Options TCA in Focus

Terry Flanagan

While transaction cost analysis has become de rigueur for institutional equity trading, it’s just getting started in the derivatives space, where uneven liquidity, slower execution, and a lack of standardization complicate the challenge of quantifying trading costs.

Hoping to bring more transparency — and perhaps even controversy — to measuring transaction costs, Chicago-based SpiderRock Platform Services LLC has begun promoting its internal methodology for traders of options and other derivatives.

“In the equities space, there is an accepted set of methods, but not so much acceptance or traction for a single methodology in options markets,” said George Papa, founder and partner at SpiderRock.

George Papa, SpiderRock

George Papa, SpiderRock

Large brokers typically measure what customers paid to market makers by the percentage change between where the order was put in and the bid-ask spread. “That method speaks to improvement but is silent on what you really pay the market,” Papa said.

In equities, the predominant metric is akin to improvement percentage and looks at the fill relative to the market at the time of arrival, Papa noted. But this isn’t necessarily applicable to derivatives, which typically trade slower.

The art to trading derivatives well is not to take the customer order and splash it into the marketplace, but to time the underlying versus the option to materially improve the market cost of the order,” Papa told Markets Media. “The customer may have a strong reason to go with the equity arrival time metric…but it doesn’t tell you your actual cost of interacting in the market.”

To measure what is going on, SpiderRock utilizes every print from the options feed, and backs up the clock to see where the underlying as well as the options were priced. “We archive this, and then look 10 minutes ahead to figure out where the underlying and the options were,” Papa said. “For many years, this is how we’ve measured costs…benchmarked, and created our own algorithms.”

The model helps illustrate how market makers behave. “Assume they hang on for 10 minutes, then they get out of the position risk at mid-market 10 minutes later,” he said. “Measure every print and consider it. This is a metric of a market maker’s short-term P&L,” he told Markets Media.

“In the listed equity option market, we know that exchange fees are typically plus or minus $0.25 to $0.50 per contract but the total market access cost when crossing blindly can easily be $3.00 or more per contract when factoring in market makers’ likely profitability,” Papa said.

According to Papa, SpiderRock can find the prints corresponding to a client’s actual executions, and based on the model, can estimate what they likely paid the market with precision. Then after factoring in which names they trade and on which exchanges, trade performance can be accurately evaluated, he said.

One of the key benefits to making transaction costs more transparent is the ability to negotiate with flow providers, according to Papa. “Market makers should embrace this method as it brings some transparency on what the order flow is worth.”

Buy-side firms, many of which don’t have a long options-trading history, are keen to know their transaction costs.

“Knowing the cost of accessing the market is particularly helpful when we work with the asset management community,” said Annabelle Baldwin, business development officer for SpiderRock.  “Asset managers are the most in the dark – removed from the dynamics of the markets, and paying a lot. We have materially improved their market access costs,” Papa added. “Institutions want to know what they are leaving behind in the market.”

Wealth management firms are an increasing focus. “That crowd wants to know about trading transaction costs in derivatives,” Papa said.

The company was a leader in alpha algorithms years ago and creating industry discussion now around what Baldwin refers to as ‘10-minute forward, short-term P&L’ is an effort to facilitate reduction of transaction costs in derivatives markets, she stated.

“If you come in randomly, naively, or slowly” to an options trade, “there could be a significant cost,” Papa said. But, “you can potentially do something to reduce that bid-ask spread cost by using algorithms designed for that purpose.”


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