Order Execution 101

Given the sudden uptick in trade alerts I have been sending out to my Global Trading Dispatch subscribers, some 60 since August 10, I have been inundated with requests for how to execute these. So I thought I’d take some time today to expound on the basics of order execution 101.

There are three basic ways to intelligently get an order into the market:

1) The No Brainer Average In. Buy half at the in receipt of the alert and half at the close. It’s that simple. If there is a tight spread and lots of volume, just go to the market. This is what a lot of institutions do, and is why you get the volume spikes in the market at the opening and the close every day.
If you are trying to get into an illiquid position, such as a far month option, the spreads can be quite wide, possibly as much as 10%. Going to the market can mean giving up a large chunk of your profit up front. So place limit orders in the middle of the spread, giving the market makers time to lay off risk in the underlying security, or in the futures. That will enable them to tighten up the spread and fill you order without taking you to the cleaners.

2) The Principal Method. If you are a large, high net-worth individual or institution, you can call you broker and ask him to make a market in any security. He will give you a bid and an offer wide enough to compensate for the risk he is taking, and you just lift the leg you want. Warning: if your broker consistently losses money trading with you, he will quit returning your phone calls.

3) The Discretionary Method. Find a broker you trust to execute on a best efforts basis at his discretion. He will want to grow your business and will do the best price he can. Expect to pay a higher commission for this service, as you should. But a good broker worth his salt will usually earn his keep and then some, so it is worthwhile. He has the news feeds right in front of him, has access to in-house and third-party research, like this newsletter, and is talking to clients and other traders all day long. So he should use this information to your advantage. Don’t expect his service to be price competitive with discount online execution services. You get what you pay for. Better not to be penny wise, but pound foolish. Caution: many brokers won’t take these orders unless they know you well, as they are afraid of getting sued.

4) Deep In-the-Money Option Spread Orders. I have been doing a lot of these lately, as they have a built-in short volatility and time decay element to them, and are great to have when market volatility declines and then stays flat, which has really been the case all year. This is the core trade that has taken me up double digits since April.

These involve buying and option on a stock or ETF 15% in-the money and simultaneously selling short and in-the-money call option only 5% in-the-money. Only enter these as a single order for the combined spread, not the individual legs. The difference between the bid and the offered side of the market on these is big enough to drive a Ferrari through. If you just go in and buy at market you will give up half of your potential profit going in.

Let me go through a real world example. The Apple December, 2012 $620-$650 call spread requires you to buy the $620 calls and sell short the $650 calls against them. The market for these is currently $18.60 bid - $19.50 offered. If you pay the gross $0.90 spread, it eats up 5% of you potential profit. But you put in a bid at 5 cents over the middle market price of $19.05 you will get done 90% of the time and cut this cost in half.

Keep in mind that the spread orders are all done by computers these days. This means you can get executions on the individual legs that can vary widely from second to second. As long as they add up to your limit bid that’s all that matters.

Be very careful of using limit stop losses these days. In the big flash crash, some unfortunate investors got filled down 50%, especially with ETF’s. Better to let your broker to use a “pocket” stop loss where he will call you before executing.

If you get a trade alert from me and the security has already moved 10%, don’t chase it. This has been happening a lot lately, with the recent extreme volatility. Sometimes merely going for a refill on your coffee, taking out the trash, or reading the morning papers is enough to miss an opportunity in this market. I know because I have done it plenty of times myself. Keep your discipline. Wait for the price to come back to you, or wait for the next trade alert. There are plenty of fish in the sea, and it is just a matter of time before another juicy one swims by.


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