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What does “Market orders for stock options are blocked due to illiquidity” mean?

Rejection: "Market orders for stock options are blocked due to illiquidity. Try placing a Limit order."

Market & Stop Loss Market [SL-M] orders are restricted in stock and commodity options due to a lack of liquidity. Alternatively, you can use Limit [LMT] & Stop Loss [SL] orders by placing a buy order with limit price much higher than LTP or placing a sell order with limit price much lesser than LTP. 

In such cases, the limit order will automatically execute like a market order since you're instructing to fill your order any price up to your specified limit. The good bit here is that the limit price you enter will act as a protection and ensure that your order won’t get executed beyond this price. 

A lack of liquidity means that the bid and ask spread in the scrip is very high and can have an immediate adverse effect on your P&L. Consider the below illustration:

Assume stock X is trading at Rs 100 and you decide to buy 110 strike price calls of this month (lot size 5000) expiry. You add the 110 calls and you see the Last Traded Price (LTP) of Rs 0.5 on the watchlist. 



You are in a hurry to buy this call and decide to place a buy order without looking at the market depth. You decide to buy 5 lots, knowing the maximum you will lose is Rs 12500 (25000 x 0.5). However, only 1 lot is being offered at Rs 0.5 and the rest 4 lots at Rs 5 (this is an illiquid contract). 



Now, 1 lot gets bought at Rs 0.5 and the rest 4 at Rs 5. So, suddenly instead of Rs 12500, Rs 1,02,500 gets blocked in this trade (0.5 x 5000 + 5 x 20000). If you want to sell it immediately, the best offer is around Rs. 0.45. As such, you just lost Rs 1 lac because of the lack of liquidity. In order to keep yourself protected from such risks, you can use limit or SL orders and restrict order execution within a given price. 

You can discuss this with fellow traders at more length on TradingQ&A