The options markets can be volatile, so securities regulators focus on keeping these markets as fair and orderly as possible. This chapter explains key market dynamics and the rules designed to reduce their negative impact on investors.
A fast market occurs when option premiums are moving rapidly and there’s an imbalance of orders. An order imbalance means there’s more buying interest or more selling interest than the market can absorb smoothly.
For example, suppose the U.S. economy is deteriorating quickly (e.g., the 2008 market crash, 2020 COVID crisis). That kind of environment can trigger a surge of bearish options activity. If many investors are trying to sell calls and buy puts at the same time, it becomes harder to find counterparties. Premiums may also swing sharply as the market tries to balance supply and demand. Those are the core problems a fast market highlights.
The Chicago Board Options Exchange (CBOE) can declare a fast market in one of two ways:
Fast markets are typically triggered by unusual conditions or circumstances, such as:
When a fast market is declared, CBOE officials receive additional regulatory authority to help restore orderly trading. For example, officials may:
Market manipulation can take many forms, and it is always illegal and prohibited. A financial professional manipulates the market when they engage in activity intended to artificially influence an options contract’s premium (or any security’s market value).
These are common forms of market manipulation in the securities markets:
Frontrunning occurs when a market participant places an order for their own account before executing a larger customer order. Because large orders can materially affect supply and demand, they can also “move the market.”
For example, a hedge fund requests the purchase of 100,000 contracts on a lesser-known underlying stock. Given the size of the order, the option premium is likely to rise. 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 acquire contracts before the large order executes, then liquidate them for a quick profit (through a closing sale) after the large order pushes premiums higher.
To engage in frontrunning, the offending party must have prior knowledge of the large trade. Without that knowledge, a similar trade could simply be a coincidence.
As we learned in the Strategies unit, equity options traders gain and lose based on movements in the underlying stock price. Investors with bearish options positions are especially concerned about rising stock prices. This is particularly true for naked call writers, whose upside risk is unlimited.
To try to prevent a stock price from rising, a manipulator enters a significant number of short sale* trades in the stock. Those short sales can apply downward pressure on the stock’s market price, potentially keeping it from rising above a certain level (for example, above a short call’s strike price). This form of manipulation is called 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 is similar to capping, but the goal is different. Instead of only trying to prevent a price increase, pegging aims to prevent both upward and downward movement - keeping the stock price relatively flat. Flat prices are especially important to straddle writers, who reach maximum profit when the underlying stock price stays near the strike price.
To peg a stock (keep its price flat), a manipulator may take two types of actions:
The more these actions are repeated, the more the manipulator attempts to keep the market price from moving.
Supporting is the opposite of capping. This form of market manipulation aims to prevent a stock’s price from falling. Investors with bullish options positions are particularly concerned about declining stock prices. This is especially true for naked put writers, whose downside risk can be substantial.
To try to prevent a stock price from declining, a manipulator enters a significant number of buy trades in the stock. The added demand can apply upward pressure on the stock’s market price, potentially keeping it from falling below a certain level (for example, below a short put’s strike price).
Options exchanges such as the CBOE typically allow investors to close out a worthless options contract for tax purposes.
For example, suppose an investor buys a call for a $400 total premium, and the contract later becomes worthless because the underlying stock price declines. The investor’s tax forms would show the $400 purchase, but no corresponding sale. For many securities, both a purchase and a sale are used to reflect a taxable gain or a tax-deductible loss. If an options contract simply expires, there may be no tax-reportable “ending.”
To make tax reporting easier, options exchanges offer cabinet trading, also called 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 most other trades, these transactions are not publicly reported. They are handled by market makers or by the CBOE’s electronic book, and they are available to any market participant (retail investors, market makers, broker-dealers, etc.).
*Cabinet trades are placed as limit orders.
FINRA Rule 5310 sets “best execution” requirements for broker-dealers. The goal is to ensure firms execute customer transactions as favorably as possible. Often that means obtaining the best available price, but firms must consider other execution quality factors as well.
FINRA requires broker-dealers to use “reasonable diligence” when reviewing the market before executing a trade. Specifically, firms must consider:
This rule also prohibits interpositioning, which is using an unnecessary middleman.
For example, a customer submits a trade request to Broker-Dealer A, and Broker-Dealer A can route the order directly to the appropriate market for execution. Instead, Broker-Dealer A forwards the order to Broker-Dealer B, and Broker-Dealer B routes it to the market. Firms have used interpositioning to increase the fees charged to customers. This practice is strictly prohibited.
The spread priority rule affects how orders are prioritized and executed on an exchange. It gives priority to complex (multi-leg) orders over individual orders at the same price. The intent is to encourage complex order strategies and support liquidity for multi-leg options trading.
However, the rule does not apply if the legs of the spread are priced better individually. Spread priority applies only when the net price of the spread order matches the best individual price available on the legs of the order.
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