The $10,000 Burrito
Vol #104: November 4th, 2022
The most important time of day on the trading floor is not the open or close, but lunch.
Traders love food. It’s more than just nourishment, it’s a way to collect on your side bets, celebrate your wins, and an event to break up the monotony of a dead tape.
Chinese and Japanese stock exchanges typically close for lunch, and the CBOT lets most of their traders go by 1pm. The uncivilized world of equities keeps the markets open for six and a half non-stop hours - covering almost two meals!
There is a cottage industry of greasy spoons clustered around exchange floors. Clerks run out for bacon, egg, and cheeses at Champs before the market opens, and traders take their tickets across the street to grab a bite (or more) at Ceres for lunch. Most of the time it’s only the salesmen and executives who have the time to sit down for a meal, because adding extra guac costs precious moments of pit time.
Lunch’s central role in market structure is not for the obvious reasons. It wasn’t because of the show stopping smell of L&B Spumoni Gardens Sicilian squares showing up on the AMEX Friday afternoons, or Jim’s South Street arriving on the PHLX. It’s because following your nose could cost you your month.
Whether you’re in the physical pit, or upstairs responding to orders on the phone and IM, an empty chair can’t make a market. Liquidity providers are in the business of warehousing inventory and managing the risk and pricing of those positions. If you’re not there to take the other side, the competition is happy to eat your lunch.
Market makers collect “edge” in the form of a tiny mark up on every trade. The bid-ask spread is the distance between the best price someone is willing to pay, and the lowest price someone is willing to sell for. Fair value is considered somewhere in between. Trade, hedge, fade, repeat.
If you sell something at 1.60, and the market is 1.50-1.60, your position is marking .05 below where you sold it, you’re showing positive $5 for every contract you sold. The real art of the game comes from the durability of that edge. The best traders are not just gobbling up edge indiscriminately, but appropriately sizing their bets so that they are doing the biggest size where they see the most likelihood of that edge sticking around.
Most professionals tend to agree on which orders are going to provide the most durable edge. Everyone wants to trade these all for themselves. Edge will persist if generally participants agree on the pricing. When dealers are simply providing the service of accessible trading opportunities, both sides can achieve their objectives. Edge evaporates when the counterparty swamps liquidity enough to shift implied vol or rate assumptions, or knows something the market hasn’t priced into the expected return distribution.
The business of trading is just as much about getting on the orders, as it is about pricing the orders. You need to identify and compete for the best order flow through decisiveness, technical capacity, business relationships, and plain old working the ref. If your Lead Market Maker shares a bowl with the broker before the P-Coast opens, there’s more than one reason crowd give ups are more generous.
Options are unique from equities in that every single order needs to be traded on an exchange, and subjected to price competition. If two participants agree to a trade within some general guidelines, they’re free to report that trade and the MSFT stock will be just as fungible as the shares you bought directly on the NASDAQ. Even if an options broker has matched a buyer and seller, for those contracts to be OCC guaranteed, they need to take place on an exchange.
On trading floors, orders can come into the pit either matched or unmatched. An unmatched order means a broker is soliciting liquidity from the crowd to generate a trade for his customer. The traders in the pit will respond with their best price, and the customer can take or leave her fill. This is less common these days, but the trick to win the trade here is being the fastest and loudest guy who’s not out to lunch.
On matched orders, the broker has already negotiated a price and a size with a counterparty and his customer. He has both buyer(s) and seller(s) lined up and all are expecting to trade this order. If someone else is willing to trade at this level, there’s a better than average chance it’s a good order. The regulatory rub is, this order needs to be exposed to the marketplace to allow for price improvement.
The reasons for this are fairly obvious. If a hedge fund in Greenwich calls their prime broker and says they want to buy 10,000 of the AAPL Jan 23, 150/160 call spread and pay $4, the bank trader might crack a smile and happily give them a fill, knowing that the real price is much closer to $3.75. Maybe the fund is naïve, maybe it’s back scratching from another trade - it doesn't really matter, the customer should get the best price.
The bank then tells their broker on the AMEX that they want to cross 10,000 AAPL call spreads at a price of $4, and into the pit he marches. On floor market makers have the right to participate in this order at the prevailing price, or offer an improved price. Most traders want to participate at the best level, so they prevent the trade from consummating in their pit by insisting on their participation rights.
For years this was called “blocking” a trade, but that term got canceled by newly woke regulators who interpreted it as maliciously interfering with the trade process. You didn’t want your e-mail and IM records littered with boasts about how you blocked an order. “Insist on Participation” it became.
