In the financial market, especially in the options market, it is very important for you to learn the option order types. If you do not have a firm understanding of them, you may end up in a very bad situation.
Traders who were previously in the stock market and have recently joined the options market face difficulties in understanding the different order types available to them. Because the Shares Of Stock provide you with only two choices, either buy or sell, whereas there are much more things you can do with options. After getting complete knowledge of the options order types, you will be able to implement the best and most effective strategies for your position.
Understand the position - it is either opened or closed.
Upon entering the options, you have two choices: open or close the position. As options are more advanced than stocks and may take time to understand, you need to check at the end of the order. Does it say "to open" or "to close"?
You can avoid accidental orders when you are clear on your position type. Let us clarify the meaning of both the above terms for you to understand the whole article.
Open position: The position is said to be open when the trader is moving forward for the long-term or short-term investment and actively buying/selling any security to create his position in the market.
Closing position: The position can be said to be closing when the investor removes his stake or liability and no more actively invests in that security.
As you now know the concept of option order, let us see the four main types of option orders.
Buy-to-open option order type: (BTO)
This position is created when the trader/investor buys a long call or a long-put option contract.
Here, the traders coming from the stock market are most likely to go with buy-to-open because their thinking works that way, and they believe buy-to-open as buying the shares of the stock.
While dealing in the stock market, you get a profit when the stock prices increase, and in the same way, you get a profit in the options market when the price of the options is appreciated.
If the underlying asset is bearish or bullish, the traders believe it will appreciate and become bullish. The other purpose of buy-to-open option contracts is to create a spread or hedge the funds.
For example, a trader owns 2000 shares of XYZ limited company and is afraid of downside risk due to poor quarterly performance. Here traders may enter the position by buying out-of-the-money put options of XYZ limited company. This will help offset the downside risk if the stock price falls far and exceeds the strike price, the put options will now be in-the-money, and the trader may sell the shares and close the position, and the profit will be high compared to the expected loss.
Sell-to-open states that the investor being bearish on the value of the stock and receiving the premium will be much worthier than holding them till the expiry.
When a trader enters the STO contract, brokers find a match who is looking for buy-to-open a long position. After submission of the sell-to-open order, traders receive the credit in their trading account, which the buyer pays as a premium.
Suppose you are writing a naked call, meaning you are not the owner of the shares you are selling; you can be exposed to a huge loss if the share prices rise significantly. In this scenario, you will be responsible for buying the shares at the market price and providing it to the buyer.
Suppose you own the shares and the buyer decides to exercise the contract; when you write the shares owned by you are called 'covered' options.
Buying-to-close order type offers the investor to exit from his existing position. Imagine if a trader has written an options contract using the buy-to-close and wants to close the position, then they may wait until the option expires or close the contract by buying the underlying security.
The trader here was in a short position and assumed that the stock value would decrease and the option contract would expire worthless. In such a case, a trader will keep the total premium received from the buyer as profit.
Buying-to-close order helps in preventing the loss if they were naked options.
Selling-to-close orders put an end to the long option position. It is similar to selling the stock you hold for a longer period. While options contracts come with an expiry date, they are not like stocks that you can keep for an undefined time. Because of the lifespan of the options contracts, traders have only a few choices to make after buying the option contract. They are as below:
In case contracts expire in-the-money, traders may exercise their rights and take ownership of the underlying shares mentioned in the contract.
The second thing is that the option contract may expire worthless, and the buyer loses the total premium paid; for the seller, the premium received is the only profit.
Lastly, the trader can close the position by selling the stock at a profit or loss.
Applying sell-to-close on your position means you no longer have any stake or authority in that option. Traders sometimes also use sell-to-close before option expiry to take the profit or to reduce the loss. Some traders may opt for sell-to-close because they no longer want to own that share.
How to use the combination of different orders:
Once you are clear with the options order types, you may combine them and create various strategies to make a profitable trade. We shall see some of the top strategies used by the traders by combining the different order types.
Bear Put Spread:
When the market seems bearish, the bear Put strategy is used to take advantage of the decline in the share price and limit the losses. In this strategy, traders buy a put option at a higher strike price and sell another at a lower strike price, both expiring on the same day. Selling the put option will help offset the premium paid for buying the long-put option contract.
Traders may use the long straddle when they are sure that the price will move but are not sure about the direction of the movement. Long straddles have the potential to earn maximum profit from both sides, and the maximum loss will only be limited to the premium paid.
This options strategy is used in the low volatile market; it combines bear call spread and bull put spread. For entering iron condors, traders need to sell out-of-the-money put options and buy out-of-the-money put options at a lower strike price, creating a bull put spread. Then they must sell out-of-the-money calls and buy out-of-the-money calls at the high strike price, creating a bear call spread.
Know what are the market orders and limit orders:
You can enter trades by two main order types: market orders and limit orders.
Market orders are those which get filled instantly. If you are looking to open or close any position quickly, you can choose market orders. But it has a disadvantage, too. You might get stuck with a price you don't desire.
While placing a market order, you are intimating the broker to fill your order at the best possible price the market has to offer. There are times when you don't want to use the market orders, such as when the market is trading low and you are trying to fill a large order. Placing huge orders with a low trading volume can put you in a very bad situation.
Limit orders ensure that you either get in or out of the position at a special price.
Let us understand with an example. Suppose you want to open a long call position with ABC company's January Options. According to you, the fair price of the shares is Rs. 250, and they are currently being traded at Rs. 290. Here, you can place a limit order at Rs. 250; this implies that your order will be filled if the option's price falls to Rs. 250 or below.
You get a choice to set up a cancellation after a particular time or may cancel it manually if you no longer want to trade in this option.
You can also set a limit sell order that also works like canceling. If you need to exit from your position by selling the options you have, set a limit sell price that will be acceptable to you for those options.
You must note here that in limit orders, you may get the price you desire, but not necessarily guaranteed to be filled.
So, we have seen different types of option orders, and as a beginner, you might find it complex, but constant practice will help you understand them better.