Limit Order - Definition
Limit Order is an order to buy or sell your options positions at no worse than a price predetermined by yourself.
What Is Limit Order?
Limit Order is one of two main forms of filling orders used in options trading. The other main form of filling order is the "Market Order".
A Limit Order is an order that instructs your options broker to sell or buy at a price no worse than what you instruct them to, hence placing a "Limit" on the filling price. This is in contrast to the Market Order which gives your options broker the freedom to fill your position at any price as long as the order gets filled immediately, or the "Even Order" that instructs your broker to fill an options spread at no cash paid or received.
Limit orders allow you to tell the broker exactly what price you want to trade your options positions at instead of leaving the decision making to them. However, doing so could come with its own disadvantages as well. We shall explore in depth how Limit Orders work, how to use it correctly as well as its advantages and disadvantages in this free options trading tutorial.
How To Place A Limit Order?
When you fill out the "Order Form" in your options broker account for either buying or selling single options or options spreads, there will always be a
section titled "Price" or "Fill" or "Filling Order". This is where you choose the kind of filling order you want for your trade. You simply
fill out the space beside the word "Limit" in order to place a limit order. This tells your options
broker that you want your position to be filled only at this price or at a better price, not a worse price.
Limit orders can be used for trading of options spreads as well. When using limit orders for options spreads, you will need to specify the "Limit Debit", if it is a debit spread, or "Limit Credit", if it is a credit spread.
The above picture depicts how a "Limit Debit" order should be used for a debit spread such as a Bull Call Spread. This order tells the broker to fill both options contracts as a whole position with net debit of no more than $0.50. In this case, the broker is not limited in terms of exactly what price to fill each of the two options contracts at as long as the net amount paid in total is no more than $0.50.
The above picture depicts how a "Limit Credit" order should be used for a credit spread such as a Bear Call Spread. This order tells the broker to fill both options contracts as a whole position with net credit of no more than $1.00. Again, the broker is not limited in terms of exactly what price to fill each of the two options contracts at as long as the net amount received in total is no less than $1.00.
How Does Limit Orders Work?
So, what actually happens when you place a Limit Order? When you place a limit order, your options broker goes into the market and looks for the bid and ask
offer by market makers that matches or betters the limit price you have set. Yes, this means that your options position can actually be filled at a BETTER price than you stated, not a worse price. If there are no offers that matches or betters the limit price, the order will stay open in the market and continue waiting for when a matched or better price turns up in the market. In the first picture above, the limit order is instructing the options broker to buy the QQQ options at $0.38 or BETTER, not a price higher than $0.38.
Problem with Limit Orders
The main problem with using Limit Orders is that you can actually miss the trade entirely if your limit price is never matched or bettered in the market. Sometimes in a strong moving market, even putting in a limit order on the price you last saw in the options chain can make you miss a trade if the price has moved on while you were filling out the options trade order form. This could mean missing a critical profit taking point, resulting in loss of profit or even missing a stop loss point resulting in catastrophic losses.
Example of Limit Order Missing an Options Trade
Assuming options of XYZ company's call options at $50 strike price is quoted with bid price of $4.30 and ask price of $4.50.
Assuming you decide to buy XYZ's $50 strike price call options using Limit Order at its ask price of $4.50. However, as the price of XYZ was rising rapidly while you were filling out the options trade form, the ask price has moved higher than $4.50 by the time your order is submitted. The price of the call options never returned to $4.50 or lower for the day and you missed entering into the trade entirely.
Due to this reason, professional options traders prefer to use market orders for good liquidity options contracts in strong moving markets as it guarantees a quick immediate fill. Furthermore, order forms for market orders take slightly shorter time to fill out as you don't have to specify a specific price hence reducing the possibility of slippage.
Another problem with limit orders is that you will not be able to use them in conjunction with advanced options orders such as "Contingent Orders" or "Trailing Stop Loss". These advvanced orders require your options broker to be able to sell or buy your position when the criteria for doing so is met at the prevailing market price. As there is no way to know exactly what price that "market price" is, such advanced orders can only be executed with Market Order, not Limit Order.
When To Use Limit Orders
Unlike Market Orders which are largely "panic buttons" to get immediate fills on options with good liquidity, limit orders are most useful in the case of trading low liquidity options contracts. It is extremely dangerous to use market orders for low liquidity options because they can get filled at a much worse than expected price. This is when using Limit Orders can be very useful. Limit orders are not that useful for highly liquid options since you will most likely be filled at the stated bid or ask price even when using market orders for such options.
Using limit orders on low liquidity options contracts ensure that you don't enter or exit the trade at any price worse than your stated price. Low liquidity options contracts can give you a very nasty filling price if you simply left it to the whims of your options broker through the use of market orders. (Read more about Options Liquidity).
There is one occassion when you can only use limit orders rather than market orders and that is when you have just enough cash in your account to buy the number of options contracts you intend to buy. In this case, you won't be able to use market orders since market orders require additional cash premium.
Price Chasing In Using Limit Orders
As mentioned above, there is the possibility of missing a trade when using limit orders in strong moving markets as prices might have moved on when you were still filling out the options order form. As such, you will frequently need to do what is known as "Price Chasing" when using limit orders. This simply means to update your limit order to the new ask or bid price if they are not filled within a reasonable time frame.
"Chasing Up The Price" is when you update your limit order to a new higher ask price when buying options and "Chasing Down The Price" is when you update your limit order to a new lower bid price when selling options. Remember that options are always bought on the Ask price and sold on the Bid price.
Example of Using Limit Order in Fast Moving Market
Assuming AAPL's May $425 strike price call options are asking at $20.00 and the stock price of AAPL is rallying strongly.
You decided to buy 1 contract of these call options for $2000 and since you only have $2200, there isn't enough cash left for market order premium requirement so you went ahead and filled out a limit order for $20.00. However, by the time you submitted your order, you found that the call options price has moved on to $20.50 and your limit order was not filled. In order to get an immediate fill, you quickly "Chase Up" the price by modifying your limit order to buy to open at $20.50. This time, the order was filled.
A few days later, your call options became profitable and AAPL started to pull back strongly. You decided to take profit on your call options position which was bidding at $24.00. You filled out a limit order for Selling To Close at $24.00 and submit. However, when you checked your order status, you found that the bid price has moved down to $23.80 and your limit order for $24.00 was not filled. In order not to miss out on more profit, you quickly "Chase Down" the price by modifying your limit order to $23.80 for an immediate fill.
Advantages of Limit Order
1. Guarantees your price or better
2. No need for additional cash premium like in market orders
Disadvantages of Limit Order
1. Possibility of missing trades if prices are not chased in strong moving market
2. More time needed to fill out the order form means increased chance of slippage