Exchanges, Brokers, and Other Market Institutions
In This Chapter
- The many different options exchanges
- The role of the clearinghouses
- Other organizations handling options
- Brokers who deal with options traders
Of course, you’ll need a brokerage account to trade options. However, you also will deal with many other institutions that have a critical role in developing options, ensuring that trades clear, and regulating the industry. This chapter gives you an overview of these institutions and how they work together to keep the options markets functioning smoothly.
Keep in mind that the financial services industry has been going through a lot of upheaval in recent years. Tons of mergers, acquisitions, start-ups, and other changes may make some of the information in this chapter outdated almost as soon as I type it, let alone by the time you read it. That’s part of the creativity of the industry.
Pricing and Trading Structures for Options
The main point of competition for many of the exchanges is how they handle orders after the brokers submit them. For the most part, this matters more to an institutional investor than to an individual. Still, it’s good to know how orders are handled after the broker submits them, both to understand how the market works and how it might change.
Many years ago, traders used paper notebooks to keep track of orders. Orders are handled electronically now, but the record is still referred to as the book.
The Role of Market Makers
Market makers are members of an exchange who agree to place a bid on every order that is entered. Each market maker works with a different set of options. They don’t have to place a bid at a price the customer wants, but they do have to be involved in the market. Some market makers are self-employed, most are part of firms that specialize in this aspect of the business, and some are associated with brokerage firms.
Definition
A trader who is in the business of ensuring that there are buyers and sellers for a particular option is known as a market maker. If no orders come from the public, the market maker will take the trade. Most market makers then hedge their positions.
Here’s what they do: if someone wants to buy a Jan (short for January in standard options lingo) call on XYZ Company, a market maker has to make an offer to sell. The market maker doesn’t have to sell at any price, but the offer has to be made.
This is an important function. Market makers ensure there is some liquidity in the market. They ensure someone will take an order and there’s a price out there that can be used to determine the value of a given option. Prices carry information, and that helps make the options markets efficient, which means people are willing to turn to it to manage risk. Without the market making function, there would be nothing for speculators to trade.
Most market makers are hedgers rather than speculators because they are taking on risk from their market-making activities. They will make trades elsewhere to protect their business, which is another way they create liquidity.
Did You Know?
Option pricing is done in cents, which makes the market maker’s minimum profit per option just 1 penny. It’s a low-margin, high-volume business.
Orders come in to the exchanges constantly. There are enough conflicts among them that the exchanges need to set a system to determine which orders are executed first and who pays the exchange.
Here are the different methods exchanges use to handle orders:
Customer priority If two orders come in at the same price, the customer orders are executed before orders placed by market makers. Market makers pay transaction fees; customers don’t.
Maker-taker Under this model, the market maker—the one who “makes” the orders—pays no transaction fee while the customer—who “takes” the orders—does.
Price-time priority Orders are given time stamps when they are submitted to the exchange. The order entered earliest at a given price is executed first, and the person placing the order pays the transaction fee.
Pro rata allocation Orders with the same priority are filled on a proportional basis if they can’t be filled completely.
Size allocation Orders with the same priority are filled largest to smallest.
The transaction fees usually run about $0.20 or $0.30 per lot of 100 options. It’s a small fee, but it can add up on large orders or for frequent traders.
Price Improvement
Price improvement means the customer pays less to buy an option or receives more to sell it than the order that was placed. It’s a good thing, and some options exchanges promote the ability to receive price improvement as a way to differentiate themselves.
If the market moves as an order is entered, price improvement might occur naturally. Customers placing large orders often want price improvement. In that case, the broker will request it, and the trade will go through an auction process. Market makers can choose to take all or part of the order at a better price.
Price improvement isn’t likely on retail orders or even on most institutional orders.
Where to Trade Options
Most options trade on organized exchanges. Unlike stocks and bonds, options are created by the exchanges where they trade and not by the underlying companies. This means the features, benefits, and rules governing different types of options might be specific to the exchange that issued the option. The exchanges were once physical locations in impressive downtown locations, but now they are often nothing more than server farms.
