The battle between the exchanges over the electronic trading of complex orders is heating up.
NYSE Amex Options is reporting the number of contracts traded on its complex order book has shot up dramatically since the beginning of the year, positioning the exchange as a contender in what had been a three-legged race.
"This is a greenfield growth opportunity," Steve Crutchfield, chief executive of NYSE Amex Options, told Traders Magazine. "We haven’t been very competitive in this space in the past."
In January, according to Crutchfield, only 1 percent of Amex’s options volume was traded over its complex order book. By September, that number had grown to 5.1 percent. That amounted to 250,000 contracts per day on average, the executive noted.
With the acceleration of its COB business, Amex puts itself in contention with the three exchanges that dominate the electronic trading of multi-leg, or complex, orders. That’s the International Securities Exchange, Chicago Board Options Exchange, and Nasdaq OMX Phlx.
ISE has the biggest business, executing between 25 percent and 30 percent of its volume in complex trades, according to trading execs. CBOE is believed to have the second largest COB program, while Phlx is third.
Overall, the amount of industry volume done in packages of two legs or more is close to 20 percent, exchange officials estimate. That figure includes trades done on COBs as well as exchange floors. Amex does about 25 percent of its volume on its floor and most of that consists of large complex orders, according to Amex officials.
Complex orders involve more than one options series. Typically, they are two-legged, although they can involve three or four or more series. They come in many varieties, typically as spreads, straddles, and combinations. A package could include two calls, two puts, or a put and a call. Complex orders can also be made up of an option and shares of the underlying stock.
Multi-leg trades have been around as long as options have been traded, but have only moved off floors and onto electronic systems in the past 10 years. Traders post complex orders on the books as a package, quoting a single net price. The prices are typically better than would be obtained by trading the component legs separately.
See Sidebar: Leg Risk Remains
Brokers use COBs primarily for small orders of no more than 20 or 30 contracts, while sending the larger orders to market makers or to exchange floors.
As to why volume on the Amex COB has soared this year, Crutchfield cites three major reasons. First, the exchange sold almost 53 percent of itself to a group of large brokerage firms-all of which promised to trade more on Amex.
Second, the technological underpinnings of Amex were substantially overhauled as part of a move to parent company NYSE Euronext’s massive new data center in Mahwah, N.J. Third, Amex cut its prices to zero for customers trading complex orders.
Crutchfield is pleased with the spike in business, but acknowledges the exchange is still behind its competitors. "We have a long way to go," he said. "Industry wide there is a much bigger pie than 5 percent."
Amex’s competitors aren’t standing still. Because market makers are the biggest suppliers of liquidity to brokers trading complex orders, both the ISE and CBOE are looking to leverage their dealer members more.
For its part, the ISE recently introduced functionality that allows market makers to quote on its COB. That is expected to add liquidity to the book, according to ISE. Heretofore, market makers could only trade against orders parked on the book or in special 1-second auctions.
CBOE Holdings is also looking to expand its reach in the electronic trading of complex orders. This summer, the exchange operator added a COB to its new all-electronic C2 platform. At the same time, it also introduced market maker quoting on the COB. Whether market makers will actually quote on the ISE’s or C2’s COB is an open question, however.
It hasn’t proved popular on CBOE’s flagship exchange where the functionality has existed for while but never activated. "This activity doesn’t seem to appeal to the liquidity providers and may not be the most efficient method of allocating liquidity across such an array of products," according to Anthony Montesano, a CBOE vice president in trading operations. "Such an approach would require the casting of a very wide net to catch potentially few fish."
A market making executive echoes Montesano. "I’m not sure it will be worth expending bandwidth to be able to quote spreads," the official said. "Especially since I believe the orders will go to auction anyway." Indeed many complex orders never reach the COBs, as they are first flashed to market makers in special auctions.
