Prime Quality Markets
Vol #151: October 19th, 2023
When stocks go up we think the market is good and when it goes down we think it’s bad. Most investors just want number go up.
The market is not synonymous with investment performance, it is necessarily neutral. The mechanism that allocates scarce resources may have better liquidity on up days (but not always) but quality is independent of price.
So what makes a quality market? It’s important for all participants, but what determines that is vastly different for each. There’s no inspector coming by to give it a grade.
The sui generis of exchange is that there is a buyer and seller to match. There is an agreement about price; goods and services are transferred. Markets are venues, protocols, or server piles that facilitate lots of transactions like this.
The term ‘market’ can refer to the specific bid and ask price of a publicly traded security, and it can broadly envelope the entire economy of nation states. No matter the size, they do not exist in a vacuum.
Basic markets have natural customers. The buyer who wishes to own the property for investment or residential purposes and the seller who wants cash for the keys to their illiquid asset. Advanced markets in complex products require intermediaries and dealers to provide liquidity that would not otherwise exist.
In equity options, the markets are the ecosystem of exchanges, market makers, and customers who wish to trade listed derivatives. Their incentives and expectations are what determine the quality of markets.
Whether customers are buying or selling options, they come to the market for something. They are liquidity takers who are paying a premium for the service of facilitating their transaction. There would be very few overwriters if every time you wanted to sell an AAPL call you had to find someone to pay you. A few pennies of edge to your friendly neighborhood dealer solves this.
The buy side has expectations for what they expect in the markets they are paying for. Whether you’re slinging 0DTEs from your basement or 5th Avenue, you want to see liquidity. The posted bids and offers in the market are as much an advertisement as an ask price. Come and dip your trade in here, the water is nice and warm. Get in, get out, let’s make some money.
What matters for your PnL is the price you get, but the price you see is what sets up the trade in the first place. Most buy side doesn’t have their own theoretical model, so they’re leaning on the market to tell them what something is worth. The window dressing helps make the sale.
If you look at a bid ask spread that is two pennies wide, there are only three prices to get filled at. (.05-.07 and .06). That is likely to be accurately priced and your worst case is only a penny over the mark. Once you get to 10 and 20 cents wide, it just feels like there is so much wiggle room for you to get ripped off. The opacity of price improvement only underlines this, where you scratch your head at why this is filled here even when it’s better than the bid or offer.
This harkens to our innate sense of fairness as humans. We’d prefer no deal to one where the parties are unequally rewarded. The Ultimatum Game has been much analyzed in game theory, and when we sense the other party knows more than us, it’s hard to believe as customers we’re getting the right amount of price improvement. Brokers are supposed to lobby for this, but they’re conflicted at best.
HFT became a slur in the early 2010s because these speed traders were shadowy super coders taking advantage of customers. While there were certainly rule breakers, for the most part the existence of competitive liquidity providers running laser beams from Aurora to Mahwah resulted in much tighter markets. Arguably the rule breakers even did a service in highlighting fragilities and flaws in order types and who had access to them.
If you ask a market maker how they would define a quality market, just because they’re taking the opposite side doesn't mean they have a totally opposing viewpoint. The holy grail of orderflow is not some characteristic of any specific order, but the overall existence of back and forth trading. A good market for them - where they can make money and provide good liquidity - is where orders come randomly in both directions.
Of course this is better when the markets are wider. You’d rather buy and sell for a dime than a nickel. But it’s a balance of being tight enough to advertise and attract material volumes of orderflow, and fat enough to pay well. It’s also much better to make 100 bets for a penny than 4 bets for a quarter.
Wider markets provide fatter edge, but the forces of competition drive these tighter with certainty and wider with less of the same. A wide market means no one is confident enough to carp it tighter. That quarter is more likely to cost you dollars than the penny is.
A dealer also wants markets where the customers make sense. Providing liquidity for a product where customers are doing predictable strategies and the orderflow is consistent is much more desirable than one where large trades happen in arbitrary ways.
The best argument for open outcry and high touch trading is that by opening the curtain on what’s going on behind the scenes in terms of size and objectives, that market makers can digest the information and provide a complete market. Trading services with large memberships often will drive prices out of line for short periods of time because a flood of small orders continues to pepper the market and dealers step back wondering when the big one’s coming.
Good markets are self supporting. There is the virtuous cycle of liquidity begetting more liquidity, but the best markets can be building blocks for other markets. Accurate pricing supports the calculations of indicators and benchmarks, and more expirations with finer grained strike prices allow for much more nuanced strategies to be designed and executed.
Necessarily a derivative can only exist because of the presence of an underlying. But the overall quality of derivatives markets can build on itself and offer additional and unique products. The VIX index is a calculation based on the prices in SPX options. The liquidity in that product allows for an index to be tracked and support listed futures and options. Those VIX options offer the potential for different strategies, that themselves feed back into SPX volume.
The CBOE just introduced a new index that further builds on this complex, and is one of the more interesting truly “new” innovations in market structure recently. DSPX is the dispersion index, and essentially tracks how broadly the implied volatility of components differs from the index’s average implied volatility. This can only exist because the components now have robust and liquid enough markets to calculate their own respective “VIX”’s. (I dig more into here.)
This will be yet another tool in the kit of professional firms that trade and arbitrage the differences across SPX, VIX, ES, SPY, etc. Even if you’ll never trade most of them, the robust ecosystem means a trade in any component will be more efficiently priced.
While the concept of dispersion has existed for decades, and certainly been on the radar for exchanges, the timing must be right for the product to be a successful and constructive development. If it can’t be calculated, traded, and settled properly, customers will sense the unfairness.
Quality markets are no different than any other quality product. They deliver a consistent experience that can be dependably relied upon. They are tight, deep, and facilitate the transfer of risks on a level playing field. That’s what Grade A Prime looks like. Sorry number went down.