Trading Rules You Should Know - dummies

By Joe Duarte

Whenever you begin trading a new market, you’ll likely get some butterflies until the first few trades go off without a hitch. It’s always nice when everything unfolds as you expected. That actually requires some advance work on your end. The following short list of trading rules hopefully helps your comfort level with initial executions, as well as considerations down the road:

  • Contract pricing: Options in general trade in $0.05 and $0.10 increments rather than $0.01 increments as with stocks. The exchanges began trading a pilot group of stocks and ETFs at $0.01 increments in 2007. Additional securities have been added to the program in a trend that will likely continue.

  • Transaction premium: The premium value that you pay for an option is obtained by multiplying the option price quoted in the market by the option’s multiplier. The multiplier value is usually 100 for stock options. So, when you purchase an option quoted at $2.80, you are actually paying $280 for the option, plus commissions.

  • Market conditions: There are different market conditions that impact both the stock and options markets. These include the following:

    • Trading halts for a security or entire market: If you hold options for a halted stock, the options are also halted. You still have the ability to exercise your contract rights when this occurs before expiration. Generally, a trading halt will not restrict your right to exercise at all.

    • Fast trading conditions for a security or securities: When this happens, you can expect to see quotes that are changing quickly, and you’ll likely experience significant delays in order execution and reporting. Unless you must exit a position for risk reasons, don’t use market orders for options in fast markets.

    • Booked order: A booked order is one that improves the current market quote and updates it. The market maker isn’t necessarily willing to take the trade at the quoted level, but another trader is. You may encounter problems with such orders because the size can be as small as one contract. If you enter a ten‐contract order that matches the booked order price, you may only be filled on one contract. The rest of your order may or may not be filled.

  • Best‐execution: Execution quality is a general term used to describe a broker’s ability to provide trade completions at, or better than, the current market for the security. This means that when you place an order to buy an option with an asking quote of $2.00, your order is filled in a timely manner at $2.00 or better. Execution quality reports use the National Best Bid and Offer (NBBO) for all exchanges trading the security.

    Option exchanges are required to send a daily report to your broker whenever a trade is executed at a price other than the NBBO, referred to as tradedthrough. They must also provide an exception reason for the trade‐through. Even with the reporting, you may feel you’re not getting the best possible executions on your option trades.

    If you are not satisfied with the execution you receive on a specific order, or if you have an order that was marketable and is still open, contact your broker immediately. The broker can check the status of the order (it may be executed but the trade report is delayed) and market condition details that are more difficult to track as time passes. More often than not, your broker really wants to get you the best execution possible.

Because an option eventually expires, you really need to understand option valuations so you don’t pay too much for the time remaining. You can manage this time risk by exiting a long option at least 30 days before it expires. Within 30 days, the option’s time value erodes at an accelerated pace.