Mids, Bids, and Limits
Vol #168: February 29th, 2024
The conference could have been in New York, Philadelphia, or Chicago. It was a generic hotel ballroom, and four score of fin types were mingling in between sessions.
Whether they were brokers, wholesalers, or the phalanx of exchange reps who were hosting the event, the one commonality of this group was being able to talk about options through happy hour and beyond. Everyone has their tiny (or large) niche of the market, and are here to socialize and defend their interests.
Know when to speak up, when to shut up, and when to take an offer.
In the tiny little corner of financial markets that is US Listed Equity Options, there’s a strong rising tide that lifts all boats dynamic. The virtuous cycle of orderflow improves liquidity, pays fees to the execution brokers and exchanges, and gives risk to the experts who price it. There might be quibbles about tweaking the specialist allocations for under five lots, but really what everyone wants is volume.
Like an engineer that needs sales to get the product in front of customers, half the ecosystem (dealers) is relying on the other half (brokers, exchanges) to generate new and improved volumes. Sigadel isn’t paying for covered call billboards, but they have plenty of marketing charges to allocate to Fidelischwab.
The old saying goes that financial products are sold, not bought. That is as true for annuities as it is for options. Twitter gurus will tell you their signal harmonizes the moon phase with the bitcoin blastoff, and that generates subscriptions and negative Pnl. Structured products put a buffered wrapper on your position, and are delivered net of rich fees.
But how do you sell yourself as an industry? What can we do collectively that gets more people using options? That was the question du jour.
Amidst a sea of blue blazers, Jack’s point hit like a fuschia colored smoke bomb. Every investor looks at the markets before making a trade. The NBBO is the best advertisement we have for options. Show me your bids, or pay my offer. A robust lit market brings the flow.
The bid/ask is a confidence interval, all the current interests best estimate in pricing the risks of the contract. But it’s also the display case window for the average options enjoyer whether they’re walking down Main Street or Maiden Lane. Ex ante any EQ, a trade only starts to happen if someone likes the jib of your spread.
Visible liquidity on the screen markets, in the form of depth, width, and granularity of strike offerings, lets options customers put together reasonable strategies. It’s a tough enough fight for marginal basis points, so giving it up on execution makes many strategies a non-starter.
An irony is that while the swanky new fit never looks as good on you as the mannequin, most of the time the fill you get in the markets is better than advertised. That’s confusing!
Psychology wreaks havoc here with anchoring and buyers remorse. The advertisement of the market sets an expectation. If you’re punching in an order ticket, the liquidity was deemed adequate, and you set the price accordingly.
If the market is $1.00-$1.20, sending in a $1.15 bid might get filled immediately. Instantaneous feedback is good, except it means your price was good enough to pounce on - could you have gotten a better fill?
Because of the dynamics of auctions and price improvement mechanisms, a $1.20 bid could even be returned with a $1.14 fill. Those six pennies cut your execution cost in half, but it’s delivered in an obfuscated and random manner. Despite the fact that most retail order flow trades at more than a 50% improvement to the bid/offer price, the means by which it’s delivered does little to advertise the liquidity of options markets.
The market’s display price is the ruler by which execution quality is measured. The segment of orderflow that is eligible for this (customer range, typically less than 250 lots) gets risk priced differently because of its typical characteristics. Posting tens of thousands of bids and offers opens you up to billions of dollars of asymmetrical risk on the screens, but a predictably random non-toxic segment is easily digestible risk.
EQ is a barometer for how much more valuable this certain segment of orderflow is. If it trades at lower than a 50 EQ (more than halfway closer to the mid than the bid or offer) that suggests it's more than twice as valuable.
The customer clearing range is not the only group that gets orders priced between the screen markets. Block orders from institutions will trade at more competitive levels for a similar reason - they can demonstrate non-toxicity by tying it to a hedge or showing their full hand.
Tightening up lit markets is both a cause and an effect of liquidity. A 40 EQ on a $0.20 cent wide market gives you still $.04 of edge - an effective spread of $1.06-$1.14. On a $0.10 cent market that’s only $0.02 of edge at $1.08-$1.12. The fear from brokers is that they’ll get their 40 EQ, but displayed markets will be wider and their customers are getting worse fills. Hence the insistence on display case advertising.
Fortunately there are a lot of dynamics both pre and post trade that make that nearly impossible. The wheel is a ruthless allocator.
Dealers can provide liquidity in more ways than just posting bids and offers. While “taking” from an order routing perspective, there are plenty of occasions when market makers send options orders to trade against a posted market. Some of this is done automatically with “electronic eyes” that scoop orders meeting edge requirements, but much is done manually in lower tier products.
In thinner names, everyone’s uncertain about the pricing. And with lower activity levels, the padding on asymmetric information has to be even greater. But greed overcomes fear, and seeing a posted order float around for several seconds or minutes, blissfully unaware of stock ticks starts to suggest it’s not pickoff flow, but a lonely single sided order. Double check your dividends, and whack the bid.
The customer on the other side of that order got the price they liked, and the dealer got enough edge to wear the inventory. Both sides are happy here, even if the maker/taker relationship got reversed. But in most cases, this doesn’t count in the EQ statistics, which is only for immediately marketable orders.
Parsing market quality from fills is complicated, and in many cases subjective. There are elements of the EQ arithmetic that make you scratch your head, but overall the forces behind it are an enormous tailwind for retail options traders. The lit markets have gotten tighter and the EQs have gotten lower (i.e better for customers).
The next step will be making this more understandable and predictable for the user. Law of large numbers works for a dealer, but most of us are only entering a few orders a day/week/month. It would be nice to know what the sale price is before you clicked buy (or sell.)