Nasdaq Brings Speed and New Approach to Price Improvement to Electronic Options Market

As the new kid on the block, Nasdaq OMX executives believe that technologically they have the edge over older exchanges that have legacy systems. "We think we have a system that has speed, that is top notch in equities. We think it will be top notch in options. Here in our data we have sub-millisecond turnaround times," says Adam Nunes, VP Nasdaq Transaction Services.

Built on the INET architecture, Nasdaq Options Market runs on the Linux Intel environment, the same as the equity system, which is known for low-latency equity trading. But Nasdaq made changes to the software to accommodate the different options messages and lack of short sales, and other features.

Nunes admits that that there are more seasoned options market systems, and that Nasdaq has not been battle tested in options yet, and that Nasdaq will have to prove that its system works in options. Meanwhile, Nasdaq is introducing some new features that could differentiate it from the status quo.

Citing its ability to process trades at the sub-one milliseconds level, Nasdaq OMX will deliver speed to market makers that must update their quotes in an entire options chain with tens if not hundreds of puts and calls in an active name like Microsoft.

While 200,000 options instruments are listed, only 25,000 trade on any given day and they're not the same 25,000, notes Nunes. Nasdaq's organic options market is going to let market-makers focus on where the trading activity is concentrated. Instead of having to update their quotes in an entire options chain, Nasdaq Options Market will let market makers register on a series-by-series basis. "We think that will allow people to focus on the series where the activity is. So we're not going to force people to make markets in something that is not going to trade and that is our plan for market makers," says Nunes.

But the feature in the new options system that is generating the most buzz is the approach it's taking to price improvement, says Nunes. Whereas in the other options markets, an incoming order comes in and goes into an auction for a number of seconds (three seconds in BOX's case), and either receives price improvement or doesn't, Nasdaq is talking about doing this in about one millisecond. "Freezing an order for three seconds is an eternity," says Nunes. While the other markets first get the incoming order, and then solicit the other side that is going to provide the price improvement, Nasdaq is working in the opposite way, he says, "If you want to provide price improvement you need to come in before we get the other order. That way no one has to wait," says Nunes. For example, if the market is $1.00 to $1.50, Nasdaq will accept an order to buy at $1.02, but display it at the nickel price which will be $1.00, and when that sell order comes into bid, it will get instantaneous price improvement and trade at $1.02, he says.

On the other hand, Nasdaq is entering a crowded space with six options exchanges battling to keep up with skyrocketing options messages rates. And with the Options Price Reporting Authority predicting peak rates of 907,000 messages per second in June of 2008, Kevin McPartland senior analyst at TABB Group, says, "It's very easy to see by the end of the year, we're going to be at one million messages per second," says McPartland. Just as the ISE introduced electronic options trading to the U.S. in 2000, followed by Boston Options Exchange and NYSE Arca, there's some advantage to building a new exchange from scratch, says the analyst.

But will participants on the other exchanges become market makers on Nasdaq? "They need to," says McPartland. "Enough liquidity will likely move over there that they'll need to move over to Nasdaq to make sure they're getting best execution," says McPartland. Also, high volume market makers had limits on the number of quotes and orders they could send in to exchanges over a certain time, according to the analyst. Nasdaq will not impose these limits. "That will be a big drive getting some of these high speed market makers trading over there," he says.

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Ivy is Editor-at-Large for Advanced Trading and Wall Street & Technology. Ivy is responsible for writing in-depth feature articles, daily blogs and news articles with a focus on automated trading in the capital markets. As an industry expert, Ivy has reported on a myriad ... View Full Bio