Over the last decade or so, traders have witnessed an unprecedented advancement in trading technology and access to the markets. Traders now enjoy everything from streaming quotes showing accurate bid/ask spreads and market depth, to point-and-click trading with instant fills, and up-to-the-second account reconciliation and accounting.
The days of an active day-trader having to manually match buys and sells to see where he or she stands is a thing of the past. To those who weren’t born into this exciting new world, the current landscape is incredible: The things traders fantasized about in the 1980s and dreamed about in the 1990s are now not only a reality, but a necessity.
With the creation of electronic global access, traders now have multiple doors of entry to many of the markets. However, this seems to confuse many traders more than help them. To better understand how this new access is a benefit to a trader, consider this: Chicago Board of Trade Treasury bonds are one market with two doors to gain entry or exit, open outcry (pit session) or the Globex market (electronic access).
Regardless of the entry method, the market is the same. It’s just that the pit session “door” is accessible from 8:20 a.m. until 3 p.m. (Eastern), while the Globex “door” is open from 6:30 p.m. until 5 p.m. (Eastern). That’s 22-1/2 hours a day for Globex! It’s also worth mentioning that you can enter through one door and leave through the other. It doesn’t matter. It’s the same market. However, those who have used both markets will tell you that the Globex alternative offers faster fills with more transparency.
NOT TRUE FOR ALL MARKETS
The only order-entry challenge for a modern-day futures trader is placing option spreads. While the equity options world has long been primarily an electronic market, options on futures are the last bastion for the futures trading floor. And while there has been progress electrifying simple options on futures, complex orders still require that personal touch. Many order-entry platforms, as well as the various electronic exchanges, do not accept multiple leg (beyond verticals) option spreads. In fact, many electronic exchanges don’t even accept market orders on single option trades, never mind what are considered complicated option chains, nor do they take limit (or better) orders on spreads.
The objective of a trader using option spreads is usually either outright premium collection, hoping to profit on the spreads erosion factor, or to collect premium to lower the cost of the primary long option. To reach this objective successfully, pricing control is essential. Not being able to work multi-leg spreads through an electronic platform on a limit order has left many spread traders perplexed. The inability to get trades filled at an acceptable price has caused many traders to abandon this type of trading.
All is not lost. Electronic option traders need to learn how to get around the limitations imposed by today’s technology to get the job done. Although option spread traders are limited in methods of order entry, the transparency of the true bid/ask spread of each leg gives the trader a little more control in the order entry process.
The reason for this is the absence of the floor’s one-leg-in rule, where on multiple-legged option spreads not all the legs had to be filled within the option’s trading range, as long as the entire spread was filled within the price limit placed. This rule was created to make it easier for the floor broker to fill these types of spreads, but it made the liquidation of the individual leg more difficult due to the possibility of a random fill when the order was originally filled.
In an open outcry environment, traders would place a multiple-legged spread all at once, taking the ask of the long option and subtracting the bids of the short options. The option floor broker would then try to fill the legs within the trader’s price limit. The price was usually derived from getting the bid-ask spreads on various suitable strike prices based upon the technical analysis at the time of the trade. Traders then would place the trade using a single price, leaving the execution of the trade in the floor broker’s able hands.
This strategy isn’t possible in an electronic environment due to the complexity of the math involved in the execution. Instead, we have to enter each leg of the trade individually. What this entails is a constant calculation of each of the legs, remembering that we pay the ask on the buys and sell at the bid on the shorts.
TECHNOLOGY MATTERS
A good quote system is needed to ensure the accuracy of the execution. Many traders are not aware that the displayed option quote is the last-filled trade and may or may not be anywhere in the ballpark of where the market currently is. The trader must be aware of whether the quote system is streaming (real time) or snapshot (has quotes that must be manually refreshed) with regards to
option prices.
It also is beneficial to set up the bid/offer data for the underlying futures contract within close proximity of option quotes. With these data close at hand, the trader can determine if the price placement of the bid and offers is in sync with the current market, allowing for adjustments to keep pace with market volatility and dynamic order flow.
A trader in the electronic markets does not have the luxury that open outcry brokers have of seeing when a large institutional house shakes up the futures and options pit. The closest thing the electronic markets might have would be a market-depth feature that displays the quantity of contracts at price intervals above and below the current bid/offer levels. This could offer clues as to where institutional positions may be setting up, resulting in increased option volatility that may increase or decrease the chances of an order being filled.
Electronic option market traders should consider a similar strategy that applies to open outcry: Tighten up the market rather than joining the current bid or offer posted on the screen. In many cases, just as in open outcry, the bid/offer quotes are the result of market makers who may have little client paper on hand that has real interest in being filled. The electronic markets offer an even greater hurdle when you join the current bid or offer: You will have little, if any, indication of where the order is sitting within the queue, or where the order sits in line as it waits to be filled.
ENTER THE S&P
One market whose options offer some of the best elements of electronic and open outcry is the E-mini S&P 500. During the trading day, the options are some of the most liquid. The bids and offers are set primarily by traders, not market makers, so price action is especially fluid. The price action on the underlying futures contract, even though it is traded electronically, offers cues on volatility and price action via the CME Group pits, so traders can see if institutional investors could be stepping in to hit with potentially market-moving activity.
There are many order entry platforms that have streaming quotes and include accurate bid/ask spreads on their option chains (see “Depth of view”). Traders can quickly fill each leg in with just the click of the mouse on most of these platforms (for example, if the trader wants to create a bear put spread with a naked leg in the E-mini S&P).
In this trade, the trader is buying the 960/930 bear put spread and selling the 1000 call as the naked leg. The trader would buy the 960 put at the ask of 3325, and then sell the 930 put at the bid, receiving 2200. He also would sell the naked 1000 call at the bid,
receiving 1700.
To calculate the cost, you simply subtract the credits of 39 points (short options) from the debit 33.25 points (long option) and tally the difference. In this case, the trader would receive a credit of 5.75 points, or in E-mini speak: $50 x 5.75 = $287.50. Of course, what the final credit is depends on the trader’s transaction costs, which are debited from the credit.
The new electronic world has many benefits, but there are still a few areas where the organic markets are preferable. Still, with the same tendency toward evolution that brought us the connected financial landscape that we benefit from today, traders can adapt their old skills and emerge better off and better prepared for the next leap forward in trading technology.
Paul Brittain and Richard Roscelli are brokers with Whitehall Investment Management Las Vegas and are regular contributors on fixed income to Futures magazine. Roscelli has managed institutional and electronic trading desks since 1995.
