The appeal of trading options contracts is almost self-apparent: They offer traders a level of accessibility and versatility unmatched by any other asset class.
However, these benefits come at a price in the form of how complex options trading is. Like all derivatives, options are volatile – so a steady hand is needed to successfully execute strategies.
With a couple of key pointers, mastering this form of trading becomes much easier down the line – and it starts with understanding options order types.
It is easy to see how the ability to buy or sell securities at a predetermined price by a predetermined date offers flexibility. Yet most traders inadvertently overlook the biggest element of this flexibility in options – and that is the vast and varied amount of order types in option trading.
Whereas other asset classes do have some complex order types, such as conditional orders, when it comes to trading options, complex order types are the norm – even for the most basic strategies. More advanced trading strategies such as covered puts which depend on multiple “legs”, require quite a bit of know-how in the order department.
Here, we’ll dive into the different types of options orders ranging from the most basic and essential to the highly conditional and rarely-seen. Though they may seem daunting at first glance, there’s nothing all too complex about it once you get the basics down.
Mastering options orders is fundamental, essential knowledge that is necessary before choosing and successfully putting into play an options trading strategy. Thankfully, once that’s taken care of, it’s all downhill from there – so let’s get into it.
What you’ll learn
The Four Basic Types of Options Orders Explained
Option contracts are considered derivatives. This is because the contract itself isn’t an asset directly – rather, the value of the contract is derived from the value of some underlying asset or security, most commonly a stock. And since options are derivatives, which are more complex than traditional asset classes such as stocks, it comes as no great surprise that the orders used to trade options are likewise much more varied and complex.
There are several ways to categorize options orders, but it is prudent to start at the beginning, with the most basic. At their core, options orders are either open or closed. It might be helpful to think of it this way – add the word “position” after open or close, and you have the gist of it.
An “open” order opens a position – meaning that a trader is either going long (with the option to buy) or going short (with the option to sell) a security. In contrast, an order to “close” a position achieves the opposite – it is meant to rid the trader of their existing liability by exiting a position.
Buy to Open Orders
By far the most simple of all options order types, buy to open orders establish a position by buying an options contract – either a long call or a long put. Essentially, entering a long position is a calculated risk – the trader pays a premium, and if their prediction of how the underlying asset will perform in the future (a price increase for calls and a decrease for puts) is correct, they can profit.
There are two ways in which buy to open orders eventually lead to profit – either the option can be exercised if the strike price is surpassed, or the options contract can be resold as the strike price is approached. In both cases, traders will have to earn enough from each trade to cover the premium and transaction costs – anything above that mark can be kept as pure profit.
This order type operates similarly to simple order types in stock trading – buy to open orders are used when options traders believe that the specific options contracts will go up in price.
Buy to Close Orders
Buy to close orders are used when traders already have an open position. To be more precise, when a trader has an open short position (they are short selling an options contract) a buy to close order is used to exit the position by purchasing the same options contract.
In addition to selecting one of these order types, you must also specify how those orders will be filled and the order timing.
As we’ve said, buy to close orders are used to close short positions. Short positions are opened with sell to open orders. There are two primary reasons why a trader would use a buy to close order.
If a short position has become profitable and the trader wants to secure profits, a buy to close order accomplishes this. To use an example ,if a trader shorted via selling or writing calls and collecting a $7 premium per contract, only to see the value of those contracts reduce to $2 per contract, buying to close would exit the position with a profit of $5 per contract.
Sell to Open Orders
A sell to open order establishes a position by short selling an options contract. In a bearish move, sell to open call options won’t be profitable or exercised in this case, the trader gets to keep the premium orders utilized by traders who believe that the value of an option will fall in the future. Sell to open orders are matched by brokerages with buy to close orders.
Sell to open orders can be used with puts and calls, but in both cases, as the name suggests, the trader is selling options contracts. This is done in exchange for a premium – a (usually) small amount of money received for writing an option.
To use an example, a trader who believes that a stock’s price will plummet will likely short or sell call options – as profit.
Sell to Close Orders
Sell to close orders are used to close open long positions (which you get by using buy to open orders). This order type most closely mirrors the simple act of selling stocks. A sell to close order closes a position by selling an options contract.
For example, a trader who bought 10 calls for $6 each would have used a buy to open order to enter that position. If the price of those calls were to increase to $15 per contract, the trader would then use a sell to close order to exit the position, raking in a profit of $9 per contract.
Keep in mind that sell to close orders are used to close all long positions – meaning that both calls and puts, if purchased, fall under this category. The only types of positions that are not closed by sell to close orders are short selling positions.
