Options traders face many of the same best-execution challenges as equities traders, such as trying to simultaneously access more than a dozen exchanges, each with different rules, without sacrificing liquidity. They even have to track a greater number of potentially market-moving factors.
“In equities, you can see the security you are trading moving, whereas options prices can move because of equity trading, because volatility’s moving [and] because other options around them are moving. There are a lot more moving pieces in options,” said Kevin Kernan, director of product development for Wolverine Execution Services.
The challenge of managing all these moving parts was one of the issues that prompted Wolverine to develop Best-X Options, an arrival price algorithm designed to intelligently determine the best-execution opportunities for options orders and seek out price improvement, while maintaining high order fill rates. The trading algorithm is based in part on Wolverine’s Best-X for equities algorithm, which was launched in 2012.
“Best-X Options is a similar brainchild to Best-X for equities, in that market fragmentation and the fee structures in exchanges get so overwhelming that it’s difficult for any trader to keep track of it all and figure out where to route orders. It’s really almost impossible without the right technology and expertise,” Kernan told Traders.
With Best-X Options, Wolverine set out to maximize the opportunity for price improvement, while also taking care not to sacrifice the high fill rates Best-X has achieved in equities markets. The challenge was accommodating the key differences between trading in the options market and the equity market. For one, algorithms are use much more widely in the equity market.
“It’s pretty common in the equity world to take a large order and hand it over to an algorithm and just let that algorithm go and work the order,” Kernan said. “That’s far less common in options. In fact, I think it’s [almost] unheard of.”
Because options traders tend to be driven to fill their orders faster, Best-X Options is more aggressive on timing than the similar equities algorithm. “We are going to try to get that order filled faster than we would under Best-X for equities because that’s the expectation that people have,” Kernan explained.
According to Kernan, those time expectations may shift, as options traders become more accustomed to trading via algorithms and the ways they can achieve both high fill rates and price improvements over time. For example, if you are looking to buy 10 options and there are 100 on the offer, as long as you are tracking the 100 options on the offer, you don’t need to lift the offer right away.
“You can either lean on that big offer or work something in between, as long as you are monitoring that 100 so that if it starts to trade, you can get the 10 out before the whole thing disappears,” he said.
Best-X Options uses its knowledge of exchange rules to balance issues such as good execution versus minimizing fees. For example, posting an offer on the highest rebate exchange may seem to have cost advantages, but an exchange with high rebates may charge high fees to the counterparty to the trade, making it an expensive exchange for a counterparty looking to draw liquidity. As a result, high rebates could effectively reduce the likelihood of an execution.
“What we are trying to do is never be on either side of those extremes,” Kernan said. “Hopefully we can post some on a higher rebate exchange, some in the middle and some in a lower rebate exchange.”
As an independent broker-dealer, most of Wolverine’s algorithms were initially developed for its own traders, and tested through the firm’s proprietary trading. Wolverine traders experienced price improvement along with good fill rates using the algorithm. Fill rates are a priority, so the algorithm would be tweaked if any slippage in fill rates were to occur.
While acknowledging that algorithms are a newer tool in the options market, Kernan said Wolverine sees opportunity for Best-X Options to deliver significant advantages. It is currently available for U.S. equity, index and ETF options, but will likely become available for options on futures as well.
“We wanted to be there early, to make sure we had a good product in place for when people get more accustomed to using algorithms in the options space, which we anticipate they will,” Kernan said. “I think the fragmentation and complexity of the fee structures and the exchange micro-structure make it an environment that should be more accepting of algorithms.
“In general, what happens in the equities space flows into the options space. It’s just a matter of time.”
