Option Traders – Expose Yourselves!

  • August 10, 2005
  • Joe Corona

Anyone who has been
trading for a while can remember the pre-electronic days when trading from
“upstairs” was a nightmare. Waiting forever for a fill, only to get
the “unable” or “nothing done” at the end of the day, even though it seemed like
prices traded over, under, around, and through yours. Back then it seemed as
though the locals of the various pits had nothing better to do than to make sure
your order did not get filled, to “teach you a lesson,” especially if you had
the nerve to place something mid-market (I should know, I was one of them!)

Electronic trading has changed all of that. Individual market makers are no
longer a factor as large, well-capitalized, proprietary trading operations,
hedge funds, and investment banks have taken over the role of the market maker.
Because these groups run large commingled “dispersion” books (meaning they have
fully integrated option volatility books covering several hundred, or even
thousand names), they no longer operate in the fashion of the individual market
makers of the old days. Now, it is the Wal-Mart model, capturing a small profit
on tremendous volume.

Anyone who has ever been on the market making side of things will tell you that
bid-ask spreads are a function of liquidity and the ability to lay-off the risks
associated with each trade. The way business is done now, with a thousand
bolt-holes available for hedging each trade, market making groups can make much
tighter bid-ask spreads than the old “one and run” days.

The Brokers

The brokers enter the picture in two ways: They can “sell” their order flow to
one of these large groups who then route the orders to wherever they control the
real estate, and they capture “the edge” from the flow, and pay the broker. This
puts money in the pockets of the market makers and the broker — none for you.

Another way is through “price improvement,” where brokers will make arrangements
with “liquidity providers” (the large groups mentioned above). As orders are
routed through the system they can be “exposed” to the liquidity providers who
can instantaneously analyze them and determine whether or not they fit into
their giant “jigsaw puzzle” trading books. They then compete for that order
against one another. This usually results in “price improvement” for the
customer, putting money back in your pocket.

Price Improvement Is Real

This is a godsend for option traders, especially traders who trade complex
spreads, as I do. Now when you enter a spread order and your order flow is
“exposed” to a liquidity provider you have a much greater chance of being filled
at a reasonable price, because spreads are the sort of “jigsaw puzzle” pieces
these liquidity providers like to trade in order to manage their books.

Check with your broker to see if they have arrangements for “price improvement,”
and if they do, make sure your orders are “exposed” to these liquidity providers
— it will save you money in the long run. If they don’t — start looking
elsewhere.

Joe

 

Joe Corona is a 23-year veteran trader who
makes his living trading options and other derivatives. Mr. Corona has been a
floor trader on numerous exchanges including the CBOE, CBOT, and CME. Joe most
recently spent 4 years as Head Trader for Market Wizard Tony Saliba at Salibaco,
a proprietary trading firm. He has also been an options instructor for the
International Trading Institute where he has trained hundreds of options and
derivative traders for major institutional trading desks worldwide. Joe is the
Director of the Asia Pacific region for CDLS Consulting, LLC which specializes
in trading U.S., European, and Asian options and derivatives.