THE OPTIONS COURSE- ELECTRONIC ORDER ROUTING SYSTEMS

THE OPTIONS COURSE


ELECTRONIC ORDER ROUTING SYSTEMS

In a relative sense, electronic communication networks (ECNs) are fairly new. Changes in the 1990s made it possible for the small investor to get access to Level II data and compete with market makers through the use of ECNs. Level II quotes are one of three levels of the National Association of Securities Dealers Automated Quotations System (Nasdaq). Level I quotes provide basic information such as the best bids and asks for Nasdaqlisted stocks. Level II data provides investors with more detailed quotes and information, including access to current bids and offers for all market makers in a given Nasdaq-listed stock. Level III is the most advanced level and is used by market makers to enter their own quotes to the system. 

In order to utilize ECNs you need to use a broker who provides direct access to them. Most traditional online brokerages offer Level I quotes; only direct-access brokers provide Level II quotes. ECNs are little exchanges themselves. There are many competing bids and offers from every single stock on each ECN. This depends a lot on the interest in the stock you are following. For example, you might find little interest from ECNs in particular stocks and sometimes find no interest at all for certain issues. By default, you will find only the best bid and ask from every ECN displayed in the Level II window. Generally each ECN is able to communicate only within the same ECN. There are some “intelligent” ECNs, though, that take all other ECNs into account. 

You are, however, able to display your own bids and offers through ECNs.The major advantage of these networks is that your orders are sent directly to the market, with no intermediary involved. They are kept in an electronic environment. For example, assume you are attempting to buy 600 shares of Cisco on an ECN and someone is willing to sell 600 shares or more for $17. If you enter an order for $17, your order gets executed immediately since there is a matching sell order. If the seller would be willing to sell only 300 shares, then you would get executed on only 300 shares. Also, since ECN orders are kept in an electronic environment they can be immediately changed or canceled at any time.

The electronic Island network is the most popular order route among day traders. It is very inexpensive and amazingly fast and offers tremendous liquidity. Some of the major rules applying to the Island network are that you can place your own bids and offers, there is no limit to the amount of shares you can trade, and you can place only limit orders. Also, Island allows you to enter price limits with less than one-cent increments. Some of the bigger stocks can be traded on the network as well as Island, accounting for a large percentage of the total trades made on Nasdaq. Archipelago is an intelligent order routing system. 

It has its own order book but is also able to communicate with other market participants. Archipelago is a very useful system for day traders. Whenever there are ECNs inside of your price limit, Archipelago is generally a very good choice. If there is a better price coming into the market, Archipelago tries to target that price. The network can only accept round lots for smart order routing, and if you get a partial fill it will keep resending your order until it is completely filled or you become the bid or ask yourself. The small order execution system (SOES) was developed in the 1980s and was made mandatory after the 1987 stock market crash. 

During the crash, market makers were ignoring their posted prices and therefore clients weren’t able to execute their orders. This system made it mandatory for market makers to execute orders at the market maker’s displayed price. It is for trading with the market makers only and cannot execute to ECNs. The small order execution system used to have many limitations to it, such as maximum number of shares that one could execute, as well as a time restriction for executing orders on the same stock. The biggest problem with it was that a market maker was required to execute only one SOES order every 15 seconds.

However, with the introduction of the new super SOES system these rules have changed significantly. Market makers are now required to execute every order they receive up to the size they are displaying, unless they decide to change their offer. You can now execute up to 999.999 shares via the new SOES. Since market makers now have to execute every SOES order they receive it has made SOES executions much faster and it has become a very interesting route for day traders again. You cannot display your own bids and offers through SOES, and the old SOES system still exists for small-cap stocks.

The other ordering system worthy of a mention is the Selectnet system, also known as SNET. SNET was developed by market makers in order to execute their trades electronically and to avoid the verbal communication process via telephone. Today Selectnet is available to direct-access traders as well. Using an SNET preference order you can send your order to every market participant available on the Nasdaq. As you evaluate any of these systems for your own trading, just remember order entry rules change quite frequently. Make sure to study your broker’s manual very carefully before making any trades.

ORDER MECHANICS

When you call your broker to place an order, it is a good idea to have all of the important information written down in front of you. What factors are important to this process? You have to know the quantity, the month, and the commodity. If there are options, you have to know the strike price, whether you want calls or puts, and if there is a price. A fill refers to the price at which an order is executed. Let’s review the important items that need to be specified depending on the type of order you are placing.

