Implied Order Functionality is here! Great. But what does it mean? The language of trading can be technical and weird. Outer-space talk. Think “implied order functionality “...did we lose you? Deep breath. Consider trusting the countdown because the orbit is often majestic.
In early May, 2012, the International Securities Exchange (ISE) became the first exchange to offer something called “implied order functionality.” The motivation? To help you with tighter bid-ask spreads, of course.
Some Home-Planet Background
Single-order improvements have been around since the early days of option exchanges. Any unrestricted limit order that improves the current market quotes must be represented, typically causing a tightening of the normal bid-ask spread.
To illustrate: suppose that the market on the 55-strike calls is 0.90 - 1.10. For a prospective option seller, it means that the most someone is willing to pay for an option is 90 cents. Conversely, for the buyer, the lowest advertised selling price is $1.10. So far, everything looks normal.
Now, suppose a retail customer enters the marketplace looking to sell the 55-strike calls. If he places a limit order to sell his calls at 90 cents, he's likely to obtain a fill. However, the customer wants to try to get a better price for himself. So rather than entering a limit price at 90 cents, he offers them at $1.00.
And because the retail customer is willing to sell the 55-strike calls at a lower price than what is indicated by the current market quote, his $1.00 offer is now the best offer and must be represented. The new market on the 55-strike calls is now updated to reflect the new offer—that is, 0.90 - 1.00.
Moving on, the $1.00 offer belongs to the retail customer. And since it now represents the best offer price, it's reflected in the exchange's listed quotes. This additional exposure not only tightens the overall market, but increases the customer's chances of finding a counterparty willing to fill the limit order.
That's how market improvement works for single orders. No alien crossfire. Until now, this type of improvement was not available anywhere for spread orders.
Star Power: Spread-Order Improvements
Suppose you have the following markets in the 50 and 55 call-option strikes:
The natural market for the 50/55 call spread would be 0.80 - 1.20. Now, suppose an order enters the marketplace seeking to buy the 50/55 call spread for $1.10. The natural offer is currently $1.20, so the 1.10-bid is 10 cents away from the best-displayed market offer.
The ISE can now do the following: Knowing there is a real market maker who is willing to sell the 50 calls at $2.10, the ISE will create an “implied” offer of $1.00 on the 55 calls. This will make the quoted market look like this:
Note the $1.00 offer on the 55 calls. This is the implied quote.
If an order enters the market to pay $2.10 for the 50 calls, the market maker will sell the calls at $2.10, and it's business as usual.
Yet, if an order enters the market to pay $1.00 for the 55 calls, the ISE will sell the 55 calls at $1.00, and buy them from the spread customer for $1.00, thereby scratching on the trade.
The spread customer, having sold the 55 calls at $1.00, will now pay $2.10 to the market maker to complete the spread.
Turn Meteor Showers Into Pet Rocks
The beauty of the process is that up til now, while the $1.00 offer was implied by the marketplace due to a spread order on the order book, there was no way to use that information to improve overall market quotes.
The ISE has found a way to turn the implied quote into a tangible market that can be traded by anyone. This is good news for traders everywhere, since the ability to create these implied quotes can dramatically reduce the possibility of trade-throughs, by allowing traders across different strategies to find each other on a given exchange.