Joining Bids and Offers
Vol #124: April 6th, 2023
Legends of the floor exist on the fringe of reality and the absurd.
Gather round for the tale of orderflow stacked so high into the bell you had to spend hours after the close matching up buys and sells for just the right amount of edge. Or of the fledgling group of sole props who dodged a mismatched trade, watching stock rocket up as they lived to fight another day.
I still don’t know if I believe it, but there were rumors that Hank Greenberg used to call the stock exchange every day at the close to see where AIG was going to print. My heart goes out to that specialist on a down day.
It’s highly unusual for a market maker to get a telephone call from a customer (or CEO). They have no reason or capacity to deal directly, exchanges and brokers are the necessary intermediaries.
Sitting eleven floors above the American Stock exchange, I was pretty taken aback when the voice on the other end of the line identified himself. “As a former market maker, I’m absolutely appalled at the markets in XYZ Holding Co.”
“Come again?”
We tended to traffic in relatively low liquidity names that had some wonky pricing, skew, or special situation. The orderflow was chunky and sporadic, but when things heated up being ready made good hay. But when nothing was happening - of course the markets were wide.
I pulled up the screen markets in XYZ and sure, they were .50-.60 wide in a ~ $30 stock. That’s not Grade A Prime liquidity, but in something that trades a few hundred contracts on a good day, it’s no slouch either.
I wasn’t the one responsible for quoting that product, but the unlucky diplomat on the exchange contact list. My response was something along the lines of how given the activity and dynamics of the product these were our screen markets, but if you have an order you’re more than welcome to try for price improvement.
When the trader and I laughed about it over beers at O’Hara’s, his response was far more curt and expletive laden. Here’s the $#!% market, &^@ take it or improve it.
While there are thousands of FIX tag configurations, there are really only three types of orders you can send. You can take liquidity by paying the offer or hitting the bid. You can make liquidity by price improving one side, tightening the spread. Or, you can also make liquidity by joining one side of the market and increasing the overall posted size (even if it’s not top of book).
All of these order types are important and necessary in the market ecosystem. Liquidity takers pay extra fees for a speedy execution, and they are the business that keeps the pipes open and the spreads tight. Making liquidity is a constructive exercise that improves the depth of the market, and allows greater size to transact with lower slippage.
As any business does, market makers constantly observe the prices that their competitors are charging. Margins are denominated by the edge padding a theoretical value, the net of the price you buy or sell for and what you think it’s worth. If Greek God Capital is quoting AAPL a penny around fair, then I need to do the same if I want to see any action.
In the pits this practice was derided as hand raising, and on the screens it’s more euphemistically referred to as joining. Hand raisers were the laggards who didn’t come up with their own market, but just elbowed onto a ticket after their sharper peers set the price.
In the electronic world, the market dynamics are slightly different. Open outcry quotes were for a specific strike or spread, while the screens are a full montage of quotes on every available strike and many different combination orders. Joiner scripts are the 101 of streaming markets, and they set your quotes to equal the market quotes so long as there’s more than your minimum edge and size on the market.
The justification for this is somewhat reasonable. Sure, it’s lazy to let someone else do the work and ride their coattails. But it’s also very keen to lean on public information in evaluating how much something is worth. Knowing someone else is also willing to trade at this price, I can’t be totally crazy, right?
Joining also acts as a safety mechanism. If your values get stale because vol is shifting down and you’re too engrossed with your lunch, the fact that others are fading off the market then pulls your own quotes off as the market drops below minimum sizes. Depending on the confidence you have in your values and the liquidity of your market, join sizes will vary widely.
Pro-rata exchanges encourage joining. The dynamics of order allocation mean that showing larger size on a market will give you a larger piece of the orderflow. If the market is .10-.30, and you have the option worth .20, even if a nickel in edge is enough to trade, you’re usually better off adding to the .10 market. You can more confidently show a bigger size, and price improving to .15 probably means everyone else matches your quote, and now you’re getting the same size but for half the edge.
Size is an important component of liquidity. If more contracts can trade with less slippage, that’s a good thing. Encouraging participants to show more size improves the customer experience. But getting the markets as competitively tight as possible is also important, and that’s a role that maker/taker exchanges play - incentivizing the first person to set the price with first dibs on orders trading at that level.
Another flavor of joining happens in the price improvement auction process. When a broker sells their customer paper to a wholesaler in exchange for payment for orderflow, if the wholesaler wants to trade against that order, they have to submit it to an auction. While this prevents complete back room internalization, the dealer with a paired trade still gets plenty of home field advantages.
Every exchange has slightly different rules, but the order originator is generally allowed to match the best price that happens in the auction. Back to that .10-.30 market, if an auction kicks off, the dealer might initiate a matched buy for .12, with a match paying up to .16. Respondents who are tapped into this feed (which only costs a few thousand bucks per month per exchange) have milliseconds to algorithmically respond with their best bids.
In some mechanisms you can see the .12 initiating price, other places it’s price blind. Which actually results in better bids is an argument for academia. But based on the various participants' price improvements, the wholesaler who kicked off the trade has rights on a certain percentage of the trade (usually 40%) up to their matched price.
To other respondents, that feels like an insider's advantage. But for the customer, it encourages competition that results in a better level. Initiators need to show their best bid if they want to take down as much of the order as they want, and respondents must parry in kind to get a slice of the trade.
While retail customers can now tap directly into electronic liquidity for instant 0DTE satisfaction; to get a large order traded, oftentimes a broker will spend all day building size and soliciting interest. (Other times Pennsylvania River Trading wants to box everyone out and take down the entire size.) Negotiations about price go back and forth, and the transaction is compiled from multiple different shops. While not an official term, traders might give a broker a quote for the order with the caveat “on a print”.
“OAP” means that you’re good for a certain size and price, but only if that entire order trades at the level. Traders don’t want to get hung out on a piecemeal ticket that ends up trading better. It’s a defensive mechanism for market makers, but it also lets them add liquidity to help manifest a potential transaction.
Joining improves the quality of electronic, auction, and voice markets. It acts as a safety and cooperation mechanism, while also encouraging competition. But there can be too much of a good thing. Where joining goes awry is where the Wisdom of Crowds devolves into the Extraordinary Popular Delusions and the Madness of Crowds.
Large groups of people are very good at things like guessing the number of gumballs in a machine. The average of guesses from a reasonable sample size tends to come fairly close to true value. Much of statistics also relies on this population effect. If you have independent guesses, their error terms tend to net into reality.
Groupthink is how wisdom becomes folly. When likemindedness becomes self reinforcing conviction, you start buying monkey jpegs and tulips. If you’re joining someone who has exactly the same market biases as you do, you’re both cementing that conviction for each other.
Whether they’re across pods or across firms, market makers can get lulled into joining quotes with peers and drag their feet on updating values. This recursive confidence masks shifts in pricing inputs and can lead to getting picked off.
It is ironic that joining sounds etymologically closer to collusion than competition. The benefits of market makers bolstering their peers bids, matching their prices, and combining size directly flows through to the price that customers pay. Efficient markets are those which can move size, fast and tight. Join away.