1. Order type. The kind of order you wish to place. For example, a delta neutral spread order.
2. Exchange. Sometimes you will choose the exchange where the order is to be placed (for futures and options). Often, however, you will simply choose “best,” which instructs the broker to send the order to the exchange showing the best price. The default in most cases is “best.”
3. Quantity. Number of contracts.
4. Buy/sell. Puts or calls (also include the strike price and expiration).
5. Contract. Name of the contract (e.g., T-bond futures).
6. Month. Expiration month of the contract.
7. Price. Instructions regarding price execution.

Types of Orders

Once you’ve decided to place a trade, you have to choose the type of order to place. There are two basic order types: market orders and limit orders. Market orders are generally not the preferred way to trade when you are trading options. By placing a market order, you are assured of getting the trade executed immediately, but at whatever price the floor chooses to charge you! You are, in effect, handing them a blank check. In reality, if you are trading a stock or option with much activity, the price that the broker gives you on the phone and the price the stock is trading at by the time the order reaches the floor (a few seconds or minutes later) will not be much different. 

However, thinly traded stocks and options may find a fairly large swing. Also, if your broker happened to give you a bad quote or you didn’t hear it correctly and you place a market order expecting a similar price, you may be quite disappointed. You would choose a market order only if you absolutely, positively had to have the trade consummated right now, no matter what. Therefore, under most circumstances, the limit order is the preferred way to trade. Limit orders come in many forms, but the basic concept is that you want the trade filled only if it meets your requirements (primarily a price that you have set). 

This protects you in several ways, not the least being that it protects you from the floor traders (manipulating the prices just as your trade reaches the floor) and from yourself (making an error in calculation, reading, hearing, or whatever). In a limit order, you will typically give the broker a price for the trade. If it is a debit trade (you are paying money out of your account) that price is the maximum price that you pay, and if the trade is a credit trade (you are receiving money into your account), that price is the minimum amount you will accept. Note: If the stock is moving rapidly, you can always set a limit outside the bid-ask spread.

For instance, if the stock is moving up and you want to be sure to buy it, you can set a buy price of $55, even if the bid-ask quote is $49–$50. Your broker should be able to get the stock (or option) even if it is moving, but you are protected from finding that the price is $60 or $70 by the time your order is filled. If the stock price does jump up to $70 by the time your order hits the floor, you, of course, will not be filled. But then not getting filled is probably a good thing, especially if it was trading at $50 only moments before.

From that basic setup, there are a number of additional choices that can be made. The first set of choices revolves around the duration of your limit order. There are basically three choices at this time:

1. Fill or kill. The broker is instructed to fill the order immediately, or kill (cancel) the order.

2. Day order. This tells the broker to put the order in for the day; if it is not filled by the close of the market today, then cancel the order. This is by far the most common type of limit order for two reasons. First, if you don’t otherwise specify, the broker will automatically place the order as a day order. Second, it protects you from forgetting that you have the order placed with the broker, and being surprised somewhere down the road when you get a fill notice on that trade you placed weeks or months before. There is nothing stopping you from placing a series of day orders, if the original order was not filled. If you forget to replace the order and circumstances change dramatically in your security, you will not be adversely surprised.

3. Good till cancelled (GTC). When you place such an order, your broker will simply put it into the system and forget about it until your criteria are met. At that time, the order will be filled. Most brokers do have a limit on GTC orders, and will automatically cancel them after some period of time—two months, six months, and so on. You should inquire of your broker as to what their standards are. For instance, one of the brokerage houses I use will accept day orders only for spread trades. However, my particular broker will automatically replace a spread order each morning if I have entered it as a GTC order. (I’ve been told this has something to do with their computer systems!)

Beyond the basic formats, there are numerous specialized order formats that could be useful for the trader in given circumstances. The following list details a few of these formats, and the reasons for using them:

1. At-the-opening order. If you want to make sure that you buy or sell a stock or option at the beginning of the day, you would place an at-the-opening order. Whatever price is set at the opening is the price at which your order will be filled. Typically, you would place this order if you were expecting a large move in the stock based on overnight news.

2. Buy on close. If you want to buy the security for the closing price of the day, you would place a buy on close order. This is often used if you are short a put or call on expiration day, there is a lot of time value still remaining in the option, and you don’t want to either purchase or deliver the actual stock. By placing a buy on close order, you will suck out the entire premium, and avoid being assigned on your short option position.

2. Buy on opening. The buy side of the at-the-opening order.

3. Cancel former order. If you have previously placed a limit order, it hasn’t yet been filled, and you now want to cancel it, you would place a cancel former order.

