Being able to enter an options trade properly is an important factor to optimize a trade’s profitability. This post aims to educate options traders on the best practices of entering options orders and highlights the importance of liquidity when placing a trade. 

Entering and Closing Option Orders

Entry Order: 

When looking to open an options position, the first task is to establish a directional view - bullish, bearish or neutral. The next step is to select an option strategy, expiration and strike price based on the directional view chosen. When opening a position, a "To Open" order is used. This can be either a "Buy to Open" or "Sell to Open" order and these are placed using either limit or market orders. 

Example of placing a multi-legged order

One thing to remember when entering multi-legged option orders is to enter them as a single strategy and not as two separate legs. The OptionsPlay tool will provide you with the parameters for each individual leg. Consider the example below of how to enter a vertical spread strategy:

Enter the following legs into your brokers platform as a single strategy

*As this is an "open" strategy, Buy to Open and Sell to Open is used. Most brokers will populate the parameters above when an option is clicked.

Exit Strategy:

An exit strategy is used to set rules for yourself on when to get out of a trade. It is important to have a sense of when to cut losses or take a profit on trades. Exit strategies should be developed using a rules-based approach. 

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Options Orders and Actions

Knowing whether to "Buy to Open" or "Buy to Close" etc. can be confusing for first time traders. Whenever you want to open a trade, "Buy to Open" or "Sell to Open" is used. Closing a trade requires using the opposite - "Buy to Close" or "Sell to Close":

Multi-legged orders should always be opened or closed as a single order to mitigate execution risk.  

Pricing on Options Orders

Options are priced using the bid/ask price of the contract. The bid price represents the highest price that the market maker will pay for the option, and the ask price is the lowest price that the market maker will offer you for the option. The difference between the bid and ask price is the spread. A mid-price can be calculated by finding the middle of the bid/ask price and this represents a fairer value of the option. Traders should try execute their trades near the mid-price as this will generate a better risk/reward trade and usually gets filled on liquid options. 

Options have larger bid/ask spreads than stocks and vary depending on large cap and small cap companies. Large cap stock tends to have options with smaller spreads and are less volatile when compared to small cap stocks with wider spreads and tend to be more volatile. This is because market makers need to be competitive with their spreads. Actively traded large cap names would therefore require the market maker to minimize spreads so that they can generate order flow. Small cap names with a wider spread do not trade as actively and there is less competition which allows market makers to mark up their bid/ask price. 

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When placing a buy order, it is best to select a price between the mid price and ask price:

For sell orders, it is best to select a price between the mid price and bid price:

Options Liquidity 

Liquidity refers to how quickly an option can be bought or sold at the current market price. As mentioned earlier, large cap names will have better liquidity than small cap names and will therefore also have tighter spreads. Using this information, it is possible to gauge a sense of how liquid options are on a stock based on how small the spread of the bid/ask price is. The general liquidity of the options market can vary. During times of market stress, options become less liquid and spreads become wider. Options spreads are the thinnest when the market is calm. 

One mistake that many traders make regarding liquidity is using open interest as a measure of liquidity. Due to the large increase in number of strike prices added in recent years, open interest is more divided. Open interest will usually pool around in the money strikes, more so if the strike price is a round number. Even if an in the money strike price that has a decimal has lower open interest, it is not any less liquid than a strike price just above or below with a much higher open interest. This is important to keep in mind when placing limit orders. Looking at the open interest in the entire options chain instead of just s specific strike gives a better idea of the liquidity of the options for that stock. If open interest is low for all the strikes, then the options on that stock would be considered very illiquid. Weekly contracts that are newly listed will naturally have lower open interest but this does not mean that they are less liquid. 

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The priority of the market maker is to hedge their risk after selling an options contract. When a trader buys an options contract from a market maker, the market maker needs to ensure that they buy the underlying stock to hedge their risk. This is why options with no open interest can still be executed at an optimal price as long as the underlying stock is liquid.

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