Trading Systems and Liquidity on Securities Markets:

A Study of the European Options Exchange

HENK BERKMAN

I. ~TRODUCTI~N

All securities markets share the goal of providing a cost effective and liquid market. Despite this common goal we observe substantial differences in trading systems across markets.

Furthermore, under pressure of increased competition, dramatic changes in the trading systems

of some exchanges have taken place during the last decade. Examples are the ‘Big Bang’ on the London Stock Exchange in 1986 and the changes on the Paris Bow-se since 1986.

The purpose of this dissertation is to contribute to the understanding of the effect of a market’s design on the liquidity it provides. Central in the study is the dealer/auction trading system that

is used on the European Options Exchange (EOE). This trading system is used on several other

securities markets (for example the New York Stock Exchange, The Chicago Board Options

Exchange and the ~e~~~c~e Tern& Borse) and is expected to become even more impo~ant in

the near future. In a de~er/auction trading system, liquidity is supplied by market makers and

public investors submitting limit orders. Both groups of traders are willing to take the opposite

side of a trade that is initiated by someone else (the demander of liquidity).

This synopsis is built around the three themes in the thesis. For each theme, the dissertation

briefly summarizes the existing literature, next the theory is extended by building a model to

analyze the problem in the context of an options market, and finally the model and related hypotheses are tested.

Theme 1: Inventory Control

Our review of inventor control models emphasizes two implications with regard to market

maker behavior: First, the quotes of market makers (dealers) are inversely related to their inventory position, and second, inventories of market makers are expected to revert to their

respective target levels. Besides these implications, the inventory control models put forward

several factors as determinants of the compensation for the market maker in the form of the bid-ask spread:

Henk Berkman l Ph.D Candidate, The University of Auckland-Tamaki Campus, Auckland, New Zealand; the

dissertation was suoervised bv Dr. Marks Jo&hart. Erasmus Universitv. Rotterdam. The Netherlands.

International Review of Financial Analysis, Vol. 3, No. 1,1994, pp. 93--96.

Copyright 0 1994 by JAI Press, Inc., All rights of reproduction in any form reserved.

ISSN: 1057-5219

93

94 INTERNATIONAL REVIEW OF FINANCIAL ANALYSIS / Vol. 3(l)

1) the standard deviation of the returns of the traded security; 2) the risk-aversion of the dealer;

3) the price sensitivity of public demand for dealer services; and 4) the quantity for which a quote is firm.

The literature is extended here by considering the inventory control problem of an options market maker. A model is derived which shows that the option bid and ask price are a function of the inventory position and the risk-aversion of the dealer, the price and the variance of the returns of the underlying stock, the hedge ratio of the option, and the quantity for which the quote is firm. Furthermore, based on the model, we derive testable hypotheses with regard to the quote setting of an options market maker in response to changes in his inventory.

In an empirical study of option quotations around large option trades we show that in the first five minutes after large option trades, quotations of option series change in the direction that is predicted by our model. This inventory control effect is weakly related to the size of the trade. For quotes reported more than five minutes after large option trades, no evidence of any influence of the large option trade is reported.

The theoretical model also forms the basis for an empirical model of the absolute option spread. For a cross-section of options it is demonstrated that the intraday bid-ask spread is well-explained by the following variables:

1) the standard deviation of the stock returns (+);

2) the price of the underlying stock (+);

3) the hedge-ratio of the option (+); 4) the number of trades in the analyzed series (-);

5) the most recent change in the stock price (+); 6) the competition for the market makers coming from the book of limit orders (-); and

7) dummy variables reflecting the time of the day.

Theme 2: Asymmetric Information

Several models which concentrate on the adverse selection problem of market makers show that rational market makers take the (possible) existence of traders with superior information into account when they determine their bid and ask prices. It is also shown that trading reveals information and results in price-changes that are, on average, permanent. If the strategic behaviour of market participants is taken into account, then it becomes clear that informed traders face a trade-off between pursuing the strategy that seems to be most rewarding at first sight, and the information revelation of doing so. The result of the trade-off is that, compared to an informed trader who does not take the information revelation of his trading into account, an informed trader wants to conceal his information by trading smaller quantities, or spreading his trading over time.

In this study, we consider the influence of asymmetric information on the option trading process. Our analysis of the investment decision of a privately informed trader having the ability to trade the underlying stock and options written on this stock indicates that among the options written on a stock the short-term out-the-money and short-term at-the-money options are most attractive to the informed trader. These options give a high return, and at the same time,

Dissertation Synopses 95

these option series provide arelatively good camouflage. With regard to therelative attractive- ness of trading the underlying stock, we are unable to draw unambiguous conclusions.