4. Exercise. If you are long an option and you either want the stock (if you are long the call) or you want to sell stock you own (if you are long the put), you would exercise your option. You would choose to exercise the option as opposed to either buying the stock and selling the call or selling the stock and selling the put if there was no time value in the option (typically if the option is deep in-the-money). You will then get the strike price of the option (buying or selling) no matter where the stock is presently trading, and with no slippage for the spread between the bid and ask prices. The exercise of the option takes place after the market has closed for the day—it doesn’t happen immediately.

5. Market-if-touched (MIT). This is an order that automatically becomes a market order if the specified price is reached. This is frequently done as a form of protection for falling prices if you are long the stock or call, or rising prices if you are short the stock or long a put. Although it will not absolutely protect you (the market price could slam down through your price and keep on going before it can be executed, or conversely it could touch the price and then rebound, but still force you out of that trade), it can be useful in some instances. This order can be used either to close out an existing long or short position or to create a new position (if you only want to buy XYZ Corporation if the price dips to $X).

6. Buy stop order. Set a price (usually lower) than the current price, and if the market price falls to that specified price, the order becomes a market buy order. This is the same as the market-if-touched order, but specifically to repurchase a short position.

7. Sell on opening. The sell side of the at-the-opening order.

8. Sell stop order. Set a price lower (as protection) or higher (to capture a profit) than the current price, and if the market price reaches that price, the order becomes a market sell order. This is the same as the market-if-touched order, but specifically to sell your position. 

Placing an order is not a simple process, especially for the beginner. The variations are many, and the consequences of being wrong are great. This is why, when asked by new traders about the type of broker to get, I strongly recommend a full-service broker—they can and will take the time to walk the novice trader through the intricacies of the system, generally protecting the traders from themselves. Even after many years of trading, I still find a full-service broker very helpful, especially when I am trying to do anything out of the ordinary, anything that is new to me, or something that I haven’t done in some time.

HOW TO PLACE A DELTA NEUTRAL TRADE

To demonstrate this process, let’s take a look at a few delta neutral orders.

Straddle Example

Trade: 1 Long June XYZ 50 Call @ 3.50 and 1 Long June XYZ 50 Put @ 4.

Place the order by saying: “I have a delta neutral spread order. I want to buy one June XYZ 50 call. I want to buy one June XYZ 50 put.”

Explanation: You then have to decide if you want to place the order at-the-market or as a limit order. A market order must be executed immediately at the best available price. It is the only order that guarantees execution. In contrast, a limit order is an order to buy or sell stocks, futures, or option contracts at, below, or above a specified price. If you want a limit order, you would say, “I want to do the straddle as a limit order at a debit of 7.50 to the buy side.”

If you place each part of the spread as a separate order, you run the risk of getting filled on one side and not the other; and there goes your risk curve. If you are going to do this, you need to carefully pick some period of low volatility in the middle of a very fast market. You need to wait until things settle down a little bit. What happens if your chosen market is between two strike prices? Be clear! State the strike prices you want. Those of you who have traded before probably already know why clarity is so important. Most orders consist of buying the stock and selling the puts. 

This buy-sell combination on a spread is pretty normal. You have to be explicit when you place an order to make sure you get what you want. Before calling your broker, always write orders down on paper or, better yet, in a trading journal. Every order you place with a broker is recorded on tape. If you make a mistake in the order process, you are responsible for that trade no matter what. By writing down exactly what you are going to say to your broker, you can avoid making costly mistakes. In addition, keeping a trading journal is an excellent way of learning from your successes and mistakes as well as staying organized.

Long Synthetic Straddle Example

Trade: 2 Long September XYZ 40 Calls and Short 100 Shares of XYZ Stock.

Place the order by saying: “I have a delta neutral spread order. Shares with options. I am buying two Labor Day September XYZ 40 calls and I am selling 100 shares of XYZ stock at the market.”

Explanation: We say “Labor Day” because “September” and “December” sometimes sound alike, especially when spoken loudly. You also want to request that the order be placed as one ticket to give you a better chance of execution. Whenever you use ATM calls, you will probably find it easier to get the order filled.

These examples are simply guides for entering delta neutral trades. Remember, the ratio does not make any difference. You could be doing 2 calls and 100 shares or 20 calls and 1,000 shares. Although you need to specify the number, all the other important factors remain the same. Again, it does not make a difference what kind of order you wish to enter. Just specify the quantity, the month, the commodity, and then if there is an option, what kind and the price. These examples are basic market orders. Let’s switch gears and try something a little more complicated.

Bull Call Spread Example

Trade: Long 1 June XYZ 35 Call @ 13.95 and Short 1 June XYZ 40 Call @ 11.05.

Place the order by saying: “I have a spread order. I am buying one June XYZ 35 call and selling one June XYZ 40 call at a debit of 2.90 to the buy side.”

