Pls help me understand option market making

I understand that the pit broker/market makers can fill the spread that way, but if the options are traded only on an electronic exchange (such as ISE) is there such possibility that the exchange's algorithm will recognize that a spread order limit fits to the aggregate limit of two individual legs and therefore fills the spread order?

 

Each exchange has the ability to show the market makers, and others, spreads that are working, like the complex order book. So if anyone wants to trade your spread they can. If your spread lines up with the bid and ask of the exchange then obviously you should be filled. If you are asking if there is a smart algorithm that would send one leg to one exchange and the other leg to another exchange to get filled at their respective prices, then I am not aware that there is such a thing.

 

No, I am not asking about sending different legs to different exchanges, I am asking just about the ability to get fills against individual legs and not necessarily against an opposite spread order. I heard that US option exchanges such as the CBOE and ISE have such functionality but that the CME does not have such functionality regarding futures options (they only have a limited implied functionality regarding futures spreads) and also other major derivative exchanges outside of the US, such as Eurex, do not have such functionality. If you are aware of anything to the contrary please let me know, thanks.

 

opt789,
Thanks for the replies, they're really helpful. Speaking about the fair value for a spread, are you referring to the theoretical value? Or is it something else?

Is there a tool or calculator that one can use to calculate this fair value, or how do you figure this out?

I have a problem with this in my own experience. You watch the vols of the legs you want to trade and they fluctuate around. This is basically the skew between different strikes of the same month, or the horizontal skew. You don't really know what a good price is. Sometimes you get filled, and the next day or 2 days later, the leg you sold increases in IV and the leg you bought drops in IV, and the P&L graph of the whole position is really messed up and it messes with you psychologically. A profit turns into a loss.

What do you do when getting into a spread? Do you have any tips? For me I try to wait till the leg I want to sell and the one I want to buy have IVs that are reasonable, before I put my order in.

Thanks.

 

Then I still don’t know what you are asking. If you are hitting the bid or taking the offer of the exchange’s disseminated quotes then you will be filled whether it is a single order or a complex order with multiple legs. I trade spreads on the CME all the time and I usually get filled at better than posted bid/ask. You might what to be more specific in your questions.

 

I heard that in the CME an option spread order will only be filled against an opposite spread order and not against individual legs (I am not speaking about spreads that include futures but only about spreads that include options) becuase there is no implied pricing functionality that enables such fills there. In the CBOE and ISE I get fills on the mid of the spread or even better, and I understand that this is because these exchanges do have implied pricing functionality.

I understand if this information regarding the difference between these exchanges is correct, or there should not be any difference in this regard between getting fills on spreads on the CME and getting fills on spreads on the CBOE or ISE.

 

Knowledge earned is far more important than information given.
You are asking a lot of basic options questions that you should spend a long time researching. Once you have read a number of books, and gone through a lot of online material then you can start asking hard questions, but not until you know the basics. If you are not already mapping and constantly analyzing the vol surface of whatever underlying interests you then you need to go back and learn everything you can.

I am not trying to be a jerk, but what you are doing is asking what a scalpel is for and then wanting to perform brain surgery. You can spend 8 hours a day everyday for a few years learning everything you can about options and that will just get you to a fairer playing field, you still may never consistently make money with them.

My most valuable tip is not to trade. I have watched thousands try and fail. If you really want to trade options then ask yourself how you are going to beat the MMs and other participants with decades of experience, lots of money, and significant computer power.

 

I have no idea where you are getting your information. As I already stated I get filled in the middle of the bid/ask on option spreads on the CME all the time, the same as any other exchange. There is no “implied pricing functionality” that gets you filled. You put your spread order out there, and whoever sees it (including market makers, firm traders, or the public) can trade with you when they want – the exchange does not fill you another trader does. That said there is a world of difference between SPY vs SPX, or ES vs NQ on the CME. Each underlying has its own particular nuances and some have good market makers and others have ones that screw you.

 

That's right. On Globex options, last time I checked, there was no implied functionality. It means that all the displayed orders on an ES put spread book are orders on that put spread, and never a combination of orders in different put legs. In the same way, a put order on globex book is never the combination of an other put order in a different strike and an order on the spread of the two.

 

Thanks for the leads.