Randy Scharringhausen is the chief operating officer of EESAT, a financial technology startup that launched in 2013. As a long-time derivatives trader who started his own institutional broker-dealer in 2006, he has seen the evolution of markets onto electronic platforms and some of the holes that transformation has created. One example is in the complex order book space.

EESAT aims to improve transparency and consolidation in the complex order books (COBs) offered by seven out of the 13 equity options exchanges. Complex orders are multi-legged strategies such as a straddle, strangle, ratio spread and butterfly.

Customers can access COBs in various ways; for example, ISE offers complex orders on their front-end order and execution management system and CBOE does so on its website, its proprietary CSM data feed and via a partnership with FlexTrade. However, there has not been a tool that combines all of the options exchanges’ complex order books onto one common language platform until now.

EESAT aggregates COB data feeds from seven of the US options exchanges and “normalizes” the data into one single application, translating the various data languages at the different exchanges into one language.

Scharringhausen, who joined EESAT in June of 2014, spoke with Sarah Rudolph of John Lothian News about the issues surrounding complex order books in the options world and how EESAT is addressing them.

Q: Which exchanges offer complex order books and how are they used?

A:  The exchanges that have COBs are the CBOE, ISE, PHLX, NYSE AMEX and ARCA, BOX, and C2. [MIAX is just getting started in the complex order space and a BATS spokesperson said the exchange “continue(s) to evaluate” the idea.]  All the exchanges look at them as business growth opportunities.

Complex orders make up between 30 and 40 percent of the options volume. They are a big part of the option trading space. The biggest players, ISE and CBOE, as well as PHLX, generate a lot of volume trading spreads. And it is certainly something anyone not in that space now is looking to get into.

So there’s a lot of volume out there, and everyone wants to get in.  There are a couple of challenges, though. The big one is market fragmentation. Market fragmentation is really tough, and it’s even tougher in complex orders.

The other has been visibility. If you manage a derivatives portfolio as a prop trader or a hedge fund trader, for example, you don’t really have a mechanism that allows you to see what’s on all these COBs.  There is no tool out there where you can say, “I want to see all the complex orders in bank stocks,” for example.  We address the fragmentation issue by putting all of those COBs in one feed and filtering out the non-marketable orders.

And each exchange’s data outputs all speak a different language. If you wanted to combine them in one place, you would have to write code to each exchange’s language and create a common language so your system could make sense of the data. We normalize all the data feeds into one language and filter out extraneous order flow.  And customers can effect some customization beyond that.

Q: Why is there so much activity in the complex order space right now?

A: Spreads have always been big part of the market. As options have become more popular and people have a better understanding of how they work and of how important they are as a risk management tool or a more cost-effective way to implement various strategies, the use of complex strategies has grown. The institutional community has always understood the value of spreads. Now it’s filtering down as the average investor has become more sophisticated.

Q: What is the value of trading a spread?

A: Instead of just taking a directional position, spreads allow you to trade your direction bias at a reduced cost. If you buy a plain call it might cost you $5 versus a call spread, which might cost you $3.  So there is a lower cost way to take the same directional position – also another way to help mitigate risk.

Q: Do most spread traders trade to mitigate risk or purely for profit?

A: It really depends. It’s a broad spectrum of options traders: for long-only investors, a conservative trade they can make is buying stock and selling calls (a buy-write). Farther up the food chain, the hedge fund universe can employ the same strategy but on a larger scale.

If you have a large position in a stock and want to protect some of your gains, maybe you buy some puts against your stock position. Or try to mitigate risk and protect your return.

Also, there is something unique about spreads in COBs. If you pull up an option quote or a montage, you can see the bid and ask in each individual call and put, but what is not reflected is the spreads that are on the COBs.  Because of the type of order they are, spreads are packaged orders of 3, 5, etc.  – they are not reflected in any quotes you look at.  So a retail investor who wants to do a spread might not even know the COBs exist.  And there is no mechanism for anyone to see what’s on these COBs because it is not reflected in the aggregated quotes. A spread could appear on your screen at a certain bid-ask, but the effective price on that spread on the COBs might be a very different bid and ask.

Q: Why are these spreads on the COBs not visible?

A:  There may be several reasons why not.  Back in the pit days, a broker would come into the crowd and a spread would get announced to everyone in the pit.  When things moved to the electronic marketplace all that went away. So you might have a larger crowd by virtue of having 500 people looking at those options quotes every day, but when complex orders come in, they are not announced.

And there is competition among exchanges. One wants to be the COB destination, then another one wants to get into that space. But I think competition will breed more transparency and that will ultimately be better for everyone.


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