The empirical research highlights two information-related issues. Firstly, we find that after correction for explanatory variables, the residual spread reveals a pattern during the trading day which seems to be related to the level of uncertainty in the market. Secondly, there is no evidence of permanent systematic stock price change after large option transactions. This result, in combina- tion with the i~signi~c~t change in the size of option spreads after large option trades, leads to the conclusion that large option trades are not perceived as information-motivated trades.

Theme 3: Market Makers and Limit Orders as Supplier of Liquidity

According to Ho and St011 (1983) every trader having the possibility to submit limit orders can be regarded as a market maker. They also show that in a competitive dealer market the size of market spread does not depend on the source of liquidity (i.e., market maker A, market maker B, etc., or limit order traders).

Our cross-sectional regression of the option spread shows that an increase in the supply of liquidity coming from the book of limit orders vis & vis market makers is inversely related to the size of the market spread. Thus, the hypothesis formulated above is rejected: there is a marked difference between market makers and public investors in their respective roles as suppliers of liquidity. This is also revealed in our study of the stock price behavior around large option trades. There is a significant difference in the stock price behaviour around trades where market makers supply liquidity, and trades where the limit order book is the counterparty to the initiator of a large option trade. The most interesting result is the systematic pattern in stock prices before large limit orders in the book are hit. This stock price pattern indicates that limit orders are ‘picked off after stock price changes.

The difference between the public and market makers is explained by the inflexibility of limit orders compared to market maker quotes. Limit orders are relatively inflexible, because monitoring costs and transaction costs prevent investors from updating their limit prices every time there is a change in market conditions. One can argue that limit orders grant a ‘free option’ to the market to trade at a known price. This option is valuable because new public information can arrive in the time period during which the limit order is outstanding. Market maker quotations are updated immediately if new public information arrives, so de facto the ‘options’ granted by the market makers have no maturity. Consistent with the above argument, our empirical analysis shows that the premium which limit order traders receive when they supply liquidity is significantly lower than the premium received by market makers. Furthermore, for our sample of large trades, the average premium which limit order traders receive, is negative. Both results illustrate that public investors have a costly disadvantage compared to market makers when they supply liquidity.

Implications

In order to offer liquidity a securities market needs traders who are willing to take the opposite side of transactions initiated by other traders. This section highlights the role of public investors as suppliers of liquidity.

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Our empirical study points at a drawback of the current trading system: because it is difficult and costly to monitor limit orders and to adjust them timely, limit orders are an inflexible instrument for public investors. This inflexibility has several harmful effects.

In the first place, as we showed, a change in public information sometimes results in ‘picking off limit orders to the detriment of limit order traders. The second harmful effect of the inflexibility of limit orders is less obvious. For example, suppose that new information arrives on the market and that the ‘true’ price of a security moves ‘away’ from a limit order which currently provides the best quote in the market. After the information is reflected in the price, the limit order will probably be pre-empted by new quotes given by other suppliers of liquidity. This pre-emption does not occur because the limit order trader is unwilling to trade at a new price, but rather because the market conditions have changed and the limit price is not adjusted accordingly. The result of the pre-emption is that a potentially competing supplier of liquidity is lost in the new market situation.

Another effect of the comparative disadvantage of public investors in their role as suppliers of liquidity is that they might refrain from using limit orders. This, of course, reduces the liquidity of the market. In our opinion changes in the trading system which aim to attract more investors to supply liquidity should be considered very seriously given the increasingly competitive market for exchange services. Further automation of the trading process and the introduction of alternative order types can be important improvements in this respect.

Automation will increase the speed of order-transmission and order-cancellation. If orders can be entered and cancelled quickly the maturity of the option provided by the limit order will be reduced and the value lessened.

The introduction of contingent limit orders is another way to give limit order traders more protection to changing market conditions. The most complete contingent limit order for an options exchange is a limit order with an automatic updating of the limit price based on changes in the price of the underlying asset, and parameters such as the interest rate, volatility, and time to maturity.’ In fact, this contingent limit order takes away the main disadvantage for public investors in the current system, by allowing them to submit limit orders with prices which closely follow the ‘true’ price of the particular option.

NOTE

1. The feasibility of such a system is shown by the recent introduction on the CBOE of a comparable system, called AUTO-QUOTE, which updates market maker quotes to the changes mentioned above.

REFERENCES

Black, F. 197 1. “Toward a Fully Automated Exchange.” Financial Analyst Journal (Novem- ber/December).

Ho T., and H.R. Stoll. 1983. “ The Dynamics of Dealer Markets under Competition.” Journal of Finance 38(September): 1053-1074.

Harris, L. 1990. Liquidity, Trading Rules, and Electronic Trading Systems. Monograph Series in Finance and Economics, 1990-4. New York: New York University, Salomon Brothers Center.