The Chicago Board Options Exchange

The Chicago Board Options Exchange (CBOE) is the primary options exchange in the United States, although options contracts trade on many stock exchanges as well (including the New York Stock Exchange and American Stock Exchange). The CBOE is also a self-regulatory organization (SRO) that maintains regulatory power over the options market.

In this chapter, we’ll cover CBOE roles and its trading system.

Roles

There are three primary roles on the CBOE:

• Designated Primary Market Makers (DPMs)
• Market makers
• Floor brokers

Designated Primary Market Makers (DPMs)

Similar to the Designated Market Maker (DMM) on the New York Stock Exchange (NYSE), the Designated Primary Market Maker (DPM) is responsible for maintaining a fair and orderly market. Depending on the market’s momentum, they can act in an agency or principal capacity. A continuous bid (buy) and ask (sell) spread must be established by the DPM, requiring the DPM to trade with the investing public at all times. The DPM is an employee of and compensated for their services by the CBOE.

Market makers

In addition to the DPM, there are dozens of private market makers that add additional liquidity to the options market. These organizations act solely in a principal capacity by buying options into or selling options from their inventory. To do so, they publish bid and ask quotes for at least one contract and accept orders from the DPM, other market makers, floor brokers (discussed below), and trading permit holders (usually broker-dealers; also discussed below). The more market makers that exist, the more trading partners there are in the options markets (and more liquidity).

Unlike the DPM, market makers are not employed by the CBOE and have no obligation to maintain a continuous market. However, the market maker must give prior written notice to the CBOE before withdrawing its quotes.

Floor brokers

Floor brokers also exist on the CBOE and work in a similar capacity to floor brokers on the NYSE. This role is typically filled by broker-dealer employees that execute large options trades for firm customers, although any person can act as a floor broker (as long as minimum CBOE standards are met). Floor brokers execute trades only in an agency capacity with the DPM, a market maker, or another floor broker.

The system

The CBOE’s market structure is considered a hybrid system. Known officially as the CBOE Hybrid System, it executes some trades electronically through computerized systems while allowing other trades to be handled manually by humans. Most marketable* and small trades are transmitted by trading permit holders to the exchange and are executed electronically, while larger and more complex trades get the human touch. CBOE rules generally require both the buyer and seller to report a trade to the exchange within 90 seconds of execution.

*A marketable trade can be executed quickly with little market movement. For example, a trade to buy an option for no more than a $4 premium when it was last quoted at a $3 premium is a marketable trade.

The electronic system responsible for executing most retail investor trades is the Retail Automatic Execution System (RAES). This system executes market and marketable limit orders for up to 50 contracts per trade at the best possible price, which could mean sending the transaction to the DPM or market maker (whichever has a better price). In plain terms, the “easy” trades are directed to and handled by RAES.

Limit orders “away” from the market* and complex orders are handled differently. Non-complex limit orders “away” from the market are typically diverted to the CBOE’s electronic book. When the order becomes marketable, the book dispatches the trade to the appropriate venue to be executed. Complex orders can be handled electronically through the CBOE’s Complex Order Book (COB) or sent to floor brokers to be executed manually.

Trading rotations

Trading rotations are performed at the opening and closing of the market every day. Typically conducted by the DPM (although a CBOE official may appoint a market maker for the job), a trading rotation analyzes market demand for options contracts to determine opening and closing premium prices. Only public market or limit orders are considered when a trading rotation is performed. While the CBOE’s standard trading hours are between 9:30am ET and 4:00pm ET, trade requests are submitted into the system by TPHs at all hours.

An opening rotation occurs before the market is open. The system collects bids and asks (trade requests) for call contracts with near-term expirations first, then works outward to longer-term expirations. After, the same process is completed with put contracts. After the rotation is complete, the contracts may be traded.

The CBOE utilizes two electronic systems while performing opening rotations. The Rapid Opening System (ROS) attempts to pair as many market and marketable limit orders as possible before market open. Let’s assume before the market opens that Investor A submits a market order for an opening purchase of a call, while Investor B submits a market order for an opening sale of the same call option. The ROS should pair these trades for execution at the price determined by the opening rotation. The ROS forwards unpairable orders, multi-leg orders*, and limit orders “away” from the market to DPMs and market makers once the market is open.

*Only single-leg trades are executed during the opening rotation. Multi-leg transactions (e.g., straddles, combinations, spreads) can only be executed during the normal trading session.

The Hybrid Opening System (HOSS) is the other electronic system utilized during opening rotations. HOSS accepts pre-market orders and distributes order data to market participants (DPMs, market makers, floor brokers). The distributed data also includes information related to unexecuted orders from the previous trading day. The DPMs and market makers use this data to determine their opening quotes for the day. Once those quotes are determined, HOSS computes the opening (premium) prices for outstanding options contracts.

A closing rotation is similar to an opening rotation, but is performed at the close of the market.