Yesterday I executed my first block order in Ethereum options.
It’s hard to describe how exciting this moment really was. It not only represented months of work to gain access to the correct venues, but also that we’d gained enough confidence in our strategy to take it to the big leagues.
For microstructure geeks and traders, what was really exciting about this new opportunity was execution quality and slippage reduction.
A block order is typically composed of multiple different “legs”, where you’re buying one security to sell another. In options we talk about call spreads, butterflies and condors, but there can be infinite variations of ratios and leg quantities. (My first trade was 67 x 45 x 25 x 80 x 80).
To execute across even two different legs at the same time opens up execution risk. Perhaps you buy one, but by the time you’ve gone to sell the other price has moved. Posting these orders electronically is juggling money knives.
The difference between the fair value of a security, and what it costs you to acquire or dispose of that buckets a number of costs into the concept of slippage. This includes the transaction costs that are paid to your broker, paid to the exchange, and maybe even the clearing company.
Slippage also takes into account that most likely you paid a small mark-up to a dealer on the actual trade price. Markets are quoted with bids and offers, and the midpoint between those two is considered the fair value. Professional liquidity providers charge a service fee in the form of putting their best buy price slightly below fair value, and their best offer price slightly above.
The wider the markets are, the more expensive the transactions, the worse your slippage will be. Executing in markets with high transaction costs disincentivizes participation, and makes certain strategies less viable. It just feels like you’re constantly getting ripped off.
While the initiators of orders (buy side) are trying to reduce their slippage, the other side of the trade is also trying to optimize their interactions. Dealers and liquidity providers are professional executors, and they don’t want to see their small mark-ups turn into large mark-downs.
Even as I was first starting on the trading floor, people would ask why open-outcry trading still existed. Can’t computers do this? It seemed like a vestige and cruft from a bygone era. The main reason they still do, is because large orders like low slippage, and a negotiated order provides the best opportunity for that.
It is true that computers have overtaken that - my ETH block trade was done via an electronic “Request for Quote” (RFQ) market - but the concept is similar. When you display your entire order neatly packaged together, each dealer not only gets to give their best price, but the customer benefits from the competition amongst dealers.
If a liquidity provider sees one part of his screen flash red, then another green, and she’s getting peppered with trades across different expirations, the spidey sense is heightened. But when they’re all presented in a neat RFQ package, where buys offset sells, and the overall risk profile is clear, it’s easy to give a good price.
The prices you see on the screens are representative of what risk dealers are willing to take on a completely blind order. You don’t know what’s coming next, so you better stay small and nimble.
In the below picture, you can see the at the money calls expiring next week in ETH have a bid price of $202.70 and an offer price of $208.90. (They’re actually priced in ETH itself, but that’s a bit mind-bending for this space.) In the size column you can see anywhere from 1 to 293 contracts are available depending on the strike and side.
In a block trade facility orders multiple times this size go up, and prices are quoted $2-$3 dollars wide, instead of $6-$13 wide. Those dollars add up across every contract and leg, making this an incredibly valuable opportunity for both sides.
Liquidity providers benefit because they can see the whole picture at once and provide competitive pricing to win the order. Buy siders not only reduce the complexity of their trading activity, but get better pricing.
Reducing slippage is the objective of all market participants. It takes two sides to make a trade, and arriving at the most competitive and fair price allows the markets to do their job of bolstering capital formation and risk management.