This sets off a negotiation and navigation dynamic across both physical and electronic markets. The bank could offer to cut back their participation and let the pit trade some of the juicy spread at $4. They could drop the price (improve it for the customer) to a level that allowed the order to cross cleanly. Or they can look for another means to effect the trade.
If the trader on the AMEX is loudly insisting on participating, the broker might call his buddy on the PHLX, and see how that pit is pricing the trade. If the current AAPL trader is too worried about his whiz wit, there might be an opportunity to sneak that trade through at $4. Getting just 4% of that trade (a very reasonable number to give up to the pit) is the metaphorical $10,000 burrito: $0.25 in edge per contract, 400 contracts, 100 shares/contract.
This dynamic begets feats of human endurance. I worked with a trader who, when he realized that paper was crossing in his pit when nature called, rearranged his hydration schedule to never miss a minute of open outcry. Brokers then complained that he was trying to cover two pits at once, and demanded the exchange draw masking tape lines on the floor. When this wasn’t enough, they resorted to decoy orders on opposite sides of the room to draw him away from the real berries. Open outcry was a canvas for our Picasso in the pits.
Only four of the sixteen options exchanges have physical trading floors, and the vast majority of volume is transacted electronically. Since the ISE came online as the first electronic market in 2000, there have been a number of different mechanisms developed to cross paper electronically.
For large orders that may have otherwise gone to a pit, there are a few different flavors of exposing the order and allowing participants a brief (50-500 milliseconds) period to respond and break up or price improve the trade. The “code is law” aspect of these mechanisms makes brokers hesitant to use them. If they walk into a pit and don’t like the quoted market, they can always pull out. If they’ve submitted the order to a solicitation mechanism, it’s out of their hands. The plus side for traders is the systems fire even when they’re at the buffet.
The $4 AAPL order is desirable because it’s a big chunky piece of edge in a well priced liquid underlying. The mispricing is obvious and there are many ways to hedge the risk cheaply. Smaller orders get competed for in a different way. These are desirable because they tend to be uncorrelated, and less likely to have an impact on the basic market assumptions about pricing, lending the edge more durability.
Orders from brokerages like Schwab or Robinhood get first routed to a wholesaler who pays the broker for the privilege to execute that trade. It’s a win-win because wholesalers get to do more of the business they’re good at with the orders they want, the broker is paid not to deal with the complexities of order routing, and the customer gets the potential for price improvement.
Price improvement is where wholesalers compete with the field. When a matched order goes into a price improvement auction, all the other participants are alerted to an auction where the other side is guaranteed to be a retail participant. Respondents have a window to send their prices, and in some cases can even see where others are bidding. Open competition is good for the customer, but not as good for the wholesaler who paid for the whole order but is only getting a piece of it.
Exchanges are constantly tweaking pricing assumptions across interwoven tiers, participants, and product mixes to capture market share. On both the venue and participant side, lots of CPU cycles get spent crunching the numbers on where the best place and price is to cross orders. Prop trading gamesmanship means tighter and tighter spreads for retail orders.
The shenanigans don’t go away because we have electronic markets, they just get a little more nuanced. If an order has been pre-arranged, i.e. matched before hitting the exchange, it has to go through a crossing mechanism. But what if a wholesaler could signal to themselves, and not others, that an exchange order outside that mechanism was a desirable retail counterparty? This way they could scoop the whole order deterministically and box out their peers.
Just this past week there was a Wall Street Journal report that one of the large Chicago firms was warned by FINRA about the dubiousness of this exact activity. When they received orders from brokers like E*Trade and TastyTrade, they would post the orders outside the crossing mechanism, and then immediately cancel them. A split (0.000002) second later, a nearly identical order would be posted and traded against instantly.
This identifiable pattern was a signal the customer facing side could send at arm’s length to the trading side, who was then “within their right” to respond and scoop the whole order. While not explicitly illegal, it could very easily be interpreted within the broad bucket of market manipulation. It certainly wasn’t in the spirit of the bulletins the CBOE, MIAX, BOX and NASDAQ sent out earlier this year on the subject.
If this feels like a victimless crime amongst a small group of nerds, I’ll forgive you, it’s a pretty arcane atrocity. Almost like crying over a $10,000 burrito. It’s not even clear that customers were explicitly harmed or got worse prices, one counterparty just got to take more of their trades. However, anything that’s a drag on competition - baiting with a burrito or cueing a customer order - undermines the integrity of our markets.
Traders skipping out on a slice might crunch their stomachs, but it’s good for markets. Having vibrant price competition on orders boosts liquidity, which ensures customers have a good experience and come back for more.
Enjoy your lunch.