Dynamics

The options markets can be volatile, but securities regulators want to ensure these markets are as fair and orderly as possible. This chapter will cover various market dynamics and the rules created to minimize their adverse impacts on investors.

Fast markets

A fast market involves volatile premiums and an imbalance of orders. An imbalance of orders means there’s either too much demand or supply for the market to handle. For example, let’s assume the American economy is deteriorating quickly (e.g., the 2008 market crash, 2020 COVID crisis, resulting in a significant influx of bearish options trades. If virtually every investor is attempting to sell calls and buy puts, who will take the other side of the trade? How volatile will the premiums of these contracts fluctuate? These issues illuminate the notable problems with fast markets.

The Chicago Board Options Exchange (CBOE) declares a fast market in one of two ways. First, the CBOE’s Screen-Based Trading (SBT) system can identify a fast market through analysis of market dynamics. Second, two or more CBOE Floor Officials (CBOE employees who work on the exchange floor) can identify a fast market through their own analysis. Unusual conditions or circumstances are the primary culprit; here are some examples:

• Pending news announcement by the issuer of an underlying security
• The system receives a significant number of buy or sell orders
• Disconnections from underlying security market data
• An event or circumstance is driving market volatility (e.g., 2010 flash crash)

If a fast market is declared, it provides CBOE officials additional regulatory powers. Officials can force an intraday trading rotation (instead of the typical opening and closing rotations), which would pause trading temporarily and ensure option premiums were correctly reflecting market demand. Additionally, CBOE officials are granted the power to take necessary actions to ensure a fair and orderly market. This could include shifting pending trades from one market maker to another with more liquidity, authorizing more market participants to execute trades with the public (e.g., clerks, other low-level market maker employees, trading permit holders), temporarily disabling electronic trading systems (e.g., the Retail Automatic Execution System (RAES)), or prohibiting the specific types of investor trades (e.g., stop and stop limit orders).

Market manipulation

Market manipulation comes in many shapes and forms, and it’s always illegal and prohibited. When a financial professional engages in an activity that artificially influences an options contract’s premium (or any security’s market value), they manipulate the market. These are the most common forms of market manipulation in the securities markets:

• Frontrunning
• Capping
• Pegging
• Supporting

Frontrunning

Frontrunning involves a market participant placing an order for themselves before the execution of a larger order. Large orders can significantly influence market demand and potentially “move the market.”

For example, a hedge fund requests a purchase of 100,000 contracts on a lesser-known underlying stock. Due to the size of the order, the contract’s premium is poised to rise considerably. Just before the order is executed, a lower-level employee of the market maker handling the trade places a smaller buy order for their personal account. They obtain some contracts before the large order is executed, then liquidate the contracts at a quick profit (through a closing sale) after the large order execution.

Of course, the offending party must have prior knowledge of the large trade to engage in frontrunning. Otherwise, the trade could be a coincidence.

Capping

As we learned in the Strategies unit, equity options traders gain and lose based on underlying stock market price movements. Investors maintaining bearish options positions are particularly concerned with the rising market prices. This is especially true for naked call writers, whose upside risk potential is unlimited.

To prevent a rising stock price, a manipulator enters a significant number of short sale* trades for the stock. The short sales apply downward pressure on the stock’s market price, potentially preventing it from rising above a certain point (e.g., a short call’s strike price). Engaging in this form of market manipulation is known as capping.

*A short sale involves borrowing a security (typically from a broker-dealer) and selling it. At a later point, the investor must buy back the security to close the position.

Pegging

Pegging is similar to capping, but the overall intent is different. Instead of preventing just a price rise, pegging also aims to prevent a market decline. Volatile market prices are a particular concern for straddle writers, who reach their maximum gain potential if the underlying stock’s market price does not rise above or below the strike price.

A manipulator would perform two potential actions to peg a stock (keep its price flat). If the stock’s price rises, they enter a significant number of short sale trades (similar to capping). If the stock price falls, they enter a significant number of buy trades (added demand increases the stock price). The more these actions are taken, the more the market price stays flat.

Supporting

Supporting is the opposite of capping, as this form of market manipulation aims to prevent a stock’s price from rising. Investors maintaining bullish options positions are particularly concerned with the falling market prices. This is especially true for naked put writers, whose downside risk potential is substantial.

To prevent a declining stock price, a manipulator enters a significant number of trades to buy the stock. The added demand applies upward pressure on the stock’s market price, potentially preventing it from falling below a certain point (e.g., a short put’s strike price).

Cabinet trading

The CBOE and other options exchanges typically allow investors to close out a worthless options contract for tax purposes. For example, let’s assume an investor goes long a call contract at a $400 total premium, which subsequently becomes worthless because the underlying stock’s market price declines. The investor’s tax forms would show a purchase of a $400 contract with no subsequent action. Most securities require both a purchase and sale of a security to reflect a taxable gain or tax-deductible loss. If an options contract simply expires, there is no tax-reportable “ending.”

To make tax reporting easier for investors, options exchanges offer cabinet trading, also known as accommodation liquidations. A cabinet trade occurs when an investor closes out a worthless contract for a total of $1* ($0.01 premium x 100 shares per contract). Unlike virtually all other trades, these transactions are not publicly reported. These transactions are handled by market makers or by the CBOE’s electronic book, and are available to any market participant (retail investors, market makers, broker-dealers, etc.).

*Cabinet trades are placed as limit orders.

Best execution

FINRA Rule 5310 establishes “best execution” regulations for broker-dealers. This rule set intends to ensure firms execute customer transactions as favorably as possible. Often, this means obtaining the best possible price, but there are more dynamics firms must consider beyond money. FINRA requires broker-dealers to exercise “reasonable diligence” when surveying the market before executing a trade. In particular, the following factors must be considered:

• The market’s character
  • Including price, volatility, liquidity, available data
• The size and type of transaction
• The number of markets checked
• Accessibility of quotes
• Terms and conditions of the order

Additionally, this FINRA rule prohibits broker-dealers from engaging in interpositioning, which is the act of involving an unnecessary middleman. For example, a customer submits a trade request to Broker-Dealer A, who has the capability of submitting the trade to the appropriate market for execution. Instead, Broker-Dealer A forwards the trade to Broker-Dealer B, who then submits the trade to the appropriate market for execution. Firms have engaged in interpositioning in the past to increase the fees they collect from their customers. This action is strictly prohibited today.