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Tuesday, November 05, 2013

Option Electronic Trading – A New Age

The advantage of electronic trading in equity market since 2005 brought a sea-change in one of the oldest trading market of the world – just look at how quiet the floor of NYSE is these days. Fundamentally, this change, which is facilitated by the Rule 611 of SEC Relation NMS (National Market System), together with the advance of computer technology and hardware raw muscle, make the traditional floor based market makers, or specialists, a thing of the past. In this space, we witness the consolidation of exchanges, a healthy growth of trading volume (on the notional value), and continuing shrinking of bid/offer spreads. On the negative side, we experienced the Flash Crash of May 2010, the Knight Capital trading debacle of August 2012.  But no matter what, the glorious days of the trading floor is a thing of the past.

All this happened from the transition of quote-based system to order-based system. In theory, the advantage is shifting from the liquidity providers to the liquidity taker. In reality, the winners and losers are not so clear cut.

While all these are going on in the equity market place, what is happening in the option space?

We see more electronic option exchanges – ISE is holding #1 or #2 spots on volume for years, while all option exchanges offer electronic venues. We have similar consolidation of option exchanges as in the equity market, and latest, we have the Miami Options Exchange (MIAX) started in December 2012, as another purely electronic exchange.

But in term of market structure, option market is still intrinsically quote-based, rather than order-based, for a very good reason. Options, as derivatives, have to have the prices driven by the underlying prices. That means the movement of underlying asset prices should automatically drive the option quotes, no matter whether there are orders or not. Multiple market liquidity providers, who have the computation power to automatically post massive number of quotes for options, will compete with each other on such computing and posting mechanism, and eventually tighten the bid/ask spread, which hopefully gives customers better prices. In this picture, the tightening is not driven by the customer orders.

Here is what we observe in the option space: just as in the equity space, computing raw muscle is flexed and competed in the option space, but we are not seeing much of the “high frequency trading” and the related problems as in the equity space. The only major incident that barely made the headline in recent years is Goldman's computer glitch in August 2013.

What can be made out of this?  Two points:  first, it appears that the computing power for option trading is put in use in the right place, which is the pricing of multitude of derivatives, and competing on the quotes, rather than competing on how close one can put their algorithm box to the exchange (though that does help for option execution).  Secondly, option exchanges do not see a multiplication of complex order types, as it happened in the equity market.  In other words, option market structure remains relative simple and rational.

As a buy side firm and active participant of advanced option algorithm executions, we take such a relatively rational market as a blessing. First of all, we are a customer driven by vol strategy as the primary initiative for trading.  We can focus on pricing with our proprietary model, rather than having to worry about being picked off by the speedier competitors.  Every trade we execute can almost be guaranteed to be at the price or volatility level we want. Secondly, since volatility is the key factor in option pricing, we can use our vol strategy and model to provide liquidity with our risk-taking orders. In this way, while the market is still mostly quote based, volatility traders armed with execution algorithm can play an increasing active role of liquidity providing, with risk taking orders, rather than quotes.

The development of electronic execution fits very well with our vision at Bell Curve:  to have a long lasting business in trading, we have to balance these two seemingly opposing strategies: we should trade and take positions according our model, but we should also actively provide order-based liquidity as a service using our rich volatility trading toolset.

Derek Wang - dwang at

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