Evolving Technology Enables Transaction Cost Analysis in Options Market
As trading technology evolves, it enables traders to capture holistic and detailed data about the costs related to their trading activity. Ubiquitous in the equity markets and moving into the options space, Transaction Cost Analysis (TCA) is the practice of viewing a trade from inception to execution and analyzing the market conditions before and after the order is placed to collect transaction costs and trade efficiencies. MarketsWiki’s Jessica Titlebaum sat down with LiveVol’s Catherine Clay and Kevin Nichols to discuss this new concept and how it could potentially revolutionize the options markets.
Q. What is Transaction Cost Analysis in your own words?
Catherine Clay: Transaction cost analysis is viewing a trade from inception to execution and measuring all the costs that occurred throughout the trade lifecycle. Most of TCA is done in the equity world and done after the trade has been sent. You hear more about post trade TCA, which looks at the trade related to entry-established benchmarks against an algorithm. From the captured data, you can decide if the trade was favorable or not. These investors are looking to see if the end result was what they intended it to be.
Q. What types of firms are using this most?
C.C.: The buy-side is using this tool the most because a fund that is trying out different strategies and different traders is always trying to determine how much a trade is costing them.
Kevin Nichols: I would say about 95% of firms on the equity side use some sort of transaction cost analysis to analyze trade execution costs. This is mostly on the post-trade side but there is also a fair amount of pre-trade that is forecasted as well.
C.C.: I believe that everything in the equity markets progresses into the options market. While the options market is more difficult to analyze because of the large amounts of data churned out, we see the practice of TCA 25% prevalent.
Q. When did TCA first come on to the scene?
C.C.: I think the concept has been around for a few decades but it stems from a rudimentary look at post-trade analysis. Technology has evolved and firms like LiveVol, which are built on tick data, provide new capabilities such as capturing very granulated information. For example, we can now tell you what the market was like in the underlying market before and after your trade, how much of the order is being filled and how the market was impacted by the order. Essentially, it’s only been in the last decade that firms have taken this holistic approach.
Capturing tick data is a hardware intensive endeavor and very few firms were capturing all of the data in the marketplace. As technology has improved and people capture more data, this type of analysis has been more available to people. Underpinning the crucial point of TCA is the data.
K.N.: Transaction cost analysis has also become more important with the growth in the options markets and the number of exchanges and dark pools that have appeared.
When Catherine and I started trading equity options there were four exchanges – and this was before multiple listings! Once multiple listings happened, most people thought that we were going to see a lot of consolidation and that didn’t happen. This is on the options side but this is similar to the equity side of things. With Exchange Connectivity Networks (ECNs) and Alternative Trading Systems (ATSs), these people have to justify their routing decisions and prove to the sellers, their customers, that they are getting good fills.
C.C.: Also, on the equity side, when the SEC adopted the REG NMS initiative, order routers had to prove to the SEC and their customers that they were doing their best fiduciary responsibility to route orders to the National Best Bid and Offer (NBBO). They need statistics to back that up.
On the options side, there are rules that require options order routers to publish those statistics as well.
Q. What kind of data is important for TCA?
C.C.: Tick data is needed for transaction cost analysis such as: what the market was at the time of the execution as well as what the market was on all regional exchanges, because you need to honor the NBBO.
For example, you may have sent your order to the New York Stock Exchange but there was a better bid at one of the ECNs or BATS and you can’t trade through that. So you have to collect all of the national best bid and offers in the marketplace at the time of your trade. That is the bare minimum amount of data you need.
Q. You can use TCA to fine-tune an execution algorithm as well. What kind of data is needed for this?
K.N.: When you start lifting the data to fine tune an execution algorithm, you are going to look at the market when the order was executed as well as what happened in the market before and after you sent the order. You will also need to look at data a few minutes later, a few hours later and at the end of the day. It requires having the data and manipulating and cleaning that information. You can look at this information and if your algorithm didn’t do what it was supposed to do, you can figure out why.
Q. Can you give me another example of how TCA helps beyond the regulatory requirements?
K.N.: On a pre-trade side, you can figure out the personality of a stock before you make the trade and the liquidity that is actually presented there.
C.C.: It’s looking at what happened in the post trade analysis to understand what should happen in the future, and then incorporating that information into your next pre-trade analysis. What’s really crucial about this tool is that it helps you find liquidity. This is what a lot of the statistics are looking for; where is the hidden liquidity?
And once you know these statistics, we can break this down even further. You can get such fine-tuned granularity that you can be very informed about what time of day liquidity is greatest and accelerate your trading to coincide with the times that have been identified through TCA, so you get better fills.
Q. Can you tell me about the LiveVol TCA tool?
C.C.: We only recently started developing this tool and the demand has been overwhelming. Our suite of TCA products goes far beyond best-execution metrics. We take advantage of our capability to capture all this data in the marketplace and record market statistics in great detail. We capture every trade that happens at every exchange in the options and equity markets, as well as the size of the trade and the trade conditions. For example, was it traded with stocks or spreads?
We also record implied volatility with the time of the trade, including all the Greeks. We record every quote in the marketplace and track every trade by taking a snapshot of the trade when it hits the market to see the impact of the trade. We also take a snapshot of the market before the trade to determine market changes before and after the trade.
K.N.: The interest is not just on the buy side but also on the sell-side and from market making firms. On one side customers want to know what type of execution they received, and on the flip side, they want to know if they are paying for short order flow.
If someone has their execution log, they can also analyze with whom they are trading and how profitable the counterparty is. Our tool also enables customers to look at event driven activity and how it impacts the market so we look at corporate events and news releases to see their influence on the market.
Q. What areas of TCA could be improved?
K.N. : I think in the options space it is the different exchange models within the market. For example, we have the maker-taker model or the BOX model – which is the taker-maker model – and then you have standard models with regular transaction costs or costs for taking liquidity or providing it. These costs and your routing decisions need to be taken into consideration at a firm level.
C.C.: The TCA tool is a flow chart telling you where your expenses lie. Whatever your order is, there is an optimal exchange for that order depending on the exchange’s market structure. This concept goes back to your pre-trade analysis, and once you understand market costs at each exchange, you can better make your order routing decisions.
Q. What was the trade cost analysis process before tick data could be captured at such a detailed level?
C.C.: This is a new character in the options market. What equity firms have been doing is a post-trade analysis of their order routing decisions, and relative to midpoint, which is the benchmark that everyone uses – how do their trades fare versus that standard.
A lot of the time you will see firms ask, did we price improve? Did we trade better than the bid or offer for our customers? They will produce statistics for that concept but again, this is a new territory and I think that most firms just meet the minimum of their reporting requirements. And it’s only now that that tools like TCA add value. It’s important to know that companies are pioneering tools that enable a detailed look at the options market and the costs associated with their trading activity on a very specific level.