Once a national exchange issues an option, it might be traded on many other exchanges. In exchange lingo, these are fungible, multiple-listed options. Some exchanges may have more trading volume, offer better pricing, or allow different order types than others. These differences might matter to your trading strategy or the particular option you want to trade.
Did You Know?
Once upon a time, the options exchanges were a riot of color and noise, as traders in bright cotton jackets stood in pits on the trading floor to conduct business by hand. This style of trading is known as open outcry, and it has mostly disappeared in favor of electronic trading. Some exchanges make open outcry available, and some products seem to trade best this way. However, the number of open outcry floors is dwindling. Some of the strategies and advice you might find in older books on trading no longer work in an electronic world. The new world is less visually interesting but far more efficient.
The first stock options were developed by the Chicago Board Options Exchange (CBOE), and that is still the largest of the exchanges. It’s also the default standard for many different explanations of options trading practices. But it is hardly the only one out there.
Options Exchanges in the United States
Exchanges exist all across the United States. Here are the top ones:
BATS Options Market (batsoptions.com) The BATS (Best Alternative Trading System) market was set up to offer better execution for common stock. The company’s options exchange, also known as BZX, handles orders on a price-time priority basis. The company has recently announced a new options exchange, EDGX, which accepts orders on a customer priority/pro rata allocation basis. The difference is important to institutions placing large orders via electronic systems, and this is an example of how competition among the exchanges is leading to services that meet the specific needs of some traders.
BOX Options Exchange (boxexchange.com) This exchange was set up to allow brokers to connect directly with its network. It offers a price-improvement period during the order execution that is designed to mimic the benefits of open outcry trading.
C2 Options Exchange (c2exchange.com) C2 is an all-electronic exchange started by the CBOE. It uses a price-time order structure.
Chicago Board Options Exchange (cboe.com) The CBOE is the first and largest of the options exchanges. However, it is no longer the only game in town. The exchange has two key advantages, however:
- It develops most of the option products traded here and on other exchanges.
- It still offers open outcry trading for many of its products, which many in the industry argue allows for better execution of large trades.
Although the CBOE has competition, it continues to set the tone for the rest of the industry.
CME Group (cmegroup.com) Once known as the Chicago Mercantile Exchange, the CME Group is a holding company for many niche futures exchanges. These exchanges also trade options on futures, which are options based on the price of other derivatives contracts. CME Group is comprised of four markets:
- The Chicago Mercantile Exchange, also known as the CME or the Merc, handles options on equity indexes, foreign exchange, and some agricultural commodities.
- The CBOT, or the Chicago Board of Trade, specializes in agricultural options and options on interest rates.
- The New York Mercantile Exchange, or NYMEX, offers options on gas, oil, and other energy commodities as well as some metals.
- COMEX, once known as the New York Commodity Exchange, has options on many different metals contracts.
The Intercontinental Exchange (theice.com) Also known as ICE, the Intercontinental is owned by the New York Stock Exchange (NYSE) and specializes in energy, metals, and environmental derivatives. It is mostly a futures and physical exchange, but it offers some options, and it handles over-the-counter transactions. ICE also offers contracts on unusual assets and has shown much willingness to experiment.
International Securities Exchange (ise.com) The International Securities Exchange, or ISE, introduced the first all-electronic options exchange in the United States in 2000. It uses a customer-priority, pro rata (or proportional) market structure. The company also operates a separate options exchange, ISE Gemini, which uses pure maker-taker pricing. Most of the offerings are traditional equity options, but the ISE folks have been willing to experiment with options on such things as cybersecurity.
The Chicago Climate Exchange was founded in 2003 to allow for active trading in carbon credits generated by cap-and-trade regulation so market forces could create environmental change. Regulators would allow companies a maximum amount of greenhouse gas emissions. Companies that used less could sell their credits, and companies that used more could buy them, creating a free market approach to a vexing environmental problem. The exchange was set up as a voluntary program in anticipation of forced regulation. But the regulation never happened, and trading dropped to nothing by 2010. The exchange was then acquired by the ICE, where it handles trading in voluntary environmental offsets and waits for regulation to make it a big business.
MIAX Options Exchange (miaxoptions.com) This is a fully automated exchange that uses a hybrid of transaction charges, maker-taker fees, and rebates in its fee structure. The parent company has plans to open an equity exchange that would specialize in Latin American stocks, which could become a point of differentiation for the options business, too.
