Option Order Types

Basics of Orders

When looking at an options chain, traders are presented with a menu of available contracts, each listed with prices, expiration dates, strike levels, and other relevant data. From this list, the investor selects the contract that suits their objectives, determines the type of transaction they wish to enter, and specifies how the order should be executed. Alongside the basic price information, the chain often includes additional indicators. For instance, the open interest column shows how many contracts of that option are currently outstanding, which serves as a measure of activity and liquidity. Another useful figure is implied volatility, which reflects the market’s expectation of how volatile the underlying asset is likely to be over the life of the contract, as inferred from the option’s current market price. Together, these details guide the trader in deciding which contract to buy or sell.

All the sophisticated strategies that appear later in options trading are ultimately built from four basic types of transactions. A buy-to-open order establishes a new long position in either a call or a put, while a sell-to-close order is used to exit such a position. On the other side of the market, a sell-to-open order is placed when a trader writes a new option, thereby creating a short position. That short position can later be eliminated with a buy-to-close order. Every combination of spreads, straddles, and multi-leg strategies starts with these simple mechanics.

Once a trader has decided on the contract and transaction type, the next step is to determine how the order will be carried out. The most basic method is the market order, which instructs the broker to buy or sell immediately at the best available price. Market orders guarantee execution but offer no protection against slippage if prices move quickly. Many traders prefer limit orders, which specify the exact price at which they are willing to trade or better. A buy limit ensures the trader will not pay more than the specified price, while a sell limit ensures they will not accept less. The drawback is that if the market never touches the specified price, the order may remain unfilled, and opportunities can be missed.

Another common instruction is the stop order, which becomes active only once the option reaches a certain trigger price. Stop orders are typically used to cap potential losses, automatically closing a position if the market turns against the trader. Unlike limit orders, once activated, stop orders execute as market orders, which means the final price may differ from the stop level. A variation is the stop-limit order, which also activates once a stop price is reached but will only execute at the specified limit price or better. This prevents the order from being filled at an unfavorable price, but it also introduces the risk that the order may not be executed at all if the market moves past the limit level too quickly.

Orders can also carry different time conditions. A day order is valid only for the trading day on which it is placed and is canceled if not filled by the close. A good-’til-date (GTD) order remains active until a specific date chosen by the trader, while a good-’til-canceled (GTC) order stays open until it is either executed or manually withdrawn. Traders may also add instructions such as all-or-none, which requires that the entire order be filled under the given conditions, otherwise nothing is executed. Without such an instruction, it is possible to receive a partial fill, where only part of the order is matched. Since prices in financial markets can shift rapidly, these distinctions matter—having the right order type in place ensures that quick changes in price work to the trader’s advantage rather than against them.

For those who want greater control, many brokers also provide advanced order types. Among these are contingent orders, which are executed only if the underlying asset reaches a particular price level. These resemble stop orders but are designed to hinge on the behavior of the underlying rather than the option itself. Another variation is the trailing stop order, which begins like a stop but adjusts dynamically as the market moves in the trader’s favor. By setting a trailing percentage or dollar amount, the stop price follows the option higher (or lower, depending on the position), locking in gains while still giving room for the position to appreciate further.

Other specialized structures include one-cancels-other (OCO) orders, where two linked orders are placed simultaneously but only one will survive. If one is triggered, the other is automatically canceled, allowing traders to set both a profit-taking level and a stop-loss level without risking double execution. There are also one-triggers-other (OTO) orders, where the execution of a primary order immediately activates a secondary one. For example, closing a position with a stop could simultaneously open a new one in the opposite direction. These advanced order types give traders the flexibility to manage risk and opportunity with greater precision, making them valuable tools for anyone pursuing more active or complex strategies.

Marking to Market and Margin

Because options provide built-in leverage, exchanges must ensure that all parties can meet their financial obligations if a contract is exercised. To safeguard the system, no options trade can be entered without collateral on deposit. This collateral is called margin, and it serves as a financial guarantee. The margin requirement varies depending on the specific contract, reflecting a complex relationship between the premium collected, the current value of the option, and the probability that it will be exercised. To help both traders and brokers manage this calculation, the Options Clearing Corporation provides tools such as a portfolio margin calculator, which shows the collateral necessary to support different positions.

At the close of every trading day, the clearinghouse performs a process known as marking to market. Each account is evaluated in light of the day’s closing prices to verify whether sufficient margin remains to support its open positions. If the account meets requirements, positions carry forward into the next session without interruption. If it does not, the broker issues a margin call, demanding additional funds be deposited. Failure to respond typically results in the forced liquidation of positions, ensuring that the system remains solvent and that no party’s losses can cascade into the broader market.

Moneyness

In options trading, the profitability of a contract at any given time is referred to as its moneyness. An option is in the money when exercising it would generate a profit, while it is out of the money when exercise would not be worthwhile. If the market price and the strike price are exactly equal, the contract is considered at the money.

For calls, moneyness depends on whether the strike price is below the underlying’s market value. A call option with a $50 strike is in the money if the asset trades above $50, since the holder could buy at the strike and sell immediately at a higher price. If the market price is below the strike, the call is out of the money. Puts operate in the reverse manner: a $35 put is in the money when the market is below $35, allowing the holder to sell at the strike while the market offers less. Above $35, that put becomes out of the money. For writers, the outcomes are flipped—the option they sold is profitable for the holder precisely when it represents a liability for them.

