Market Order:

This is the most common of customer orders where we ask the broker to buy or sell a stock at the best available price. It is also called an “unrestricted order” and will always be executed.

Limit Order:

This is an order to buy or sell a specific number of shares at a certain price or better. A buy limit order can only be executed at the limit price or lower. A sell limit order must be executed at the limit price or higher. These are particularly useful on low-volume or highly volatile stocks.

Stop Order:

An order to buy or sell a security when its price surpasses a specific price called the stop price. At that point the stop order becomes a market order. A sell stop order is placed below the current market value of the stock and is used to prevent or limit a loss or to protect a profit on a long stock position. For example, you may have purchased a stock for $20 per share and it has appreciated to $30. A sell stop order @ $25 will guarantee at least a profit of $5 per share (barring a gap-down in the price of the stock). A buy stop order is always placed above the current market price of the stock. It is typically used to protect a profit or limit a loss on a short sale (selling a stock you didn’t own by borrowing it). For example, if you sell short a stock @ $30 expecting to buy it back at a lower price but it starts going up in value instead, a buy stop order can limit your loss. It may kick in @ $32 thereby minimizing losses to $2 per share. Once the buy stop price is reached, the order becomes a market order.

Stop Limit Order:

This is a combination of a stop order and a limit order. Once activated, it becomes a limit order which means that it can only be executed at a specific price or better. The benefit is that the trader has precise control over when the order should be filled. The disadvantage is that it may never get filled. A sell stop-limit order is always placed below the current market price of the equity and is used to limit the loss or protect the profit on a long stock position. Once activated, it becomes a limit order. A buy stop-limit order is always placed above the current price of the stock and is used to limit a loss or protect the profit on a short stock position. Once activated, it becomes a limit order.

Summary of Orders entered Above the Market:

• Buy Stop-Limit
• Buy Stop
• Sell Limit

Summary of Orders entered Below Market:

• Buy Limit
• Sell Stop
• Sell Stop-Limit

Covered Call Trade Orders:

Most writers of covered call place their trades by legging in. This where a market or limit order is placed to purchase the equity and once executed, a second order (limit) is placed to sell the option. For maximum profits, these two legs should be executed simultaneously (Buy the stock and immediately sell the option. Do not buy the stock, go to the mall and then come back home to sell the option). Another methodology permitted by some online discount brokers (not USAA, the one I use) is to place a net debit order. This is where you buy the stock and sell the option at the exact same time, not for specific corresponding prices but for a limit net debit. For example, if a stock is selling for $20 and the A-T-M call is selling for $1.50, the net debit or amount we would owe is $18.50 ($20 minus $1.50). This way, even if the price of the stock and option change, the order can still be filled if it meets the requiremnts of our debit order. This would be particularly useful for investors who can’t be in front of their computers but want to execute a covered call trade. As stock investors and covered call writers it is critical to know and understand the different types of customer orders and the appropriate time to implement them.

Industry in the Spotlight- Paper Products:

This industry is up in value 27% in the last 6 weeks and 60% in the last 18 weeks. One of the best performers in the group is RKT which has been up in price 25% and 56% in the same time frames. This stock meets all our system criteria and has options. Let’s look at a current nchart:

RKT as of 8-20-09

The technicals are near perfect. We have uptrending moving averages with the short term above the long term and price bars at or above the 20-d ema. MACD is positive with the histogram neutral. The stochastic oscillator is rising indicating the bulls are in control. Volume has been impressive during the recent price surge.

Blue Collar Investors throughout the world are always looking for ways to generate additional profits into our portfolios. This includes the use of some of the more esoteric maneuvers that may produce small returns of $40, $50 or more. One of the main philosophical approaches to Blue collar Investing is that by generating small but consistent, low risk returns and then compounding those profits, we can become financially independent. 

In my book and DVD series, the following phrase appears on numerous occasions:

Sell at the “bid”, the lower price; buy at the “ask”, the higher price. This references the price lists found in the options chains.  Before we discuss some common sense applications to maximizing profits by playing the bid-ask spread, let’s review some definitions (stay awake now, this can make you some cash!).

Definitions:

BID: An offer made by an investor, a dealer or a trader to buy an option. It will usually stipulate the price the buyer is willing to purchase the option and the quantity to be purchased.

ASK: The price a seller is willing to accept for an option, also called the offer price. The ask will always be higher than the bid.

BID/ASK SPREAD: The difference in price between the highest price that a buyer is willing to pay for the option and the lowest price a seller is willing to sell it. If the bid is $2.80 and the ask is $3.00, the the bid-ask spead is .20.

Theoretical Value: The hypothetical value of an option as calculated by a mathematical model such as the Black-Scholes Option Pricing Model. 

Black-Scholes Option Pricing Model: A model used to calculate the value of an option, by factoring in stock price, strike price and expiration date, risk-free return, and the standard deviation of the stock’s return.

