This chapter covers 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 market conditions, the DPM may act in an agency or principal capacity.
A DPM must establish a continuous bid (buy) and ask (sell) spread. In practice, that means the DPM must be willing to trade with the investing public at all times. The DPM is an employee of the CBOE and is compensated by the exchange for these services.
Market makers
In addition to the DPM, there are dozens of private market makers that provide additional liquidity in the options market. These firms act solely in a principal capacity by buying options into, or selling options from, their inventory.
To do this, 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). In general, more market makers means more potential trading partners and greater liquidity.
Unlike the DPM, market makers are not employed by the CBOE and are not required to maintain a continuous market. However, a market maker must give prior written notice to the CBOE before withdrawing its quotes.
Floor brokers
Floor brokers also operate on the CBOE and work in a similar capacity to floor brokers on the NYSE. This role is typically filled by broker-dealer employees who 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, trading with the DPM, a market maker, or another floor broker.
The system
The CBOE’s market structure is a hybrid system. Officially called the CBOE Hybrid System, it executes some trades electronically through computerized systems while allowing other trades to be handled manually on the floor.
Most marketable* and small trades are transmitted by trading permit holders to the exchange and executed electronically. Larger and more complex trades are more likely to be handled manually. 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). RAES executes market and marketable limit orders for up to 50 contracts per trade at the best available price. That may mean routing the transaction to the DPM or to a market maker, depending on which is quoting the better price. In other words, RAES is designed to handle the more straightforward orders.
Limit orders “away” from the market* and complex orders are handled differently. Non-complex limit orders “away” from the market are typically routed to the CBOE’s electronic book. When the order becomes marketable, the book sends the trade to the appropriate venue for execution.
Complex orders may be handled electronically through the CBOE’s Complex Order Book (COB) or sent to floor brokers for manual execution.
Trading rotations
Trading rotations occur at the opening and closing of the market each day. They are typically conducted by the DPM (although a CBOE official may appoint a market maker). The purpose of a trading rotation is to analyze supply and demand for options contracts and determine opening and closing premium prices.
Only public market or limit orders are considered during a trading rotation. While the CBOE’s standard trading hours are between 9:30am ET and 4:00pm ET, TPHs may submit trade requests into the system at all hours.
An opening rotation occurs before the market opens. The system collects bids and asks (trade requests) for call contracts with near-term expirations first, then moves outward to longer-term expirations. It then repeats the same process for put contracts. Once the rotation is complete, the contracts may be traded.
The CBOE uses two electronic systems during opening rotations. The Rapid Opening System (ROS) attempts to match as many market and marketable limit orders as possible before the market opens. For example, if Investor A submits a market order to buy a call at the open and Investor B submits a market order to sell the same call at the open, ROS should match these orders for execution at the price determined by the opening rotation.
ROS forwards unmatchable 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 used during opening rotations. HOSS accepts pre-market orders and distributes order data to market participants (DPMs, market makers, floor brokers). This data also includes information about unexecuted orders from the previous trading day. DPMs and market makers use this information to set their opening quotes. Once those quotes are established, HOSS computes the opening (premium) prices for outstanding options contracts.
A closing rotation is similar to an opening rotation, but it is performed at the close of the market.
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