Moneyness applies equally regardless of whether the option is American or European in style. While American options can be exercised at any point before expiration and European options only on the expiration date, the concepts of in, out, and at the money describe relative profitability, not exercise flexibility.

Open Interest

Another key measure of activity in the options market is open interest, which counts the total number of contracts outstanding at any time. It differs from trading volume, since many trades are simply the closing of existing positions rather than the creation of new ones. Market participants watch open interest closely because it reflects sentiment and liquidity; higher open interest typically signals deeper markets and stronger investor participation.

At the individual level, traders also have limits on open positions. Brokerages often impose caps based on the trader’s available margin and their level of experience. These limits prevent traders from overextending themselves with obligations they may not be able to cover.

Expiration and Exercise

Every option eventually expires, creating decision points for holders and writers alike. Standard equity options generally expire on the third Friday of the contract month, with trading ending at the close of business the day before expiration. Some contracts, however, stop trading earlier. For example, A.M.-settled options cease trading on the Thursday before expiration, while certain P.M.-settled contracts stop at midday on Friday. In addition to monthly contracts, many exchanges now list weekly options, which begin trading on Monday and expire that same Friday, giving traders a way to capitalize on short-term moves.

The time from initiation to expiration is known as the option’s life or time to expiration. Traders who wish to maintain exposure beyond expiration often roll their positions—closing out the current contract and simultaneously opening a new one with a later expiration or different strike. Expiration cycles are especially active during the “Quadruple Witching” days in March, June, September, and December, when equity options, index options, stock index futures, and single-stock futures all expire together, often creating sharp volatility.

To exercise an option means to act on the right it conveys. A call holder exercises by purchasing the underlying at the strike, while a put holder exercises by selling at the strike. For example, if you hold a call giving you the right to buy Johnson & Johnson at $100 when the stock is trading at $105, exercising secures you the ability to buy below market value. Some brokers permit immediate resale of the acquired stock, while others require settlement first.

At expiration, brokers may automatically exercise profitable contracts, though practices vary. Automatic exercise ensures that traders do not lose gains through oversight. When exercise occurs, the clearinghouse randomly assigns the obligation to one of the option writers. The broker of the assigned writer then passes the responsibility on to a customer in that firm, typically also chosen at random. Despite this mechanism, it is important to note that most options contracts expire unexercised, with the holder choosing to let them lapse instead.

Delivery and Settlement

Settlement depends on the type of option. For equity options, the standard is physical delivery. If a call option is exercised, the writer must deliver the actual shares of stock to the buyer’s account. If the writer does not already own the shares, they must purchase them on the open market in order to meet the obligation. Only the transfer of the actual shares closes the deal.

Other types of options, such as index options, are settled in cash rather than with physical delivery. In this case, the settlement amount equals the difference between the strike price and the closing value of the index, multiplied by the option’s contract multiplier (often $100). For example, if an index stands at 561 at expiration and a call with a strike of 541 is exercised, the cash settlement equals (561 – 541) × $100, or $2,000. This amount is transferred from the writer’s account to the holder’s account.

Commodity and futures contracts may require cash settlement as well, though in certain markets physical delivery remains possible. Exchanges even maintain infrastructure—warehouses, grain silos, or depositories—to ensure delivery can occur if demanded by the contract. While most financial traders close their positions in cash, physical settlement is vital for producers and commercial users who actually rely on the commodity in question.

Extrinsic and Intrinsic Value

The price of an option can be broken into two main components: intrinsic value and extrinsic value. The intrinsic value represents the portion of the option’s price that comes directly from its relationship to the underlying asset. Put simply, it is the amount of money that could be realized if the option were exercised immediately. For that reason, intrinsic value exists only when the option is in the money. If exercising the option would not result in a profit, its intrinsic value is zero.

The second component is known as time value, or extrinsic value. This is the difference between the total market price of the option and its intrinsic value. To think about it logically: the intrinsic value measures what could be gained by exercising today. If the option’s price in the market is higher than that amount, the excess reflects the value of time. By holding the option rather than exercising immediately, the investor preserves the possibility of greater profit if the underlying asset continues to move in the desired direction. The time value is also tied to the insurance-like aspect of options, since the contract provides ongoing protection until it expires. This explains why many traders keep options even when they are already profitable—exercising early would lock in gains but eliminate the remaining time advantage.

Both intrinsic and extrinsic value contribute to the option’s market price, and recognizing their roles is essential for proper valuation. Later chapters explore pricing models in detail, but the core idea is that no option can be assessed accurately without considering both elements together. A related concept is parity, which occurs when an in-the-money option trades for only its intrinsic value, with no time value remaining. Options usually reach parity only in the final moments before expiration, when the remaining time has no meaningful effect on price. Weekly contracts, which exist for just a few days, tend to have very little time value from the start, making them more likely to trade near parity.

Relationships Among Options

It is important to remember that a single underlying asset is associated with a wide range of options, not just one. Traders can choose from multiple strike prices and expiration dates, each offering different potential payoffs and risks. This variety creates a spectrum of opportunities for both speculation and hedging, and it forms the basis of many complex trading strategies.

These relationships are organized in several ways. The options cycle, sometimes referred to as the expiration cycle, describes the pattern of expiration months available for contracts on a given asset. Traditionally, options were listed in three-month intervals, but not all assets followed the same schedule. Instead, exchanges divided listings into different cycles, ensuring a spread of expirations across the calendar year. Understanding the cycle matters because it determines which expiration months are available at any given time, and thus which strategies can realistically be implemented.