A broker walks into the crowd. CGC, May 10 calls, how are we?
After the split second that it takes to recenter from whatever hedge you were fretting over, now’s the time to give a market for the near upside on a highly volatile cannabis company that is (should be? I thought?) reporting earnings in two weeks.
As you’re fumbling over to the machine with that product loaded and finding the tab, the broker is already itching to get moving. Frank might still be called a two dollar broker, but commissions have dwindled and he’s got other orders to fill. “C’mon I haven’t got all day”.
“Uh, okay, which expiration again?” An attempt to stall for time lets you confirm the earnings date and refresh your memory on what’s trading here.
“The regular one junior.”
“CGC, May 10 calls, I’ll be $0.70 - $0.75 100 up”.
This is a very safe bet, because Frank’s a jackass. The markets on the screen are also a nickel wide, there’s decent size, and about 50k contracts of open interest in this month, 2500 on this line. Is this some junior PM that just took options 101 and plays good enough golf to get the leash off for a 100 lot? Whatever, plenty of room either way.
“Pay $0.75 for 100”.
That’s it. The deal is over. Down the exchange tubes, out to the clearing companies and OCC. You will receive $7,500, and bear the obligation to sell 10,000 common shares of the Ontario Canada based Canopy Growth Corporation at $10 USD, any time before 4pm ET on May 17th, 2024, anno domini.
Roughly 35 words were exchanged in a transaction that could be worth tens of thousands of dollars. And 15 of those were filler. Unhedged, you’re looking at a $40k+ loss if this hits the 15 strike. Markets today give that roughly a 10% chance.
A hundred lot in CGC is peanuts compared to the volume that flips in the SPX or VIX pit. Billions of dollars are processed every session by traders who look like circus clowns with their colorful jackets, using hand signals because the barking is too loud. But word is bond, and there’s no funny business here.
Dive into the trenches of the internet, and you’ll find plenty of market maker conspiracy theories. At face value, they do have some preferential access, and by law of the jungle, have to be the most sophisticated. But there is no market participant, observer, or commentator that’s held to a higher standard.
This preferential access isn’t a VIP tunnel where they peep over customer’s shoulders before an order gets sent. It’s mostly about the ability to send in “quotes,” and have access to risk mitigation tools at the exchange side. The bargain exchanges make is that MMs wear the asymmetry and create revenue per contract, but also get some defense mechanisms in return.
Quotes are distinct from orders. They are necessarily two sided, containing price and size in bids and offers. Dealers give quotes, because they don’t know what the customer is going to do. The width and size is the only axe to buy or sell, and the purpose of them putting prices into the markets is to allow other people to transact and charge fractions of pennies to house that inventory.
The bids and offers of market makers are the building block of equity options markets. It is a quote driven landscape, because there’s no way that two customers will match at a given time, strike, and expiration when there are a million different listings.
At 9:30:00 AM, 252 days a year, the first flickers you see on the screens are dealers. They’re required to put their quotes into the market within 5 seconds of the first equity print. We all watched futures overnight, but the buy side gets to “wait and see how the market settles” before putting in any trades. Everything delta one is just arithmetic, where’s vol going?
Not only do these quotes have to be there, they have to be of a certain width. Each exchange has a dozen or more pages dedicated to this complexity. That CGC option would only have to be opened $0.50 wide. For a very liquid name, that’s more than enough room for error, and the reality is most markets open slightly wider but quickly converge on their average daily trading width. But for roughly half the options listed, $0.50 wide ain't a bad market and opening can be hairy.
Quotes have to be in early, often, and of a certain quality (width and size). But the most important part of the quote is that it is firm. A quote is an offer to buy or sell, and if someone takes it, you’re on the hook.
The SEC makes this very clear. The “Quote Rule” clearly defines what a firm quote is. It “requires each member to execute orders presented to it, including orders received through the options intermarket linkage, at a price at least as favorable as its best bid or offer in any amount up to the size of that bid or offer”
If you put up 100 contracts at $0.75, there are no take backs. No “whoops I did the wrong price” or “sorry my Risk Manager won’t let me”. When you enter the arena, you have to play by the rules. Same goes for the customer; while it seems like your order takes eons to fill, it’s running through a highly structured process.
These rules not only say that if a quote gets hit you have to trade, but also that sending in a quote without the intention to trade is illegal. Spoofing is using orders to create the perception of a certain market dynamic (e.g. significant bid/offer imbalances) and mislead counterparties. It’s considered wire fraud, and punishable by up to 30 years in prison.
As if that’s not enough, trading solely with the intention to show activity is prohibited - “painting the tape”. Generating fake volume is considered market manipulation, and is typically done to create the impression of opportunity.
A firm quote is a cornerstone of market integrity. It accelerates the price discovery process. Valuations converge towards their best estimate through participants who back up their actions and opinions with capital. Better valuations bring more participants, and expand the potential use cases of volatility products.
More important than the economic principles here, is honoring your word. Whether over instant message or in the pits, the tight knit community quickly learns which brokers, customers, and liquidity providers are the honest operators. You’re SURE that’s the end of the order?
Alas, regulation has to enforce these nuances because the disreputables follow the cheddar. If you’re operating as a regulated entity - a broker dealer, investment advisor, or otherwise - someone will eventually be knocking on your door. You can’t dodge a market, lie about performance, or pretend risk doesn’t exist.
Otherwise, caveat emptor. Avoiding regulation is a precursor to selling theories not facts. Standards don’t guarantee quality, but they cut the bullshit.
Lurking at the edges of the regulatory specter, relying on some kind of exemption is an excuse for accountability. Talking heads, social media strategists, and “trade ideas” are for entertainment purposes. That’s why the SEC doesn’t take them seriously, and neither should you.
There are dozens of high quality tools available to DYOR. Or find a professional. (Obviously, I am talking my book.)
Everyone puts a disclaimer at the bottom of their commentary. Sometimes it points to a carve out, other times it points to a credential. Guess where you get a firm quote? Executable markets put the capital of honest dealers on the line; everything else is fiction and hot air.