Ride in Your Broker's Yacht

Vol #71 - February 25th, 2022

The longer it’s been since a flood, the cheaper insurance will be.

Insurers cut their rates to bring in new business, but when mother nature knocks, they ultimately get wiped out with margins underwater from long term probabilities.

The same thing happens with spreads in options and equity markets. Calm markets bring tight spreads, and panic pushes them back out. Sometimes trading firms even blow out. 

The NBBO is the National Best Bid and Offer, or the prevailing best price at which a liquidity provider is willing to sell or buy a stock or option. Fierce competition drives these prices closer and closer together, particularly as markets slow down.

240 days of the year, trading is like shooting free throws in an empty gym. For professional traders, the 12 days that really count are when the market is going haywire. Unlike basketball though, for most people doing nothing is the right answer. Stick to a plan, dollar cost average, and in the long run you’re better off. 

Of course there is also opportunity when the market jerks around violently. But how you make those moves is just as important as the move itself. 

The price you pay is always the most important driver of returns. That’s why efficient markets, with deep posted liquidity, are extremely important. If you had to go to one of the various bucket shops that existed in the late 19th and early 20th century, you were guaranteed to be ripped off. Separate, captive audiences meant buyers would pay $10 in one place, and sellers would sell at $8 in another. 

Regulation NMS was a watershed moment in 2005 which harmonized the various national markets. It helped define what is considered an exchange, and required that brokers route their orders to the one that provided the best price. The definition of “best” gets as murky as the definition of “is”, but for the most part it meant far better execution for customers. 

One of the great frameworks I learned for pricing a spread, is that the width between your bid and offer is a standard error on certainty. The more information you had (size and depth of other markets, historical data, etc.) the better you could price that option, and so the less margin (for error) you had to charge.

 When Russia bombs Ukraine, certainty goes out the window, and spreads widen.

For a customer, this means trading gets more expensive. In a world of free commissions, the effective spread that a customer pays is their major cost. When you’re used to seeing options a nickel wide, a dime wide feels like highway robbery. 

Those obvious mark ups on the order make it very tempting to try and float out a mid market order. We’re very loath to execute when it feels like we’re getting ripped off. In defense of liquidity providers, they have to price in that uncertainty - they have their own hedges and risk to manage. The price of liquidity got higher. 

When it does come time to trade in a choppy market, I’m going to make a counter-intuitive statement. It’s better to lift the offer. Hit the bid. 

There is a whole soup of fees and stat padding that goes on behind the scenes of your order. Who is executing, how big the order is, what time of day, how busy the month has been; all these things go into the pricing of any random order that hits the tape.

While Reg NMS requires brokers to route to the best bid or offer in the market at the time, wholesale market makers have taken this a step further, and offered to provide price improvement to the clients of retail brokers. This generosity is not purely altruistic, they enjoy trading against lots of small orders rather than a few big ones, and are willing to pay for that randomness to put the law of large numbers in their favor.

In order to police the liquidity providers, the brokers perform monthly analytics about how their customer orders get executed - in aggregate. The design of these statistics is weighted in favor of the market makers, and can ultimately have an impact on how your individual order gets routed.

Broadly these statistics are called “Execution Quality” or EQ, and are measured in percentage improvements. 100% EQ means the order trades at the bid/offer, while a 0% EQ would be the midpoint, and everything in between is interpolated. If a customer buys below the midpoint, that would be negative EQ. Like the golf courses where these deals are negotiated, lower numbers make you look better. 

If you ask a mathematician how to aggregate different size orders with different percentage scores they would simply do a weighted average of size and percentages. 

When the fox guarding the hen house is asked to create a statistic, they’ll talk about pennies improved. Instead of weighting by size and percentages, simply add up all the “improved pennies” and divide that by “available pennies”. 

The effect this has is that wide markets create big opportunities to pad the stats. Not all pennies are equal. Bringing in more pennies on wider markets, means you can pull back pennies on tighter markets. Borrow edge from the inefficient and use it in the efficient markets.

Liquidity providers are no different than anyone else - and are prone to perhaps overreact when things get choppy. When the market over-reacts and stays wider than their confidence interval, they can execute for edge, while also looking good for their broker clients. 

Beyond EQ, the brokers also divide up the orders into different buckets. There’s marketable and non-marketable flow, and orders of different sizes (usually +/- 250) are treated differently. 

Non-marketable flow means it’s not priced at the bid or offer. That’s a lot less valuable to a liquidity provider, so it’s price and EQ score are much less important in these negotiations. When you send a non-marketable order, it’s just waiting to get cherry picked when the market moves, there’s no incentive for a market maker to improve. 

By sending an order at the market, it’s more likely to get improved. And in volatile markets, the other side even gets the benefit of improving more pennies than they might otherwise. This is especially true in top tier names that often have their own carve outs.

There’s a saying that it’s the brokers and not the customers that have yachts. Let the professionals pad their stats with your order flow, and go along for the ride. It might not work every time, but on average you’re aligning yourself with their incentives, rather than trying to outsmart the house.