Shea and Shepelin, Tabb Forum, Get Your Fills: Capturing Options Liquidity With Smarter Order Routers, here.
The fragmentation of US options exchanges, consolidation of liquidity providers and faster technology have made capturing liquidity increasingly difficult. Two frequent scenarios cause traders to miss displayed liquidity: race condition and quote fade.
In a race condition, a competing order with lower latency arrives at the exchange first. In a quote fade situation, a market maker detects a sweep order in the market and reacts by adjusting their quotes.
Firms have attempted to combat these two situations by improving latency, order placement and sweeping logic of their smart order routers. In fact, the three types of the router decisions that most impact execution performance are the number of exchanges targeted, the relative order size and the duration of the order sweep. An increase in one or more of these three factors (i.e., more venues, larger order sizes, longer sweep durations) potentially worsens fill rates and hit ratios.
The difference in performance, and the effect on the bottom line, can be calculated based on slippage from arrival price. Smarter order placement and sweeping can drive modest improvements in fill rates that translate into substantial reductions in slippage and therefore savings.
In our study entitled, “Why the Smartness of Order Routing Matters in Options Trading” (below), we draw upon our own experience to illustrate the use of slippage in measuring the performance of our smart order router improvements. By reducing latency through co-location, and information leakage through parallel order processing, we saw a 5% improvement in fill rates. This was accompanied by a 91% reduction in slippage, which would translate into a savings of about $1 million per year for a trader who trades 1,000 contracts a day.