Different Types of Filing Orders
While stocks and some other assets can be purchased without utilizing the services of a brokerage, this isn’t typically the case with derivatives such as options.
Unlike with stocks, when placing an options order, traders have to specify how that order is to be filled by their brokerage of choice. This has to be done with every option order and there are only two choices – market orders and limit orders. Thankfully, as we’ll see in a minute, both are easy to understand and differentiate between.
Market Orders
A market order instructs a brokerage to fill the order at any available price – no matter what that price might be. This has the benefit of immediacy – any such order will be filled as quickly as possible, but there are also drawbacks to consider.
For options contracts that are highly liquid – meaning that they exhibit low spreads, stable prices, and evenly high levels of trading volume, market orders are fine.
However, volatile contracts that have higher spreads, lower trading volume, and unstable prices aren’t always suitable for market orders.
Simply put, the price that the trader ends up selling at or buying for can be much lower or higher than anticipated, which can not only eat up profits (or dip into unprofitable territory), but also makes precision and managing your trades much more difficult.
A simplified explanation of how market orders and limit orders work.
Limit Orders
A limit order instructs a brokerage to fill the order at a price no higher (if you are buying) or no lower (if you are selling) than is specified. This adds an additional level of control and precision, allowing traders to counteract any potential rapid price swings.
Limit orders will not be executed until specified conditions are met – that can happen as quickly as with a market order, or it can happen days and weeks afterward – but the chief advantage of limit orders is that they make managing a beginner options trading strategy much easier when combined with clear profit targets.
Combined with trading signals or an options picking service, limit orders (in the form of buy to open orders) can be used to automatically enter favorable positions at good price points. Conversely, limit orders in the form of to sell to close orders are the best way to insure a position.
Categories of Exit Orders
Exit orders are another key element of complex trading strategies – and the key word here is automation. An exit order automatically closes a position when some predetermined criteria are met. This goes a long way in reducing the micromanagement and hands-on work needed to trade options.
The most straightforward example of the utility of exit orders are profit targets – once an options contract’s price reaches an acceptable level of profit, it is automatically sold – thereby locking in profits and securing them from any potential downswings.
On the other hand, exit orders can also be used to mitigate risk in the opposite direction – by placing exit orders that go into play when the price drops to a certain point, traders can automatically close out their position before they accrue large losses.
Stop Orders
Stop orders are the most common type of exit orders. With stop orders, once a certain price is reached, the position in question will be closed.
There are two main ways in which stop orders are traditionally utilized. In the first approach, the stop order is placed at a price point that is above the current price point. This is commonly referred to as setting a price target. If the options contract’s price reaches the price point, it will automatically close out the position and secure profits.
In the other approach, the stop order is placed at a price point below the current price of the options contract. Should the price of the options contract fall to meet the criteria of the stop order, the position will automatically close – thus preventing any further losses.
Market Stop Orders
Market stop orders function in the same way as traditional stop orders – but once the criteria that are set are met, the position is closed by means of a market order.
An example of how market stop orders work.
In other words, when a certain price point is met, the position will be closed in its entirety – no matter what the cost ends up being in the end. Like all market orders, market stop orders are generally not recommended unless time is of the essence.
However, market stop orders can be very useful in the type of situation best described as “high-risk, high reward”. Options traders who use elements of news trading – for example, waiting for financial reports or earnings reports always run the risk of disappointing news triggering a sell-off. In that case, a wisely positioned market stop order is perhaps the best way to incur minimal losses.
Limit Stop Orders
Limit stop orders combine the features of stop orders and limit orders. Once a certain predetermined price is reached, the limit stop order acts as a limit order – meaning that it will only be filled if another set of conditions can be met.
Graph representing the function of a limit-stop order.
Limit orders are essential for a couple of popular advanced strategies such as vertical spreads and put credit spreads.
Trailing Stop Orders
A trailing stop order will exit a position once a certain amount of change from the options best price has taken place. Whereas a simple stop order might go into play when the price of an options contract reaches $20, a trailing stop order would go into effect when the price moves by 4%.
Trailing stop orders might initially seem complex, but the main idea – as illustrated above – can be easily gasped.
In much the same way as other stop orders, setting a percentage worth on the upside for securing profits and on the downside for preventing further losses is a sound risk-management strategy.
Contingent Orders
Contingent orders are among the most versatile and secure methods of securing profit and stopping losses – but they require some skill to utilize. Contingent orders will only execute when a predetermined parameter is met.
Contingent orders are more versatile than trailing stop orders for example – while a change in options price can be a parameter, so too can the price of the underlying asset.
