Do all trades go thru market maker?

[LM3886]

Greetings, I'm getting familiar with options trading. The bid ask spread often takes up a big chunk of profit, or worse, increases the loss. To understand it, I tried placing a few market orders and different limit orders, but the result was confusing.

Most of the time, the market orders were executed in within the bid ask spread and in favor of the market maker. They were never executed outside the spread. Sometimes, however, they were executed within the spread in my favor, which I don't know why. Why did the market maker do that? Was the market maker still be able to make money in this case?

Given that the market orders were almost all executed within the spread similar to the limit orders I placed, which seems contradictory to what I learned from the books, I wonder if people here still primarily use limit orders to negotiate with the market maker? Is the extra time and effort still considered best practice?

Thanks!

 

[LM3886]

Sorry, realized that I used a different title. I was thinking about another related question: does the order go thru market maker, if one placed a buy limit order at price $1.0, and another one placed a sell limit order at price $1.0? Would both orders be automatically matched and executed bypassing the market maker?

 

[Robert Morse]

Greetings, I'm getting familiar with options trading. The bid ask spread often takes up a big chunk of profit, or worse, increases the loss. To understand it, I tried placing a few market orders and different limit orders, but the result was confusing.

Most of the time, the market orders were executed in within the bid ask spread and in favor of the market maker. They were never executed outside the spread. Sometimes, however, they were executed within the spread in my favor, which I don't know why. Why did the market maker do that? Was the market maker still be able to make money in this case?

Given that the market orders were almost all executed within the spread similar to the limit orders I placed, which seems contradictory to what I learned from the books, I wonder if people here still primarily use limit orders to negotiate with the market maker? Is the extra time and effort still considered best practice?

Thanks!

What broker do you use?
Are you using SMART routes or Direct Market Access?

Bob

 

[Metamega]

A market maker is required to provide a price for the bid and a price for the ask. He doesn't have to be top of queue. He could by chance be the best bid but be 6th best price on the ask. Nothing says your order had to be bought by a market maker, the best offer could be a retail trader with a limit order.

Your broker is required to get you the best price. If the listed ask is 1.00$ their required to get you that offer for 1.00$. Now when you end up getting a better price then expected your order was routed to a dark pool or some firm paying your broker for their orders.

They submit your order to this firm and they get first dibs on it. They can't jump the queue on the books but they can offer a better price and take your order. They pay your broker a few pennies, they sell to you for 1.01 or maybe better and all is good and legal. If their not interested in the order it could get routed to another firm or dark pool and if no one is interested it will route to whatever exchange has the best offer finally.

Designated market makers are required to be on both sides of the market. Buy and sell where as us retail folk can't have limit orders on both sides.

Some brokers will allow you to route your order to a specific exchange perhaps because you want some liquidity rebate but the best order might not be at that exchange leaving you hanging.

 

[zdreg]

Buy and sell where as us retail folk can't have limit orders on both sides.

statement is correct for option orders.

 

[LM3886]

What broker do you use?
Are you using SMART routes or Direct Market Access?

Bob

I'm using Charles Schwab. I have no idea whether its using SMART or DMA. How do I find out?

 

[LM3886]

A market maker is required to provide a price for the bid and a price for the ask. He doesn't have to be top of queue. He could by chance be the best bid but be 6th best price on the ask. Nothing says your order had to be bought by a market maker, the best offer could be a retail trader with a limit order.

Your broker is required to get you the best price. If the listed ask is 1.00$ their required to get you that offer for 1.00$. Now when you end up getting a better price then expected your order was routed to a dark pool or some firm paying your broker for their orders.

They submit your order to this firm and they get first dibs on it. They can't jump the queue on the books but they can offer a better price and take your order. They pay your broker a few pennies, they sell to you for 1.01 or maybe better and all is good and legal. If their not interested in the order it could get routed to another firm or dark pool and if no one is interested it will route to whatever exchange has the best offer finally.

Designated market makers are required to be on both sides of the market. Buy and sell where as us retail folk can't have limit orders on both sides.

Some brokers will allow you to route your order to a specific exchange perhaps because you want some liquidity rebate but the best order might not be at that exchange leaving you hanging.

Thanks for the detailed reply! I was trying to determine if the fill price of the market orders is as good as limit orders. From my limited experience, it seems that the fill price of market orders is pretty good most of the times, and sometimes better than that of limit orders. Maybe the books I read were outdated, but the books often say to avoid market orders, and that was my confusion.

 

[Robert Morse]

I'm using Charles Schwab. I have no idea whether its using SMART or DMA. How do I find out?

If you don' t know, it is a SMART route. Basically, there are 15 option exchanges. Your broker, CS, has a deal with one or a number of Market Makers. Their order router sends your orders to them on one or more of those option exchanges. They get paid to give that MM first look at your orders. This is all very common.

IMO, you are too concerned with what the MM is doing. You enter your order at the price you want to trade it. If the spreads are too wide, maybe you should avoid those options. When there are no customer orders, you will only get filled if the MM gets to buy order sell better than what they think fair value is. That does not mean you can make money too. They will hedge everything and you might not.

With regard to price improvement, sometimes they have to provide that to participate on the trade, or you might trade with another customer or MM . You just need to concern yourself with what you want to do. One more point. IMO, I would NEVER use market order with options. At some point, you might get a very bad fill from wide markets. Always work your order trying to get the best price and balance that with how fast you want to put on the trade.

Bob

 

[Metamega]

I personally always use marketable limit orders. What this means is I enter a limit above the best offer. Market orders are like writing a blank check. Never know when what you see in the book might disappear between you clicking and it getting to the exchange.

 

[LM3886]

Always work your order trying to get the best price and balance that with how fast you want to put on the trade.

Thanks, I've tried entering a limit buy order at a price that is close to bid, and wait half a minute to see if gets filled. If not, I increase the price by 10 cents and continue. It should get me the best possible price with a limit order, but I didn't try market order on the same option so I don't know where a market order will be executed. Does this "trail-and-error" sound like a reasonable approach? Although it takes time and can sometime be confusing if I want to buy a few different options.