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U.S. equity options market models

Author
Steven W. Poser

Director of Research

Published
January 11, 2024

Our recent article discussing trends in U.S. options trading made us realize that some of our readers may not be aware of the various market models employed by the 17 - soon to be 18 - options exchanges.1 Unlike U.S. equities, where, with the exception of the NYSE, all exchanges are fully electronic and 100% price time priority2, options markets also attract order flow based on specialized auctions, floor presence and execution priority. U.S. options trading is executed only on an exchange, compared to U.S. equities, where orders are executed on exchanges, ATS’s and on single dealer platforms, that largely internalize retail orders.

A very brief history

U.S. options are a relatively new phenomenon, at least on a regulated exchange. Over the counter options have existed at least since the 1600s, if not earlier. The first U.S. options exchange was born in 1973, when the Chicago Board of Trade (CBOT), a futures market, launched the Chicago Board Options Exchange (CBOE). Volume was initially quite low as there were only call options available and only on 16 stocks. It did not help that there were few people who understood how to properly value an option, at least until Fischer Black, Robert Merton and Myron Scholes published their paper: “Theory of Rational Option Pricing”. Smart traders used the new pricing model, which gave them an advantage over those that did not use it.3

As the Black-Scholes model was adopted, options trading started to move out of the shadows. The American Stock Exchange and Philadelphia Stock Exchange launched their options markets in 1974, and the Pacific Exchange started trading options in 1976.4 Further helping the growth of options trading was the launch of a consolidated tape for options trades and quotes, the Options Price Reporting Authority (OPRA), which was approved in 1981.

All of the early exchanges were fully floor-based. Today, only five exchanges currently have floors, which operate side-by-side with electronic trading under the same umbrella: NYSE American, NYSE Arca, Nasdaq PHLX, CBOE and BOX. A sixth, MIAX Sapphire, is expected to launch pending SEC approval in 2024.

Options exchange models and differentiators

As we noted above, only five of the current 17 exchanges boast a trading floor. Floor brokers can handle larger orders and are given discretion on how they handle the orders they receive. In addition to the presence of a floor, there are several additional ways exchanges distinguish themselves:

Execution Priority

There are two basic methods: Price/Size Pro-rata and Price/Time. These two models typically attract different clients and types of order flow.

Pro-rata

Size pro-rata means that the time an order comes in does not determine order of execution. Instead, larger orders receive preference for execution. For example, consider an order book where the best offer price on the book is $10.00. There are three orders on the book to sell:

Order 1: 50 contracts to sell at $10.00

Order 2: 40 contracts to sell at $10.00

Order 3: 10 contracts to sell at $10.00

If a buy order for 20 contracts arrives, Order 1 receives an allocation of 10 contracts, because they represented 50% of the liquidity on the book. Order 2 trades against eight contracts, and Order 3 trades against two contracts.

Size pro-rata priority encourages liquidity providers to put more size on the book. Note that displayed liquidity will always receive priority over dark liquidity and fractional contracts are not awarded. Instead, remaining contracts are generally executed in size priority with ties broken by time.5

Most size pro-rata exchanges have additional priority overlays that can supersede the pro-rata allocation.

Price/Time

A price time order book means that after determining the best price (highest buy or lowest priced sell order), orders are executed on a first in / first out basis. Most price/time markets pay a rebate to orders that provide liquidity and charge a fee for aggressive orders. This structure encourages liquidity provision and tighter spreads. As a result, price/time markets typically are at the best price more often than pro-rata markets.

Customer Priority

Customer Priority means customer liquidity providing orders execute ahead of all other orders at the same price, regardless of size or time of order entry (if there are multiple customer orders, they are allocated on a price/time basis). Customer Priority puts retail investors and other non-professional activity on a more level playing field as it makes speed less relevant (as does size pro-rata). Customers are put in their own bucket away from other orders because their orders tend to be smaller in size and could not compete with larger broker-dealer orders. Many exchanges that offer customer priority also offer price improvement auctions, such as NYSE American CUBE. These auctions allow market makers to guarantee a retail order an execution at or better than the NBBO.

Additional Priority Overlays

Multiple exchanges also offer market makers the opportunity to trade against customer flow. This includes percentage allocation of the order volume as well as rules that allocate small orders to trade wholly against certain market makers.

The table below identifies all current U.S. options exchanges and some of their key attributes.6

U.S. Equity Options exchange models

Group Exchange Allocation Priority Customer Priority? Pricing Has Complex Book? Has PI Auction? Has Floor? Has Lead / Primary Market Maker
NYSE Arca Price/Time No Make/Take Yes No Yes Yes
American Pro-rata Yes Classic Yes Yes Yes Yes
Nasdaq BX Hybrid Yes Make/Take No Yes No Yes
GEMX Pro-rata Yes Make/Take No Yes No Yes
ISE Pro-rata Yes Hybrid Make/Take Yes Yes No Yes
MRX Pro-rata Yes Make/Take Yes Yes No Yes
NOM Price/Time No Make/Take No No No No
PHLX Pro-rata Yes Classic Yes Yes Yes Yes
CBOE BATS Price/Time No Make/Take No No No No
C2 Pro-rata No Make/Take Yes No No No
CBOE Pro-rata Yes Classic Yes Yes Yes Yes
EDGX Pro-rata Yes Classic Yes Yes No Yes
MIAX Emerald Pro-rata Yes Make/Take Yes Yes No Yes
Miax Pro-rata Yes Classic Yes Yes No Yes
Pearl Price/Time No Make/Take No No No No
MEMX MEMX Price/Time No Make/Take No No No No
BOX BOX Hybrid Yes Hybrid Make/Take Yes Yes Yes No


1 This does not include options on futures, which trade on the various U.S. futures markets.

2 One exchange offers intraday auctions.

3 The Black-Scholes model only properly prices European options - options that can only be exercised on the day they expire, but modifications to the model allowed it to be applied to American options, which can be exercised at any time.

4 The NYSE joined the fray - much later - in 1984 but dropped out of options trading in 1997. The key figures of the NYSE options market were partners in the International Securities Exchange (ISE), which launched in 1997.

5 When the order cannot be allocated in whole numbers, the remaining contracts are usually allocated price/time. For example, in the above case, if there were 19 orders on the book, order 1 receives nine contracts, order 2 seven and order 3 just one. Then the remaining four contracts would be allocated based on the times the three orders were received.

6 Hybrid allocation priority means that some symbols are pro-rata and some are price/time. Hybrid pricing means there may be make/take, take/make pricing or a classic fee structure depending on the order type.

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