Competition and Innovation in Option-Market Models

Abstract

The equity options market has shown rapid growth and the competition among different options exchanges and trading platforms has intensified in recent years. As growth and competition in the U.S. options market continues, it becomes increasingly important for market participants to evaluate market quality in different options trading venues. A sound comparison of market quality among the competing trading markets requires a clear understanding of their specific market structures, since each venue attempts to differentiate itself with a unique value proposition. This article provides a review of the market microstructures of the major options exchanges and trading platforms in the United States. Using a sample period around the entry of the NASDAQ Options Market and the BATS Options Exchange, it analyzes the competition for trading volume in the options industry, investigates the characteristics of trades and execution costs in the major options exchanges and trading platforms, and examines the determinants of execution location for trades. It shows that during the first three months of their operations, the NASDAQ Options Market and BATS Options Exchange do not make a big impact on the trading volumes of the other options exchanges. It also finds that the NASDAQ Options Market has the smallest quoted spread and effective spread values for equity options among the seven exchanges during the first three months of its market entry. The BATS Options Exchange shows lower average trade size and average dollar trade size, and does not demonstrate competitive execution quality indicators or competitive execution costs in the earlier months of its operation. A probit analysis confirms that in spite of the increasingly complex and nuanced nature of options exchange competition, the main factors determining execution location for new market entrants are: i) posting quotes at the NBBO; and ii) being alone at the NBBO.