Say you want to exit a long option position at a loss; you set a stop loss order. The problem is due to the wide bid/ask spread in the options market (compared to stocks/ETFs - of course, liquidity and bid/ask spreads differ based on the strike prices, expirations, underlying etc.) By the time a completed trade hits the stop trigger, the bid is much lower than where we wanted to sell. I guess you could compensate for this by setting the stop trigger at a higher price but that encroaches on other aspects of my strategy ! You could also use a stop limit but that does not guarantee a fill if the price drops big and fast. My question is this - can you set a stop trigger based on the bid and not a completed trade?
Yes, some brokers have this feature. So it depends on your broker whether you can place such an order or not.
Be careful. When there is a fast market, or any time the market makers widen their bid ask spreads, the bid price drops by a significant amount. That could trigger your sale. There is no good method for using stop loss orders when trading options. Consider spreads: They have a built in stop. No system is perfect Mark http://blog.mdwoptions.com
Indeed. Generally, if you insist on using a stop order then it would be more prudent to tie it to the ask price with some offset as the bid can drop to zero.
I emailed TDAmeritrade customer service and they said this: For long positions, when entering a stop loss order to exit the trade the bid price is used as a trigger for stocks but the ask price is used as a trigger for options. (My opinion is that using the ask is even worse than using a completed trade to trigger). I guess I would need to use a stop limit - the stop being the ask, the limit taking into account the bid/ask spread. OF course as will all limit orders there is a danger of not filling.
Actually the logic behind it is exactly what I mentioned above. Bids can drop to 0.01 or zero, which would trigger your stop. The ask price, on the other hand, is not prone to this. Using the last trade price for options is the worst alternative, especially if it's not a liquid option.