Prime cuts and price discovery
Vol#228 - May 29th, 2025
We have officially entered barbeque season.
Everything tastes better on the grill, and my favorite summer meals are served outside and flame kissed. A little protein, a medley of vegetables, sometimes potatoes too. Plate it all on a big tray and uncork the Beaujolais.
Ingredients always matter, but the simpler the meal the more important they get. With little more than salt, oil, and fire separating the raw materials from the final product, freshness and quality are paramount. And as summer days reach their apex, there are plenty of farm stands to meet that demand.
Down the road I have a neighbor who raises American Wagyu on a farm in Vermont. Breeding Black Wagyu bulls from Japan with the French Charolais and American Angus, you get a multi-cultural steak that has all the marbling of A5, but still cuts and cooks like a rib-eye.
Their garage is lined with chest freezers; chuck over there, strip steaks here. A nice 3 lb sirloin that will melt after a few hours in the sous vide - to finish on the grill of course. There’s plenty of supply to go around. And the prices are fair; barely more than I pay at the butcher who’s twice as far away.
The catch is that it takes a little bit of coordination for buyer to meet seller. It’s a lot easier to pop into the supermarket when I happen to be driving by then scheduling a meat date with my purveyor.
Fortunately, shopping for prime just got a little easier. A local specialty market now carries their beef, stocked right next to pork and lamb from another nearby farm. Right there and available every day of the week, it just costs a little bit extra.
Making supply available has a premium. We know it’s not free to keep the doors open, lights on, and freezers stocked. I’ll happily pay an extra buck a pound to avoid the hassle of coordinating every beef drop.
The taker of liquidity gets charged, and the maker of liquidity gets paid. Whether your service is strips of steaks or greek risk, making that buy or sell instantly available to a customer lets you charge a fee, and better liquidity generates more business.
In the options markets part of that fee comes in the form of the bid/ask spread. The thin difference between the offer to sell and the bid to buy is the premium charged for warehousing the opposite side of the taker’s information asymmetry.
Hidden beyond those market widths are a few other moving parts. Payment for orderflow and auction fees add layers to navigate for wholesalers and directors of retail paper. For customers that spinning wheel pits counterparties against each other to deliver the best possible price.
But regardless of your clearing code, a fundamental pricing model for options and equities exchanges is the maker/taker dynamic. Fees for makers subsidize the liquidity they bring to the table by giving them a credit on each transaction, while takers of price pay an offsetting fee to transact at the best publicly available market.
For most retail traders, the actual payments are obfuscated by the priority routing soup, and save for brokers like IBKR who eschew this “conflict of interest” there is no exchange fee charged per order. The payments are managed by the wholesaler, to whom these fees make a significant difference in how buys and sells are routed in the marketplace.
On average these rates come in around $0.80 per contract. So if you pay $150 cash for a single contract on the $1.50 offer, the out of pocket expense is $150.80 dollars. In names that are decremented in pennies, the rates are roughly half that. When making liquidity the signs are reversed, where only $149.20 of cash comes out for a trade priced at $1.50.
The nudge here is to incentivize posted orders. By putting a buy or sell at the top of the market, a counterparty now has either a better price or deeper liquidity available to them, increasing the chances they can or want to trade.
This works as both a revenue model for the exchanges (their vig is the difference between fees and credits) and as a support mechanism for the market. More transactions accelerate price discovery, making markets more efficient. The liquidity/volume flywheel spins as more risk transfers and use cases for options are available, further driving spreads tighter, fees lower, and prices “more fair.”
When liquidity is removed, it’s no longer available to the next customer in line, but it leaves a footprint that is valuable to the entire marketplace. “Buy side” flow (whether it’s buying or selling) carries information. The taker of liquidity is impatient. Sometimes because they see something, other times because it’s not worth it to behave any other way.
Arbitrage is a good reason to take liquidity. If you can buy here and sell there for a net profit, it’s in your best interest to trade before the gap closes. But even when your flow isn’t a lock, it still has signaling power.
Buyers of out of the money puts might be focused on the risk to their individual stock position, but to the tape watchers they are expressing marginal demand for downside skew. Collectively their information is digested and priced into the market. Providers of liquidity don’t know ex nihilo the price of a security, they rely on the ebb and flow of demand to price that.
Sometimes that information is too good, or more likely too fast. Long before AI was catapulting NVDA stock to the most valuable company in the world, high frequency traders were juicing GPUs to get just one tick ahead. If you see an arb, read a stock feed faster, or process news sooner, that orderflow becomes “toxic” as it pre-empts a market repricing. No one wants to make liquidity facing that.
One solution to that is to simply slow everything down for takers, which is the route that IEX has taken with its equity markets. As they move into options, we’re likely to see some interesting market structure evolutions too.
Other exchanges embrace the takers, and are willing to go so far as to flip the model. By paying takers of liquidity, the venue attracts a different mix of orderflow. Even knowing they’ll be charged to make, a participant might post here because the importance of getting filled is worth more than saving a few pennies. Orders here complete 2.5x faster than maker/taker as both sides are anxious, excited, even giddy to trade.
Yet the market share of those inverted exchanges is not only relatively small, it continues to dwindle. While the trading landscape has never been more efficient, it’s also increasingly fragmented. There are so many different places for buyers and sellers to meet, finding the best matchup is a constant juggle for best execution.
Buying and grilling a steak is a lot easier than routing equity options. But the dynamics aren’t that much different. You’ll have wealthier farmers and happier customers when the right mechanisms are in place to match supply and demand. Richer, deeper, and more liquid markets come from efficiently matching the various different trading interests.
Trading a few hours investment advice for a quarter cow would be a complicated transaction, which is why we have money. But even if we introduce fees and an intermediary, both parties win when there’s an exchange that facilitates two lonely orders becoming a taker/maker pair.