Basic and complex options, Related Lessons

Option buyers are charged an amount called a "premium" by the sellers for such a right. In contrast, option sellers option writers assume greater risk than the option buyers, which is why they demand this premium. Options are divided into "call" and "put" options.

But this also means capturing liquidity that is fragmented across multiple options exchanges. Complex orders or spread trades allow traders to simultaneously buy or sell a number of different options in what otherwise would require separate orders.

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Historically, multi-leg orders were executed manually through brokers and by picking up the phone. However, the basic and complex options to execute these orders electronically through electronic complex order books has only gained traction in the past five years.

The availability of front-end tools, such as execution management systems EMSthat scan complex order books and aggregate liquidity across multiple exchanges have leveled the field among asset managers and hedge funds.

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More than that, those implementing and developing these strategies can obtain significant advantages when they package orders together. The lower cost of hedging and the chance for higher returns are drivers behind the trend, says Nybo.

Even retail investors are being given web front-ends that they can use to line up the legs of an options trade with the NBBO.

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Whoever hits it first trades with them. If a complex order arrives on the book but no one is interested, the order is maintained until someone responds. Or, when the net prices match up, the trading system trend series of the order can leg into the regular order book. The fill rates are likely to be higher. But the visibility into electronic systems housing complex orders has not always been so transparent.

In the past, complex orders would sit in the complex order book and there was no interaction between the order book and the listed quotes.

In addition, because complex orders could contain three or more sides, it can be difficult to execute the entire order simultaneously.

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Because finding the other side of the trade is challenging, buy side firms are looking to front-end trading tools to access complex order books. In the Tabb Group options survey, 36 percent of those responding said that front-ends need to support complex order capabilities. Fragmentation Executing complex orders can be challenging since traders must access fragmented liquidity across seven complex order books. This trend has led to the evolution of sophisticated algorithms and more tools that scan complex order books for liquidity.

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First, customers are able to access the complex order books more readily through brokerage front-ends, notes Schwatz. Exchanges Spread trading is also driving order flow to US options exchanges. Many expect that number to rise.

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Reportedly, MIAX is said to be working on a complex order book, and while BATS does not currently operate one, options insiders would not be surprised to see that change. Retail Investors Dive into Complex Orders Online brokers paved the way for multi-leg options trading among retail investors, supplying them with front-end tools and widgets to set up complex orders.

In fact, the popularity of multi-leg options trading has been a force in propelling many acquisitions in the online options brokerage space.

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Both Schwab and TD Ameritrade acquired options specialists known for pioneering multi-leg orders to retail investors. In addition, OptionsHouse and tradeMonster recently merged. But retail investors are not interacting with the complex order books or subscribing to the proprietary complex order book data feeds.

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In terms of executing complex orders, retail brokers rely on order routing partners or aggregators — the likes of Citadel, Susquehanna and Citi for equity and equity options order flow. But wholesalers are not the only ones in the game. The ecosystem for complex orders involves market makers and high frequency trading firms investing in low-latency infrastructure and platforms.

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Manual executions occur basic and complex options the retail and institutional sides of the business, he says. However, those competing against large market making firms are operating in a completely automated fashion. Since the business is so competitive, exchanges do not break out their complex order volumes.

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Some exchanges are surpassing those percentages. Institutions Get Sophisticated On the institutional side, major brokers are providing their clients with routing technology so that clients can post their own spreads. Five years ago, very few front-ends had the capability to trade a spread, he said. Others are seeking access from third-party EMSs, which provide connectivity to all the brokers.

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Splitting Orders with Algos With the fragmentation of complex orders, one way that traders gain an edge is by using algorithms to execute multi-leg strategies across exchange complex order books. In some cases, they are relying on algorithms to manage the complexity of the options strategies. Some execution management systems offer an algorithm in the complex order space, allowing a trader to divide up the order and take a percentage of each complex order book they want to hit.

But given the proliferation of complex order books and lack of linkages, there are some challenges.

The distinction between American and European options has nothing to do with geography, only with early exercise. Many options on stock indexes are of the European type. Because the right to exercise early has some value, an American option typically carries a higher premium than an otherwise identical European option.