Most brokers give the COBs high marks for introducing efficiency into the trading of complex orders and facilitating their growth. The mechanisms offer better pricing than is found on the regular books for the individual components and eliminate so-called "leg risk." That’s the danger traders face when trying to assemble a spread by trading its individual legs in separate transactions. The trader might get one side of the spread, but miss the other and lose some of the economics of the trade.
Pat Read, head of derivatives at agency brokers Investment Technology Group, is a COB fan and called the jump in Amex’s COB volume "fantastic news." Read explains the early adopters of complex trades were professional traders in Chicago, but notes hedge funds are increasingly deploying multi-leg strategies.
"The hedge fund community has started to take notice of the available liquidity and volume in these COBs," Read said. "They’re putting on positions to hedge or when they have an ax to grind in something like volatility."
The tricky part for a broker servicing sophisticated clients is building a tool that allows the trader to quickly filter all the data on the books in order to find a suitable trade, Read explains.
Because some clients want to see the contents of the books-and not simply post to them-a broker has to be able to take in the private exchange feeds. This has proved problematic for the vast majority of firms as the feeds can contain a tremendous amount of data, much of it superfluous.
Very few have committed themselves to investing in the necessary infrastructure to be able to take in market data from each exchange. Most brokers get their options data from the Options Price Reporting Authority. The OPRA feed does not include exchange COB data. To get that, a broker must contract separately with the exchange.
ITG is one of the few brokers to take in the exchange feeds, taking in data from ISE, CBOE and Philly, and making it available to customers through its front-end trading platform. "We have created a COB window that aggregates those exchanges," Read said. "And we give the user the ability to search for particular spreads."
How a customer accesses a COB can depend on the type of customer, according to Jim Michuda, chief executive of agency brokerage Wolverine Execution Services, a subsidiary of Wolverine Trading, the market making and arbitrage firm. "The buyside is typically initiating," Michuda said. "The sellside, and perhaps the more sophisticated buyside shop, will be takers of liquidity."
Like ITG, Wolverine also takes in COB feeds and makes them available to its customers via a front-end. And like ITG’s Read, Michuda says that’s not so easy.
"It’s much more difficult to support trading in complex orders than it is to support single leg trades," the exec said. "The challenge is in getting at the market data from each of the exchanges. It’s different for each one." The challenge comes in dealing with different APIs, different symbology, and integrating with the COBs via FIX messaging, according to Michuda.
Even if they do all that work, brokers must still filter the data to make it meaningful. Some believe the exchanges have a role to play here-an obligation to pare back the amount of data they send out.
"The exchanges need to limit some of the bids and offers that should never trade," ITG’s Read said. "These should be filtered out." For Read, that means orders that are far from the market’s best prices and those that would involve an instant loss, either for the quoting party or the contra-party.
The exchanges are taking steps to ease the process of taking in their COB feeds. The ISE, for example, recently introduced a set of feeds that are specific to its COB, and not mixed in with its regular book feeds.
Leg Risk Still a Factor
For institutional brokers tasked with trading large complex orders COBs are helpful, but only by so much. Because resting order sizes are small, liquidity is limited. That leaves brokers with two choices: tapping floors and market makers for liquidity or squeezing more out of their electronic tools. Instinet, for instance, puts considerable emphasis on using algorithms to source liquidity. But when the books dry up, the algos must ferret out the liquidity in the individual legs on the regular books. That entails leg risk for its customers. The brokerage will turn to market makers for help when necessary, but that also increases trading costs.
"If liquidity isn’t going to increase on the COBs," Instinet chief strategy officer John Duffell says, "then we need to find better ways of reducing leg risk while still finding liquidity.
"That means collecting as much information as possible about the exchanges and trading patterns in order to fine tune the algorithms. "By increasing the amount of data we get on those trades, our algorithms will be able to reduce risk so it becomes more manageable," Duffell said. "Over time clients will be able to set the dial as to how much risk they’re willing to take, which should in turn increase liquidity on what would essentially look like a COB to a client."