Mary Schapiro, the Chairman of the SEC (Securities and Exchange Commission) indicated in a speech earlier this week that she would like to press ahead with plans to change the structure of the US stock markets, so that certain types of  stock trading strategies incur punitive fees.

Typically these strategies involve large numbers of order cancellations. Sometimes in fact the ratio of orders that are submitted and then cancelled, compared to the number of orders that actually result in a trade, can be as high as 99:1.

One of the problems with the SEC’s proposals around so-called “cancellation fees” however, is that it can be perfectly valid to continuously submit and then cancel large numbers of orders, particularly if you are a market-maker in options.

To understand this, you have to know how the option trading software used by market-makers actually works.

Option prices are calculated based upon where the underlying instrument is trading. So if for example IBM stock is trading at $160, all IBM options (of which there are hundreds, at various strike price intervals and expiry months) will have a so-called “fair value” around which the market-maker will quote a bid and an offer.

Now, every time that underlying IBM stock price moves (from $160.00 to $160.10 for example) the fair value of each of those individual put and call options changes, so the market-maker has to cancel the price at which he was previously prepared to buy and sell, and replace it with the new price at which he is prepared to trade.

For all 200 or so individual option strike/expiry combinations.

Every time the underlying price moves.

And it can move hundreds or thousands of times in a day.

So it is therefore not surprising that cancellation ratios are so high, it is a perfectly valid situation. Does this mean the cancellation tax is a bad idea? If levied on options traders, the answer has to be yes, because it will probably just serve to drive liquidity out of the US to overseas markets.

So a message to the SEC might be “beware the law of unintended consequences”.

Filed under: stock market basics

Like this post? Subscribe to my RSS feed and get loads more!