Electronic Trading (without a PB) vs with a Prime Brokers for Equity Options

[Wannabe]

This is a spin-off from the 'How to start a hedge-fund thread' which has taken an interesting but slightly tangential path.



I have been dipping my toes into the equity derivatives market and am enjoying the beginner's luck. I have learnt a few lessons, especially about (not) trading options only listed on the AMEX and about looking at liquidity of ETF options before taking positions.



Since I am trading primarily using spreads I do look to split the bid-ask spread in the middle. In many cases I am able to do it but sometimes the order just does not execute even if it has the right bias for the counterparty (5c in their favor)



Right now my trades are small (10-20 contracts/order). However, I do expect them to scale up in size over time.



This is where liquidy will become something I need to consider.



1. When the size of my orders increases to say 50 to 100 contracts can I still continue to trade electronically without a PB or would I need a prime broker?



2. Will a prime broker help in getting better split of the bid-ask spread in:

• single option leg orders (vanilla options or covered writes)
• two (or more) option leg orders
• different securitiy classes (ETF, large cap, small cap, ADRs)

3. At what order size does an investment in algorithmic trading to break down the option orders into multiple smaller orders starts making sense? I know that this depends on the security and the volume of derivative trades but is there a ballpark number I can start using. I am primarily trading in large caps or liquid ETFs.

[FDAXHunter]

Brokers in vanilla markets are ridiculously over-rated. For more exotic stuff it's different, as they can represent different liquidity pools but for plain vanilla stuff, there's nothing a broker can do for you that you yourself can't do. Market makers will deal with you, and gladly. You can go directly on the screen for the sizes you describe (I go on the screen for much larger sizes). Depending on the exchange, the only reason to pick up the phone is if you do something with deltas or a combination (spread) that's either not supported by the exchange or that just doesn't get picked up by the market makers.

(It's also quite amazing what sort of monkeys are employed by some PBs.. not necessarily the kind of people that you'd like to execute anything with more than one leg...)



A prime broker's option execution is no better than anyone else's in the major option markets (we avoid the prime broker route for that reason. The fees they'll charge are higher than that of a clearing member providing DMA (always will be, as they have higher overhead). All the big names provide a PB division (where they flog a bunch of "fund services") and a DMA division (where you get clearing only).



As a very rough number you're looking for... how does roundabout 500 sound? That's usually where the delta becomes sufficiently large to have some market impact (although if you're entering into the spread book then obviously you can do much more).



There's all sorts of details here, depending on the exact exchange and market involved, obviously. But long story short, you shouldn't have any problems and you will not benefit from having some sort of "PB" setup for listed options.

[Wannabe]

Thanks FDAXHunter.



That really helps. 500 will be more than enough for my needs. It is too early for me to think in terms of anything more exotic than simple spreads.



I noticed that with AMEX only listed options, my limit orders which split the bid-ask do not show up in the spread screens IB provides. They do show up for other options.



Is this a function of AMEX not supporting limit orders on spreads (vanilla verticals) or something different. Is there a resource I can use which can describe the different kinds of orders supported by each exchange?

[FDAXHunter]

Amex is like the bubonic plague: A sickness to be avoided at all cost.



I don't know the specifics of Amex (nor do I care to know them), but there's a few (ex)-Amex guys on NP, maybe they can give you specifics?



I'm not aware of a resource that compiles all exchanges and supported order types. Sorry.

[DocAdam7]

There is no reason to ever go to AMEX unless you're looking to trade against a specific limit which is only posted there. Otherwise you're much better off using BOX or ISE as your main routes.

As far as electronic spreads go, right now ISE and CBOE are the only exchanges that support spread functionality electronically (and thats what you would see in IB unless they're posting customer spreads internally for other IB customers to view). I believe both exchanges support pretty much the same strategies although I believe ISE may also support buy-writes and/or delta-neutral trades while CBOE does now (again, this might not be completely accurate since I know they're both in a sort of arms race and things change every week)...



To reiterate what FDAX says, if you're trading simple spreads or individual options there is ABSOLUTELY no need for a broker of any kind. All you'll do is pay extra commissions. There is more than enough liquidity on the screens in most names to satisfy any retail account and most hedgefunds as well. If you're looking for midmarket fills your best bet is to just hang limits out there. No broker will facilitate you or even pay much attention to your order unless you provide significant commission dollars. Its just not worth it to them otherwise.

[segv]

I agree completely with the other respondents, there is absolutely no need for prime brokerage in your case. I recommend Interactive Brokers or ThinkOrSwim institutional if you are in the US. I hear good things about OptionsHouse though I have not worked with them directly.

[Wannabe]

Thanks guys.



In general when doing spread trades, is it reasonable to expect a fill at the split of the bid/ask price? The had reasonable success in the past week or two in getting fills in the middle. Was it a side-effect of the high volatility or something which is the norm?

[Randumb]

I think it all depends on your size.  Spread or no-spread, I often think that if I split the bid/ask with a 1-10 lot order, market makers will just fill the order out of irritation.  But if I split the bid/ask with 50 contracts, then there's some risk for the mm's to consider and I don't think they take the order as quickly.  I think it has more to do with contract liquidity than underlying volatility.