Simplifying Complexity: Trading Complex Order Books in Options - Part 2

Primary Challenges

Traders seeking an edge in multi-leg options trades are relying on technology to navigate a complex market structure.

One major challenge is that there is no linkage with regards to complex order books spread across seven US options exchange.  Hence, it’s very important to scan all the exchanges to see what’s out there. In addition, the complex orders just sit in the complex order book and there is no connection to the listed quotes in the regular order book.  “That was a problem, because there could be a spread that looks like it could execute but it doesn’t,” says Henry Schwartz, CEO of Trade Alert.

“So you have 12 markets and they’re all quoting all the time. With the concept of best bid and offer, you’re looking at the bid on the CBOE and the offer on the ISE.  If one leg of a spread you are executing happens to be a bid on Arca and an offer on the BOX, historically there has been no way to buy it on the BOX as well as on Arca, at least not in a risk-free manner,” says Schwartz. “The reality is that one of those options markets could change before the order gets there. So the fragmentation problem in the past has made spread trading very frustrating.”

Exchanges, however, have introduced innovative functionality to improve the chances of executing a complex order that is several pennies away from the current market.

ISE’s Implied Orders

In a major breakthrough, ISE launched implied order functionality, which creates an order in the regular order book when the spread becomes almost tradable. Implied orders allow the display of liquidity from the complex order book on the regulator order book.  “With implied orders our system will actually generate a mid-market order in the related series and tighten the market. And as soon as one of the orders gets filled, it triggers the execution of the order. If the implied order is traded, then it would allow that complex order to execute,” said Boris Ilyevsky, managing director at International Securities Exchange .

About six or seven percent of ISE’s complex order volume trades not executed through auctions or crosses, go through the implied order functionality.  “These are orders that we believe in many cases could remain unfilled,” says Ilyevsky.  ISE maintains that the implied orders lead to tighter spreads and can increase liquidity on the regular order book and better fill rates for complex orders. In addition to complex orders, ISE introduced buy writes and any other strategy that is tied to stock. “You not only have the options, but also have the underlying ETF and the stock as well,” says Ilyevsky.

CBOE: Auctions and Price Improvement

At the CBOE, multi-leg or complex orders will execute either as the result of an electronic auction via the exchange’s Complex Order Auction (COA), or by matching with an opposing complex order of the same strategy, explains Anthony Montesano, CBOE vice president of Trading System Development. Or, they execute by matching against the individual series/legs that comprise the strategy.

Another method is to execute as a result of an electronic auction via CBOE’s Automated Improvement Mechanism, an electronic crossing auction.

“A focus for complex orders has been price improvement to the submitting customer via COA and AIM,” says CBOE’s Montesano. “Both auction mechanisms, COA and AIM, provide an opportunity for increased customer order execution rates and price improvement,” wrote Montessano. “If an order doesn’t execute in an auction, there is a benefit realized from displaying the order in our COB, [and] disseminating that COB via our proprietary CBOE Streaming Markets (CSM) data feed for exposure to the entire marketplace, and to CBOE’s vast pool of customers along with proprietary traders and liquidity providers/ market makers,” wrote Montessano.  This is “combined with the ability to integrate the individual series/leg markets into the complex order execution process,” he said.

“At the end of the day, exchanges are trying to improve the levels of prices that the clients are getting, whether it’s price improvement or through the implied orders,” says  Andy Nybo, principal and head of derivatives research and consulting at TABB Group. “It sniffs out price improvement opportunities and better ways to get that spread done.”

However, not all complex orders are traded electronically. On CBOE’s Hybrid market, brokers in open outcry can also execute complex orders and brokers can also trade those orders against resting COB orders or the individual series/legs bids and offers.

But is there a level playing field when it comes to market data and visibility into the complex order books?

After all, not everyone subscribes to a proprietary data feed.

“It does require a proprietary data feed to get to the data,” notes Schwartz. “In terms of a level playing field, any broker can subscribe to that, but it takes money and technology,” he says.

Market Data

In 2011, CBOE began displaying the COB bids and offers on the proprietary CBOE Streaming data feed, which helps to integrate the complex order book and the regular market together.  Montessano points out that COB market data, including five-layer book depth, is disseminated to any interested party via CBOE Streaming Markets, a proprietary market data feed.  CBOE publishes COB market data on its web site, COBWeb. Anyone can key in a symbol and see the price and size of the CBOE top-of-book resting CBOE complex orders in real time. COB information is also viewable by on-floor and off-floor users of its PULSe workstation, and by on-floor users of the Floor Broker Workstation and its PAR execution workstations.

Looking Ahead

As exchanges continue to expand their functionality and savvy traders design and implement these strategies, exchanges are attracting more volume to their complex order books.

The most active participants are options-centric firms like Citadel, Timber Hills and Getco/KCG. “They are very plugged into the complex order books,” says Schwartz.

That said, many types of firms are participating in complex order books, while others are still unaware.

“There is a big divide depending on the type of user, “says Ilyevsky.  “Between discount brokers and technology firms there has been a proliferation of front-end technology and specifically tools for complex orders,” says Ilyevsky.

Going forward, exchanges are expected to bring out new complex order functionality.  Currently there are 12 options exchanges and next year, the total may be 14 or 15. “The exchanges are hypercompetitive in what they do. If they can attract order flow by developing new functionality they will,” says Nybo.