Topic was discussed recently on this forum:
Liquidity (number of bids/offers) on stock options is quite low. For example look at the market depth of Cipla Sep 600 CE (current market price of Cipla stock is 560).
1 lot of Cipla is 1000. As you can see there are bids for 59 lots and offers for 16 lots. If you look at the offers closely, the best offer is at 6.65 for 1 lot. The market depth shows upto the best 5 bids/offers. So the 5th best offer that you can see on the market depth for Rs. 9.20.
Assume you have decided to buy this option. Market depth is not a default view on most trading platforms. It shows up only if you invoke it with an action like double click or some menu action. So when you decide to buy, what you see by default is the LTP. So in this case you would be seeing LTP of Cipla Sep 600 CE which is 6.25.
Assume you got very bullish on Cipla and decided to buy 10 lots of these options as soon as possible at market price. Since you see LTP as 6.25, you'd probably assume that you need around Rs 62500 to buy 10 lots (or 10000).
If you hit a market order, 10 lots would be bought in this sequence(look at marked depth). 1 @ 6.65, 1 @7, [email protected], [email protected], [email protected] (that makes it 6 lots). The rest 4 lots could be anywhere. If the next offer is at 20, it could be at that. What this means is that the market buy order that you were expecting to get executed at around 6.25, could now have gotten executed at upto Rs. 20. Assume it got executed at an average of around Rs 10. This would mean instead Rs 62500, Rs 1lk would have gotten used up to buy this option.
Realizing your folly if you decided to sell it fast as another market order, you probably would realize looking at the bids on the market depth, it would probably get executed at Rs 4 or under. So the idea of buying at market, just caused Rs 60000 loss (assuming you bought at average price of 10 and sold at average price of 4).
The above option contract is not the worst in terms of liquidity. There are over 40000 stock option contracts trading at every point, and there are contracts where liquidity could be a lot lesser.
Many trades make this mistake and lose a lot of money. Hence market order on stock options was disabled as a market protection policy.
But here is the thing to know, even without market order, you can use a limit order like a market order with a protection. In the above example if you placed a limit order to buy 10 lots of the option at say Rs 7 (price higher than ltp), it would be like a market order upto the best offer of Rs 7 ensuring nothing gets bought above 7. So 2 lots would get bought, and the rest will remain pending as best bid at 7. Similarly if you sell with limit price as 5, it will ensure that nothing gets sold below 5.
So using limit orders with a price higher than current market price for buying and price lower than current market price for selling acts like a market order but with a protection of upto the limit price you mention.