NASDAQ OMX (nasdaq.com/options) NASDAQ, an electronic equity exchange that started life as the National Association of Securities Dealers Automated Quotation System, operates an options exchange in addition to its better-known equity market. NASDAQ specializes in options on foreign currencies and financial assets. The company operates three electronic options exchanges:
- NASDAQ BX has customer priority for retail orders.
- NASDAQ NOM uses a price-time priority structure.
- NASDAQ PHLX uses both electronic and open outcry floor trading for institutional customers.
NYSE Options (nyse.com/products/options) The venerable NYSE issues options on equities and on different exchange-traded funds. It also has two options exchanges:
- NYSE Amex Options uses a customer priority/pro rata structure.
- NYSE Arca Options uses a price-time priority model. Both have electronic and open outcry models available.
In most cases, your broker will decide on the exchange for the trade based on the order flow on any given day. Some brokers allow customers to direct trades to a specific exchange, although there might be a fee involved.
Over-the-counter (OTC) options do not trade on an organized exchange. Instead, they are issued by brokers and rarely have a secondary market. These are sometimes known as exotics because they cover unusual assets or situations, often customized to meet a specific customer’s needs.
Definition
Over-the-counter (OTC) options are options that do not trade on an organized exchange. They’re often customized by a broker to meet a particular customer’s needs.
As an options trader, you might never come across an OTC option, but it’s nice to know that they exist.
Finding a Broker
Options trades are executed by brokerage firms, and almost all of them handle options trades. However, that doesn’t mean just any firm will be able to meet your particular needs. The occasional options trader might not need to shop around, but someone who is day trading options or who plans to make a significant number of trades should check into different features that distinguish options brokers from the rest. The benefits in information and execution could be significant for you.
Some brokers use different brand names for their options trading services than their primary business. For example, TD Ameritrade’s options brokerage is known as thinkorswim. The difference is usually related to the types of trading platforms (discussed later in this chapter) available to different types of customers.
Did You Know?
Most brokers allow you to open a free demo account to let you test their services with play money.
How important the different features are depends on your own needs. The following sections highlight different features to help you comparison shop.
Commissions and Trade Execution
Brokerage firms charge commissions to make trades. That’s fair, because they have to make money. Traders often fixate on the pretrade commissions different brokers charge, but it is only part of what you pay. You also pay any exchange fees, and then there’s the price at which you buy or sell. Would you rather buy at a lower price or pay a lower commission? As a customer, you should look for the lowest overall price, especially if you will be trading options on a regular basis. Commission is just one part of the price.
Many brokers have different fee schedules based on how much money you keep in your account or how many trades you place. Keep that in mind as you check out different firms.
The discussion of the exchanges earlier in this chapter included information about different pricing and priority structures. They often include tradeoffs between, say, paying an exchange fee and receiving priority in execution or getting a better price and having the order executed right away. Brokers must disclose information about trade execution prices and speeds once a quarter, so you can get that information to make comparisons.
Trading Tip
Some brokerage firms don’t charge commissions. That doesn’t mean their services are free. They will be passed on to you in other ways, usually in the form of worse execution from their own market makers. When evaluating firms, look at the total cost of trading, and not at any one line item.
Position Limits
Brokerage firms have to manage their own risks, and one way they do this is by setting limits on what customers are able to do in their accounts.
The broker might set a position limit, for example, which is the maximum number of open contracts an investor can hold in one account. This might be expressed in terms of number of contracts on one side of the market or in terms of total long or total short delta. If you plan on being an active trader, you’ll want to check on this.
Definition
Position limit is the maximum number of contracts any one account holder can have in the same underlying asset. It may be set by either the exchange or the brokerage firm.
Active traders often make decisions based on the information on their computer screens. Hence, the software offered by the brokerage firm is really important.
Later in the book, I cover information about different types of research and services people use (see Chapter 16). For now, though, compare brokerages based on the following:
- Additional fees for the use of software
- Sources of real-time price quotes
- News feeds
- Charting services
- Backtesting
- Performance tracking
Most active traders find that the platform is more important than the other aspects of the broker’s services, so be sure to look for a system that works for you.
