Stop Routing Market Orders on Options. Tom Preston Says You're Getting Eaten Alive.

Key Concepts

• Market Order: An order to buy or sell an asset immediately at the best available current price, with no guarantee on the specific execution price.
• Limit Order: An order to buy or sell an asset at a specific price or better, ensuring the trader does not pay more or receive less than the set limit.
• Slippage: The difference between the expected price of a trade and the price at which the trade is actually executed.
• Price Discovery: The process of determining the fair market value of an asset through the interaction of buyers and sellers.
• Liquidity: The ease with which an asset can be bought or sold without significantly affecting its price (e.g., SPY vs. GE options).
• Bid-Ask Spread: The difference between the highest price a buyer is willing to pay (bid) and the lowest price a seller is willing to accept (ask).

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1. The Risks of Market Orders

The speaker strongly discourages the use of market orders when trading options. The primary argument is that market orders are held to neither time nor price.

• Regulatory Context: Regulators do not hold brokers to specific price or time constraints for market orders. Historically, this allowed brokers to potentially seek better prices, but it also exposed clients to significant price fluctuations during the execution window.
• Electronic Trading Reality: Even in modern electronic markets where execution happens in milliseconds, market orders remain dangerous because they grant the trader zero control over the final fill price. If the market moves against the trader during the routing process, they are forced to accept the unfavorable price.

2. The Advantage of Limit Orders

Limit orders are presented as the superior alternative because they provide control over execution costs.

• Price Protection: A limit order ensures that a buyer will not pay more than their specified price, and a seller will not receive less.
• Execution Control: If a trader sets a limit at the current ask price, they are guaranteed that price or better. If the market moves, the broker cannot fill the order at a worse price, unlike a market order.
• Price Discovery: Limit orders allow traders to "work" an order. By starting at a mid-price and incrementally adjusting, traders can test the market's willingness to fill the order at a more favorable rate, rather than blindly accepting the current ask.

3. Real-World Applications and Examples

• GE Options (Low Liquidity): The speaker highlights GE options, which have wide bid-ask spreads (e.g., 4.15 to 4.55). Using a market order here is described as being able to "drive a truck through" the spread, resulting in massive, unnecessary slippage.
• SPY (High Liquidity): Even in highly liquid assets like SPY, where the spread might only be a few cents, the speaker argues against market orders. While a market order might get filled at the ask, there is no benefit to taking the risk when a limit order guarantees the same or better price.
• Floor Trading Analogy: The speaker recalls his time on the trading floor, noting that brokers would effectively turn customer market orders into limit orders by "working" the crowd to get the best bid, rather than simply shouting "market" and allowing market makers to widen the spread to the customer's disadvantage.

4. Strategic Recommendations

• Avoid Market Orders for Spreads: The speaker emphasizes that for complex strategies like vertical spreads or iron condors, market orders are particularly destructive and will lead to excessive slippage.
• Control What You Can: The core philosophy presented is that while a trader cannot control market direction or the outcome of a strategy, they can control execution costs. Minimizing slippage is a critical component of long-term trading success.
• Default to Limit: Most trading platforms default to limit orders for a reason. Traders should never manually switch these to market orders. If an order is not filling, the trader should manually adjust the limit price upward or downward rather than switching to a market order.

5. Notable Quotes

• "When you route a market order, the broker is not held to time or price."
• "One of the big issues in trading longevity is successful trading is keeping your execution costs to a minimum."
• "You're not trying to do [market makers] any favors. Don't do them any favors, either."
• "You can't control the direction of the market... but you can control your slippage."

Synthesis

The main takeaway is that market orders are a significant threat to a trader's profitability due to the lack of price control and the high probability of excessive slippage. By consistently using limit orders, traders maintain control over their execution prices, engage in effective price discovery, and protect themselves from the predatory nature of wide bid-ask spreads. Regardless of the asset's liquidity, the discipline of using limit orders is essential for maintaining a sustainable trading edge.