Let’s make use of an example. A trader is interested in buying call options for Netflix. However, there is still no clear signal that the stock will continue climbing from its current price of $270. Based on their research, the trader is confident that should the stock climb above $285, the trend will continue, presenting a buying opportunity.
In this instance, the trader would place a conditional buy to open order, with the condition being that the price of the underlying stock (NASDAQ: NFLX) hits $285.
To protect them self from potential losses, the trader could also place another order – a conditional sell to close order triggered should the price drop to $275, which would prevent any major losses.
Order Timing
Last but not least, order timing concerns another vector of control that traders have over their positions – when and how they are filled.
Timing plays an important role in risk management – determining when and under what conditions orders are filled can serve to lock in more profit while determining when and how orders are cancelled prevents orders from being executed under less-than-ideal conditions that can lead to losses.
Day Order
Day orders are options orders that will, if not filled, expire on the close of the trading day. The rationale behind this is simple – the rapidly-changing conditions of the options market mean that a fair price today might be a steal tomorrow – and quite a lot of traders are all too aware of that fact.
For example, in the case of a trader wanting to sell an options contract, having the order be cancelled and putting it in again tomorrow might pay off. In general, the end of the trading day sees less volume and interest, and that often translates to lower prices – a good opportunity to buy, but a bad opportunity to sell.
In contrast, the first two hours of a trading day are generally buzzing with activity, and present a much better time to sell options. If the trader in our example couldn’t sell his options for a decent price by the end of the first day, they could stand better odds of doing so tomorrow – and this is exactly what day orders were designed for.
All or None
All or none orders are pretty self-explanatory – if the order in question cannot be filled in its entirety, it will not be filled. To use a simple example, a trader that wishes to buy 60 options contracts at a certain price point sets an all or none order. However, the trader’s brokerage can only provide 40 contracts at the given price point – so the order will remain unfilled.
The important thing to note with an all or none order is that it will remain open until it can be filled – AON orders can be combined with day orders, good until cancelled orders, or they can manually be cancelled at any time.
Fill or Kill
Fill or kill orders are a variation of all or none orders with one chief difference – unlike with AON orders, in the case of a FOK order, if the entire order cannot be filled instantly, the order will be cancelled. While this might seem slightly inflexible, keeping positions reasonable in size and using a good provider for options alerts does offer a lot of opportunities to use orders of this type.
Another element to consider is that trading options don’t come free of charge. In case your brokerage of choices charges a flat fee per transaction, doing everything, whether it be buying or selling, in one go can help keep the price of trading down.
On top of that, fill or kill orders have a much more mundane and overlooked approach – keeping an options portfolio tidy. Ensuring that exact numbers of contracts are bought and that entire positions are terminated at the same time decreases mental load and allows traders to devote more focus to other areas – and seeing as how keeping track of the underlying and metrics such as the Greeks requires a lot of attention, this point shouldn’t be underestimated.
Good Until Cancelled
The opposite of a day order, a good until cancelled options order will remain in play either until it is filled or until it is manually cancelled by the trader
Immediate or Cancel
An immediate or cancel order functions most similarly to a fill or kill order or an all or none order, but with one key difference – with an IOC, a position can be partially filled.
To use the same example we used for AON orders, a trader wishing to buy 60 options contracts at a certain price point with only 40 available options contracts would receive 40 contracts, and the remainder of the order (in this case, for 20 additional contracts) would be cancelled.
Market on Close
A market on close order executes at the end of a trading day or close to it as a market order. The main utility of the market on close orders is for traders who wish to close out expiring positions at the last possible minute, or options writers seeking to maximize profits by using the decay of extrinsic value.
However, to be fair, markets on close orders do have their uses. For one, options trading is volatile – while limit orders work better (on paper, at least), some options contracts see such choppy or sudden price movements that limit orders often end up unfilled.
On top of that, sudden unexpected changes in the price of the underlying asset can spell bad news for the price of an options contract. In some cases, it truly is better to get rid of it at any price rather than keep on owning the contract and suffer additional losses.
Market on close orders remain open until the end of the trading day.
Conclusion
There is a lot of variety when it comes to different types of options orders – while some are relatively simple and straightforward, others are complex, delicate, and a bit harder to use. However, this area of options trading constitutes a full half of an experienced trader’s toolbox – the other half belonging to strategy.
No matter what approach, timeframe, or strategy is used to trade options, mastering order types increases the odds of success. The ability to set precise price targets in order to secure gains or stop losses to prevent unprofitable traders is not only useful – it is well worth the effort required.
