Options Trading: The Real Enemy of Liquidity

Posted On March 23, 2018 1:48 pm

Back in the 1990’s, when I was a market maker on the floor of the Chicago Board of Options Exchange (CBOE), options trading was different; options were quoted in fractions, there were only monthly expirations, and all trades were conducted in person.

This last item is particularly important. Because of the rules of being a market maker or specialist, when you quoted a price, which consists of both a bid and ask, you were required or held to buying or selling at least 10 contracts at those prices.  This was known as “the 10 Up Rule,” and it guaranteed at least some minimum of liquidity.

Without this rule, especially during volatile periods, orders might find themselves entering a vacuum. This could lead to huge slippages in price, without any actual trades happening.  This is essentially what happened during flash crash. And with the advent of electronic trading, human market makers fell by the wayside, so this dynamic occurs to a lesser extent every day now.

Basically, computerized ‘specialist’ systems are not bound to honor the quotes you see on your screen. They can be yanked, or disappear in a fraction of a second before your order, which was entered at the bid or ask, can be executed.

Couple this with the rise of ETFs, in which large baskets of stocks and options need to be executed simultaneously and it can lead to a gaping hole of liquidity just when it’s need most during times of volatility.

The Wall Street Journal has an important piece on the vulnerability of ETFs to liquidity jams, especially the funds tied to high-yield bonds.

Bets against exchange-traded funds have hit multiyear highs as some investors question whether this industry—which grew rapidly in the bull market—could handle sudden redemptions in a downturn.

Investors are shorting the shares of some ETFs that buy securities like high-yield debt, which may be hard to sell if markets turned suddenly, a fear stoked by increased volatility this year.

The ETF industry is now worth more than $4 trillion, up from below $1 trillion in 2008, raising its importance in the global financial system and magnifying the risk if the funds run into difficulties.

 Related: 5 Steps to Protect Your Portfolio

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About author

Steve Smith

Steve Smith have been involved in all facets of the investment industry in a variety of roles ranging from speculator, educator, manager and advisor. This has taken him from the trading floors of Chicago to hedge funds on Wall Street to the world online. From 1987 to 1996, he served as a market maker at the Chicago Board of Options Exchange (CBOE) and Chicago Board of Trade (CBOT). From 1997 to 2007, he was a Senior Columnist and Managing Editor for TheStreet.com, handling their Option Alert and Short Report newsletters. The Option Alert was awarded the MIN “best business newsletter” in 2006. From 2009 to 2013, Smith was a Senior Columnist and Managing Editor for Minyanville’s OptionSmith newsletter, as well as a Risk Manager Consultant for New Vernon Capital LLC. Smith acted as an advisor to build models and option strategies to reduce portfolio exposure and enhance returns for the four main funds. Since 2015, he has worked for Adam Mesh Trading Group. There, he has managed Options360 and Earning 360, been co-leader of Option Academy, and contributed to The Option Specialist website.

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