Explanation: A plain old bull call spread will enable you to understand the debit and credit side of a trade. In this example, we are going to place the order as a limit order. We are not going to do it at-the-market.

Just for a little calculation, let’s say the premium on the buy side was 13.95 and the premium on the sell side was 11.05. This is where they closed. We come in and want to do it at whatever price they closed at. On the buy side, we are out-of-pocket paying 13.95; and on the sell side, we are receiving 11.05. What is the point difference? We are paying 2.90 more than we are getting. This is just an ordinary bull call spread where we buy the lower strike call and sell the higher strike call. The trick is to figure out an acceptable limit order based on the premium on the buy side (debit) and the premium on the sell side (credit).

This process is pretty easy and would be the same if you were doing a 10 × 10, a 20 × 20, a 100 × 100, or a 2 × 2, as long as it is a 1-to-1 ratio. There is no other calculation than just doing the simple math. This would be the same process if you were doing a put spread. You would need to determine both the debit and the credit and net them out. If you are taking money out-of-pocket, it is a debit to the buy side. If you are receiving money, it is a credit to the sell side.

Put Ratio Backspread Example

Trade: Long 10 July XYZ 35 Puts @ 11.05 and Short 5 July XYZ 40 Puts @ 13.95.

Place the order by saying: “This is a put ratio backspread. I am buying 10 July XYZ 35 puts. I am selling 5 July XYZ 40 puts for a 8.15 debit to the buy side.”

Explanation: Perhaps you have a specific idea—particularly when you are doing ratios—of a certain price you are willing to pay. Maybe this spread is trading at 8.15 but you are only willing to pay 7.50. You can put that order in; however, it may not get filled. The point is that you can enter a trade at whatever prices you like. The previous prices were just used to demonstrate the calculations. If you are debiting the buy side, you don’t say “credit” because you are actually taking money out-of-pocket. This is a debit. A credit means that you are taking money in. It is something that goes on the sell side of the ticket.

A debit means that you are taking money out. It is something you are paying on the buy side. Don’t worry about the prices. Just make sure you get the right spread to make the trade work the way you want it to. If you want to do a credit of 5, do you care whether you do it at 15 and 20 or 5 and 10? No, you don’t care what those prices are. All you care about is the differential between the two prices. The floor will not fill a limit order if you give them premium prices on each side. Before you place a trade, write the order in a trading journal to keep an accurate account of every trade you make and glean as much knowledge as possible from your trading experiences.

AVOIDING COSTLY ORDERING MISTAKES

Option trading can sometimes be very complex; some positions may be constructed using a couple of different instruments. If adjustments are added to an existing position, then the complexity of the matter can become even greater. Even seasoned traders can become confused when dealing with the trades that they have created. It’s just the nature of the beast. But confusion can lead to placing a trade incorrectly. You may end up putting yourself in a position where you are exposed to a greater amount of risk than what you originally intended. The severity of the mistake will determine the course of action that is required to fix it. 

This topic really hits home with me since I just went through an experience of confusing strike prices, which caused me to make a mistake on the long and short options that I wanted to trade. Let’s go through a couple of different scenarios. Let’s say you receive the confirmation from your brokerage firm and then realize that you placed the wrong trade. Unfortunately, in this business you can’t go back and say, “Hey, “I really didn’t mean to place the trade this way.” However, if you are able to call your broker immediately after the trade was executed and tell him or her that you need to “bust” the trade, then they may be able to accommodate you; but that certainly is not the norm. Fortunately, I was able to have my trade busted and I certainly learned my lesson!

Scenario 1

Let’s say that you intended to get into a Cisco Systems (CSCO) bull call spread using the 20/40 strike prices for a small debit. However, the symbols that you gave your broker were incorrect and you ended up with the 20/30 bull call spread for that same debit. This is not a complete disaster because the risk profile is going to be similar to what you originally wanted. You have a couple of different actions that you can take in this situation. 

First, you can just sit with the trade and see what happens. If your original assumptions were correct and the stock moves higher, then you should be okay. The position just won’t move as quickly as the intended trade. Another alternative is just to exit the trade immediately and realize the loss that you will incur because of the bid-ask spread. All other things being equal, I would probably stick with the erroneous trade, since there is plenty of time for the trade to work out.

Scenario 2

Now let’s look at a situation that’s a little more serious that requires immediate attention. Let’s say that you had a synthetic straddle on Best Buy (BBY), and you have been trading it very aggressively—as the stock moves, you are buying and selling off shares in order to lock in profits and remain delta neutral. Another adjustment that you could make to the position is to sell calls against the long stock. In the process of doing this, you neglect to double-check the number of shares that you were long. You end up selling more calls than you have long stock. This is a very serious situation, because the position now has an unlimited amount of risk due to the greater number of short calls compared to the number of long shares available to hedge the trade. 