How the bid-ask spread is set:

There may be several bid prices and several ask prices at any point in time. However, only the highest bid and lowest ask are used to calculate the spread. These are the figures you see when accessing the options chains. Utilizing an estimate of the volatility of the underlying stock, a theoretical option value is calulated using an option pricing model, such as the Black-Scholes model. A market maker will then set the bid below this theoretical value and the ask above this theoretical price. This is the spread and is determined mainly by liquidity. For example, the highly liquid ETF, QQQQ, have bid/ask spreads as low as .01. This is one of the reasons I require all stocks owned in our portfoilios and on our watchlist trade at least 250,000 shares per day. Market makers derrive their profit from bid/ask spreads. The greater the spread, the more money they make. Playing the spread will decrease their profits and increase ours.

Market order vs. limit order:

If you use a market order when executing a trade, you will sell at the published bid price and buy at the published ask price (this is called “lifting” the offer or “hitting” the bid). This may be okay for the purchase and sale of stocks where the spread is tight (small), but for options, which have a wider bid/ask spread,  a limit order is more appropriate and beneficial.

The Limit Order Display Rule (Show or Fill Rule):

Officially known as the “Exchange Act Rule 11 Ac1-4″, this is the slingshot Blue Collar Inverstors can use to fight off Wall Street’s Goliaths. It behooves us to know and understand this rule so we can generate those $50 returns in 50 seconds. Market makers will never mention this rule so I will !

Let’s assume the bid for an option is $1 and the ask is $1.25 (.25 spread). If we put in a market order to sell at the bid, we will get $1, case closed. If we put in a limit order to sell @ $1.10, the market maker has 2 choices according to the Show or Fill Rule:

1- Fill the order- you get a favorable trade execution above the bid.

2- Show the order- bid is now $1.10 and ask remains @ $1.25 (.15 spread).

The market maker is required to fill or show even if your order is for just 1 contract. Score one for the little guys! In the past, security dealers did not have to show our offers and we could not compete with them. This was not fair and damaged the market efficiency. Now higher bids and lower offers decrease the spreads, attract more buyers and sellers and enhances the world of the Blue Collar Investor.

How to Play the Spread:

If the spread is tight (.05 under $3, and .10 over $3), there is no playing the spread. Just accept the bid or ask with a limit order. For example, if the bid is $2 and the ask is $2.05, place a limit order for $2 if selling a covered call option. Many option investors accept spreads up to .20 before playing the spread. 

Let’s go back to our above example wherein the bid was $1 and the ask, $1.25. Why settle for $1 for our option sale. Let’s play the spread and  put in a bid for $1.10. Now some of you are probably thinking: Hey Alan, why not $1.20, don’t be a whimp! Here’s my thinking: If you had your home on the market for  $200,000 and someone came along and offered you $190,000, there very well could be a negotiation and a symbiotic agreement. If, however, you were offered $150,000, there would be several 4-letter words out of your mouth and the conversation would be permantly over. So let’s not insult the market maker, let’s play the spread so we can all be satisifed investors. But let’s not be taken advantage of!

I like to place my limit orders short of the halfway point of the spread favoring the market maker as we have in this case. Because of the Show or Fill rule, the dealer must give us the additional .10 or show the higher bid of $1.10. Once displayed, most exchange rules require the market maker to provide at least 20 contracts at that price. Our 5 contracts then represent an annoyance to the market maker, another reason not to insult him with our offer. Many times, our offer will be accepted so that the $1.10 will not have to be displayed. Remember, the wider the spread, the more profit for the dealer. In this case, we are happy with the favorable execution (if we get the $1.10 bid price), the dealer still has his favorable spread and we have just generated an additional $50 ($10 per contract) in 50 seconds by playing the spread.

 

All or None Orders:

Here’s another point you’ll never hear from the dealers: Market makers are NOT required to show your order if it is marked all-or-none (AON). DO NOT CHECK THE AON BOX ON YOUR EXECUTION SCREEN WHEN PLAYING THE SPREAD. If your order is for 20 contracts or less, the quote size must be good for at least 20, so it is redundant to mark it with the AON retsriction. By NOT requesting AON, you will allow your limit order to be shown.

Conclusion:

Playing the spread is another tool that Blue Collar Investors can use to level the playing field with Wall Street insiders. These $10, $20 and $50 profits will become hundreds, then thousands and then tens of thousands over the years. As with all other aspects of our system, education and common sense is what will elevate us to levels that will result in our financial freedom.

 

Last Weeks Economic News:

Let’s get through this quickly and hope next week will be better.

The Commerce Department revised GDP growth downward for the 4th quarter, 2008 to – 6.3%, the largest quarterly drop in 27 years. New-home sales declined more than 10% in January compared to December 2008 results. Consumer confidence dropped to a record low and the manufacturing sector continued to shrink as durable-goods orders had their 6th consecutive monthly decline. For the week, The S&P 500 decreased by 4.5% for a year-to-date return of – 18.2%.

Note:

This article was written in response a great email question I received from a fellow Blue Collar Investor. Although I have a myriad of ideas for future publications, I welcome your suggestions for future topics. Many times your ideas will allow me to respond to the important issues that concern you the most.

Wishing you the best in investing,

Alan (alan@thebluecollarinvestor.com)