Last Wednesday, OCC and the U.S. options exchanges announced the adoption of pre- and post-trade risk control principles that are designed to enhance the monitoring of trading activity on a real-time basis and reduce the risk of errors or other inappropriate activity that poses a material risk of significant market disruption.

Here’s some additional information about these principles. Please visit The Options Insider over the next few days for more on this initiative.

EXCHANGE PRE-TRADE RISK CONTROL

Price Reasonability Checks

Price reasonability protections are generally designed to prevent limit orders and market maker quotes from being entered and displayed if the price on the order or quote is outside a defined threshold set in relation to the current market price, or NBBO.

?Examples of existing options exchange price reasonability protections include:

  • ?Restricting entry of limit orders where the limit price is more than a set percentage (e.g., 25%) away from the NBBO.
  • The intended trade price of a limit order in a pre-open market is compared against current prices on other markets or the previous day?s closing price.

?Most options exchanges have established mandatory price reasonability protections that reject placement of a limit order based on a certain dollar or percentage threshold away from the NBBO for orders submitted during normal hours or, with respect to pre-market orders, based on the prior day?s close.

On some exchanges, a flagged order is routed for manual intervention and review by a trader who will make a determination of validity. For complex orders, some markets have implemented certain checks ensuring against the sale of options that never result in the payment of a net premium (i.e., negative premiums).?

Specific practices mandatory under this category include:

  • Exchanges will impose mandatory limit order and quote price reasonability checks or limits.
  • Price reasonability checks or limits will apply to complex orders.
  • All trading sessions, including market-openings, will be covered by the checks or limits.
  • The checks or limits will apply to orders that are routed away to other exchanges.

Drill-Through Protections?

Drill-though protections (e.g., price collars) are closely related to price reasonability checks, requiring all orders, including market orders, to be executed within pre-determined thresholds of the NBBO and further preventing immediate severe price gapping from the NBBO due to the size of the order.

These protections restrict orders from immediately trading up or down an unlimited number of price intervals, and allowing market liquidity to be refreshed prior to the execution of further trades. Orders affected by drill-through protections are either rejected, routed for manual order handling, or routed to another exchange through the options linkage.

Some exchanges also establish a maximum order size by participant, canceling any orders that exceed the maximum order size.

?Examples of existing option exchange drill-through protections include:

  • ?A market order is allowed to execute through up to five price level increments, with any remaining balance of the order cancelled or reviewed prior to further execution.
  • An order is blocked if the final execution price would be more than an exchange-set fixed percentage traded through the NBBO.

While all options exchanges have established drill-through protections, the specific parameters applied by each exchange vary. Drill-through protections for complex and block orders are in place at only some exchanges.

Specific practices mandatory under this category include:

  • Exchanges will impose mandatory drill through-protections with reasonable quantifiable limits.
  • All quotes and orders will be covered by drill-through protections, including market, limit, complex, and block orders.
  • All trading sessions, including market-openings, will be covered by drill-through protections.
  • The drill-through protections will be designed to prevent orders from trading through a large number of price increments in a short period of time.

 

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