to specify the trigger as midpoint, trade, etc. I use midpoint of the bid/ask) and 1.00 LMT. When the midpoint of the spread reaches 1.05, then the order will go out to be filled at no lower than 1.00. This is similar to bullet #2 above, but will get you more fills on average since you are really pinpointing the price.
As you can see, you opened up quite a can of worms. I wish there was a simple way to structure everything to be automated.
Can we make it easier for ourselves in trading the FB combo above? With mobile trading being so effective and easy now, I typically tell people to set an alert at 81.05 (text message, email, etc.). When you get the alert, you usually will have time to jump on your smartphone, log in and place the order based on the current market prices.
Of course, there are some people’s lifestyles that just don’t have the freedom to step aside from what they are doing for 1-2 minutes, but I have found that most people usually can do this pretty easily. If you have a lifestyle or something that day where it needs to be automated, then just decide which of the above three (3) methods for entry you like best, then just set it up and let it happen.
Hopefully this helps,
Robb
* NOTE: Some original wording has been modified for legibility.