Futures Commission Merchants
Most options trade through regular brokers, but some types of derivatives don’t. If your trading strategy will include futures contracts, options on futures contracts, retail off-exchange foreign exchange, or swaps, you’ll need to trade through a futures commission merchant (FCM), a broker registered with the futures exchanges. Many FCMs are the same brokers who also handle stocks and options, but not all stockbrokers are FCMs.
Market Maxim
A future is similar to an option in that it allows you to buy or sell something at a date in the future at a price agreed upon today. The big difference is that a futures contract must be exercised if it reaches expiration, so most futures contracts are closed out with an offsetting transaction before expiration hits. An option on a future is a way to get exposure to the price change of the underlying asset without actually having to buy or sell.
In order to trade options—in your existing brokerage account or a new one—you need two pieces of information on file to ensure you understand the risks of option trading and can cover them:
- The margin agreement covers the borrowing of funds inherent in options trading.
- The options agreement covers all the information about the risks of options trading, as well as details about any limits that may be placed on your account and information about exercise assignment.
Not all options strategies are risky, but a few have the potential for huge losses, and the brokers aren’t taking chances.
Definition
The margin agreement is the contract a customer signs with a brokerage firm that states he or she understands the risks and costs involved with margin. The options agreement is the contract a customer signs with a brokerage firm in which the customer acknowledges receiving a guide to options from the broker and understands the risks and fees involves with trading options.
Other Institutions in the Options Game
The options industry has its own set of regulators and related organizations that oversee the industry. They have their own rules and quirks, and you might not know much about them if you are new to options trading.
Some of these organizations were invented to handle aspects of options trading that are different from stock and bond trading.
Options Clearing Corporation
The Options Clearing Corporation (OCC) ensures that options trades clear. This means they guarantee that options orders go through and options exercise takes place as contracted. A key part of the OCC’s job is setting and enforcing margin requirements. It also operates the centralized system used by clearing brokers to help the system work efficiently.
The clearing brokers, or clearing members, are the people who handle the transactions involved. They guarantee that a market maker will deliver on his or her trades. Clearing brokers also provide different cash management and account services.
The OCC itself doesn’t make transactions, but it oversees the work that takes place.
Options Industry Council
Whether you are new to options trading or want to keep current on all the new products, the Options Industry Council (OIC) is your best friend. This industry-sponsored organization offers educational programs about options at every level: speculation, hedging, beginner, advanced, retail, and institutional. Its purpose is to help people be successful with options trading so they will keep it up.
At the OIC website, optionseducation.org, you’ll find lots of webinars, courses, publications, and other information to help you learn about options and refine your strategies.
The Regulators
The options industry is highly regulated. To complicate matters, different types of options are handled by different types of regulators. That will probably change some day, but not in time for my deadline on this manuscript.
The first line of regulation is made up of the exchanges themselves. They determine which firms are allowed to trade with them and what practices they must follow.
Beyond that, many different government and industry regulators are involved:
U.S. Commodity Futures Trading Commission The first equity options exchange, the CBOE, was founded by the CBOT, which specializes in agricultural futures contracts. This organization, also known as the CFTC, oversees the commodity exchanges. Given that options on futures, swaps, and other derivatives contracts trade on the commodity exchanges, the CFTC plays a role in the options market.
Financial Industry Regulatory Authority The Financial Industry Regulatory Authority, or FINRA, handles the licensing of brokerage firms and their personnel. This is not a government agency, but rather an organization made of people in the financial industry. It works closely with the Securities and Exchange Commission (SEC).
National Futures Association This private organization, also known as NFA, works closely with the CFTC to regulate the futures exchanges, and that includes exchanges that handle options on futures. It provides licensing examinations for futures commission merchants and their personnel.
U.S. Securities and Exchange Commission More commonly known as the SEC, this government agency oversees the operations of stock and bond exchanges as well as exchanges that trade options on stocks and bonds.
The Least You Need to Know
- Options trades are executed through market makers who use different fee and priority structures.
- Many exchanges in the United States issue and trade options.
- Brokers expect customers to sign option agreements before allowing them to trade options.
- Options trading is overseen by both equity and commodity regulators.