Cancel Fees Aggravate Options Traders
Nina Mehta
Order cancellation fees at options exchanges are a thorn in the side of some active customers-and as the industry moves toward trading in decimal increments next year, those same fees could limit growth in the booming options market, observers believe. "Don't get us caught in your net," Jerrell Watts told the International Securities Exchange at a Futures Industry Association conference on the options industry in September. Watts, a managing director at Merrill Lynch, is responsible for the firm's global order flow and risk aggregation strategy for equity options.
Watts was referring to the ISE's use of cancel fees to limit trading behavior by active, or so-called professional, customers, many of whom are traders employing arbitrage strategies and combination trades. Cancel fees are imposed by exchanges to prevent public customers from acting like market makers without taking on the obligations of market makers. These public customers have various advantages when trading and aren't charged exchange transaction fees.
The ISE and Chicago Board Options Exchange, the two largest options exchanges, charge $1.25 and $1 per cancellation, respectively, when a customer's monthly order cancellations (over a certain minimum) exceed its executed orders.
Watts said broker-dealers wind up butting heads with exchanges over this issue. High cancel fees can make it difficult for brokers' active customers to execute various options strategies.
Costly Strategies
If an account wants to put on a pairs trade or do a correlation trade between two names, Watts said, the account must currently post two separate limit orders. When one side gets filled, that customer may want to change the aggressiveness of the other leg to ensure it gets filled as well. Cancel fees can make that process costlier-and some say that's unfair.
Watts added that accounts with delta-adjusted limit orders and those trying to replicate over-the-counter variance swaps also face hurdles because of cancel fees.
Merrill Lynch spends a lot of time managing cancellation fees for customers, according to Watts. The broker tracks the number of orders and cancellations on various exchanges. That ratio can affect Merrill's routing decisions, subject to best-execution requirements.
In a penny world that encourages algorithmic trading, cancel fees could also limit the efficiency and use of electronic trading tools. If the issue involving cancel fees is not addressed, "we'll be starving ourselves of certain types of order flow," Watts said. The adoption of direct market access in the options industry, which is likely to increase once pennies arrive, could also be slowed by the presence of cancel fees.
Options exchanges that rely on their market makers to quote deep markets, understandably do not want to see them get picked off by customer orders. In some cases, those orders come from professional traders, whose orders get priority and jump to the front of the line.
At the largest options exchanges, cancel fees are a work in progress. In recent months, as active customers found ways to adjust their ratio of executed trades to cancel orders-such as by "shredding" a single 100-lot trade into 100 one-lot trades-some exchanges reacted. For instance, in May the ISE instituted a rule that counts all executed orders in the same series on the same side at the same price within a 30-second period as a single order.
The Boston Options Exchange and NYSE Arca Options do not charge cancel fees. Unlike the ISE and CBOE, both exchanges have price-time priority algorithms that match trades. But those exchanges currently have limited liquidity in their markets.
Routing Decisions
Watts spoke on the panel with Thomas Ascher, the ISE's chief strategy officer, and Anthony Saliba, a principal at First Traders Analytical Solutions, a provider of options routing and execution systems. Saliba is also the founder of options broker LiquidPoint.
Saliba pointed out that routing decisions in the options industry have many moving parts. "Smart routing in options is really smart order management," he said. "Not all destinations are created equal." Speed, differences in execution quality and other factors-such as the cost of cancellations-determine the appeal of particular venues.
Retail customers and hedge funds engaging in statistical arbitrage also make routing decisions differently. The latter flow usually requires immediate execution.
Merrill's Watts noted that discussions about smart order routing often focus on marketable order flow. However, decisions involving non-marketable order flow are tougher.
"What if someone wants to join the offer, or be in the middle of the market-where should they sell?" he asked. He said some customers give brokers constraints around cancellation fees to control their costs.
The ISE's Ascher stressed that the options industry thrives on depth of market and the quality of that market. "That depth comes from competitive market makers that have accepted affirmative obligations," he said. According to that view, customers whose orders get priority and who pay no exchange fees should not act like market makers without the accompanying responsibilities.
Blunt Force
Saliba believes the customer base is advancing faster than options exchanges. "Exchange facilities view certain types of order flow as detrimental to their liquidity providers"-and blunt that flow by charging cancel fees, he said. That constrains customers whose activities the exchanges did not intend to constrain, and whose flow many market makers actually want.
He added that all market makers do not see order flow from active investors the same way. What one market maker considers "toxic" flow may be welcomed by another.
Ascher agreed that cancel fees are a "blunt instrument." However, he said it's difficult to find a practical solution that works for exchanges, fits into the regulatory framework and is fair to customers.
Cancel fees also result in increased bandwidth demands, which must be funded. Bandwidth is "not absolutely, positively free," Ascher said. Cancellations generate a tremendous amount of message traffic in the options industry, whose capacity requirements have already increased exponentially-and are due to rise further once penny trading begins. All six options exchanges are currently developing quote-mitigation plans to control the increase in message traffic.
Changing Fees
Merrill's Watts proposed a solution to deal with the problem some exchanges face. It might be possible for an industry group to define trading metrics for active or professional investors whose trading is similar to market making, he said. Adjusting the cancellation fees for those customers could then prevent the strategies of active and sophisticated customers from snagging on the fees.
That arrangement would involve the industry policing aspects of its own behavior, instead of relying on the exchanges to do so.
With the options industry currently going through a period of change, the problem produced by cancellation fees isn't likely to be immediately resolved. But one thing is certain-decimalization and the onset of new trading strategies will only amplify the issue.
(c) 2006 Traders Magazine and SourceMedia, Inc. All Rights Reserved.
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