Wholesalers create differential option pricing by not only systematically varying execution methods, but also the pricing within each method, according to a new research paper.
The paper titled “Some Anonymous Options Trades Are More Equal than Others” compared retail option trade execution by placing simultaneous market orders across six brokers.
Although option trades are all anonymously executed on exchanges and therefore should be treated equally, we find that execution prices vary significantly: the average round-trip execution cost ranges from 0% to 7% across brokers.
According to the findings, a primary economic driver for differential pricing seems to be payment for order flow (PFOF).
“However, specialists affiliated with and without PFOF-paying wholesalers provide similar pricing,” the authors (Xing Huang, Washington University in St. Louis – Olin Business School; Philippe Jorion; University of California, Irvine – Paul Merage School of Business; and Christopher Schwarz, University of California, Irvine – Finance Area) said.
The brokers in the sample use some or all of the same five wholesalers, but the amount of PFOF that they receive varies significantly – two brokers receive no PFOF, while four other brokers all receive PFOF at various levels.
The experiment generated approximately 7,000 trades from mid-March 2024 to the end of June 2024.
For this trading, the authors selected 18 tickers that represent approximately 45% of market volume.
They also chose symbols where not all wholesalers could route a trade to an associated Designated Market Maker (DMM).
The authors placed intraday orders at their brokers that were identical in type (market orders), contract (symbol, strike, expiration), size (number of contracts), direction (buy or sell), and submission time.
Then they compared execution prices across brokers and venues.
“Since we placed the trades ourselves, we know whether each trade is a purchase or sale, which is crucial to measure price improvement,” the authors said.
“In contrast, empirical studies based on the The Options Price Reporting Authority (OPRA) database must approximate the trade direction,” they said.
“Even though trades on exchanges are anonymous and therefore should be treated equally, we find that price execution varies widely across brokers,” they added.
The findings indicate that the primary source of differential pricing is the wholesaler, who routes the retail trade to the exchange, rather than the DMM.
The findings also show that when wholesalers have this choice, they route only 24% of their trades to exchanges with an affiliated DMM, which is only slightly higher than the probability of random routing.
“We find that routing to an exchange with an affiliated DMM is more likely within auto-execution trades. In these cases, wholesalers are 69% more likely to route to an exchange with an affiliated DMM than would occur with random routing,” the authors said.
“One possible reason is that, in auto-execution trades, the DMM can capture the spread, which can be strategically leveraged to consolidate profits within the organization,” they added.
“Although wholesalers tend to route more auto-execution trades to exchanges with affliated DMMs, we find no evidence that these connections lead to worse execution,” the authors said.
The results have several policy implications, according to the paper.
According to the authors, option execution is very opaque, and complex: “Unlike equities, there is no regulatory requirement for option execution disclosure.”
For brokers, the only comments related to option execution are in their Form 606 disclosures, usually stating that they do not negotiate PFOF in exchange for execution or that they do not expect PFOF to impact execution, the paper said.
“However, we find that PFOF, which totaled $1.6 billion in 2023 alone, is likely a primary economic driver for execution. Thus, our findings suggest that an option equivalent of the newly finalized 605 rule is needed, both for wholesalers and brokers,” the authors stressed.
They also note that they only examined one specific aspect of brokerage trading.
The experiment was based solely on placing one contract market orders for call options during the day: “ We do not evaluate other types of orders.” they said.
“We only examine execution quality in terms of price improvement, while other aspects may be important as well,” they added.
We do not consider other features that investors might value when selecting brokers, in particular the breadth of offerings, the ability to short; investment and margin fees; quality of research and educational products; ease of platform use, trading tools, and mobile apps; customer service, and so on.
“Variation in price execution is only one part of the mosaic of information available to evaluate brokerages,” they commented.