The reason to trade a synthetic straddle is to limit risk, not create an unlimited liability. The action to take here is to immediately buy back the appropriate number of calls that were sold short. This action eliminates the unlimited risk that became part of the position, which is exactly the goal when dealing with this type of scenario. As you can imagine, there are many different types of mistakes that can be made when placing orders; some mistakes are more serious than others. It is up to the trader to discern what has happened and determine how the risk characteristics of the position have changed, and then act accordingly. Maybe you will just stick with the trade or maybe something will need to be done immediately.

The best way to keep yourself from getting into these problem situations is to be well prepared when you trade. There are five steps that I always go through before placing a trade. This process should help you catch any of the possible mistakes that are easy to make.

1. Write out the trade exactly that you want to place, including the appropriate actions (buy/sell), the number of contracts, the months, the strike prices, the appropriate option symbols, as well as the net price for the overall trade.

2. Write out the various characteristics of the trade. Know and understand the margin requirements that the brokerage firm is going to require once you’re in the trade.

3. Use an options analysis software package to view the risk profile.

4. Know your exit strategy or at what point the next adjustment will need to be made.

5. Place the trade with confidence.

Hopefully, some of these ideas will help you to avoid panicking if you realize that a mistake has been made with one of your trades, as well as to provide some ideas on how to prevent mistakes from occurring.

POINTS TO REMEMBER

The typical brokerage firm ticket has the buy side of the trade on the left and the sell on the right. Generally, we would always start from left to right, writing down your buy side first. You would say, “I have a straddle order. I am going to buy three of the June XYZ 45 calls and buy three June XYZ 45 puts at ______” at the market or as a limit order with a certain number of points to the buy side.

With a spread order, always give the quantity, the month, the underlying instrument, the price, and the strategy: “I am buying three [quantity] June [month] XYZ (stock) 45 [strike price] straddles [strategy].” The other half of the order would be, “I am buying three June XYZ 45 puts. I am buying three June XYZ 45 calls.” Now we have to calculate the cost. It is either a debit, a credit, or at even. If it is at even, you do not want to receive a debit or a credit. You want to stay at net cost of zero. I prefer to do my trades at even or better. However, a straddle is a debit strategy because you are buying both legs.

If you are not comfortable with the specific language of straddles and spreads, then state each part of the trade instead. Tell your broker, “I want to buy three of the June XYZ 45 puts. I want to buy three of the June XYZ 45 calls.” Spell out the whole thing if you are more comfortable doing it that way. In fact, you don’t even have to say “straddle” and “strangle” if you are not comfortable with those terms. In the beginning, it is a good idea to be specific about each leg to make sure you get it right. 

Once you have experience in these types of trades, it will become second nature to properly state your orders correctly. If you are trying to get a credit, do not state the credit as a dollar value. You do not say, “I want $200.” You specify the credit, if that is what you desire, at the point level you want. So $200 is actually 2 points. You need to specify the trade in the terminology used by the floor. Most importantly, it has to always be in tick values or point values, not in dollar terms of how much you want to spend or take in.

You can go into any market at whatever price you want. The floor will either execute the trade at that price or it won’t. You could say that you want the trade at even, but if the market is not at even, your order will not get filled. At one point during the day, perhaps the market does get to even and you finally get what you want. Bottom line: If you don’t enter, you can’t win. If you want it at a certain price, put the order in as a limit order. Then wait to see if you get the trade filled. If you do not get your credit price or at even, try the trade at some other time. Do not chase the trade.

The more volatile the market is, the wider the bid-ask spread will be. If the market is pretty quiet that day, the bid-ask spread will be smaller. The bid-ask will be smaller for the at-the-money (ATM) options and for the body of the trade and greater for the wings. Floor prices primarily depend on volatility and liquidity. In addition, the longer the time your options have until expiration, the wider the spread. Floor traders will widen the spread when there is a greater chance of their being wrong due to time, volatility, and volume.

CONCLUSION

The progression of an order through the trading system is a fascinating process. It has come a long way from the days in the late 1700s when traders met under a buttonwood tree on Wall Street. Today’s floor traders run an average of 12 miles each trading day just to get the job done. Although many traders never set foot in an exchange, it is important to understand the process your order goes through before returning to you as a profit or a loss. As we progress further into the twenty-first century, this process will undoubtedly become even more electronically synchronized. As the information superhighway speeds up, it will be very interesting to see how it changes and if the nature of the game itself remains the same.

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