December 8, 2022 · Blog Posts
Spread Trading and Rival One Primer
Part Three: Trading Spread Across Exchanges
In the last several posts, we explored the nuances of spread trading, a strategy that can use either options or future contracts, or both. Let’s examine how spread trading across exchanges is a natural result of the dynamism of markets.
Rival One allows platform users to trade the spread between Bitcoin on Coinbase and E-mini S&P 500 futures on CME Group. Why would a trader want to do that? Because a trader may simply have a theory of the relationship of the two assets, a theory that justifies a long position on one and a short position on the other.
The key relationship in that spread may not be between the two asset classes involved after all, but between the two exchanges.
There is a venerable data storage principle to the effect that a trader, or other entity, should be consistent in deriving a particular piece of information from one place. This is known as the “single source of truth” principle (SSoT). In trading that involves multiple exchanges, one exchange (perhaps CME) can serve as the SSoT.
Quote orders can be driven on Coinbase, and they can be hedged on Coinbase or Binance. In other words, the hedge leg can be different, and derived from a different exchange than, the driver leg.
Optimizing Risk-Adjusted Return
There are many reasons traders want to split a hedge among multiple exchanges, something they cannot do with most off-the-shelf SAAS platforms. For example, traders might want to use liquid assets on one exchange to create a new market on an illiquid exchange.
Like the goal of many other strategies, the primary aim of a spread’s strategy is to optimize risk-adjusted return. This means that the assets chosen, as all the particulars of the contracts are chosen, with profit and risk management in mind.
Typically, the legs of a spread are composed of publicly traded assets. It is the liquidity and transparency of public exchange that makes the strategy feasible. Let’s advance today’s discussion by asking a simple question about exchanges.
What is the bid-ask spread?
The question gets us to the heart of buying and selling, especially on exchanges.
By standard definition, a bid-ask spread is the difference between the highest price that a buyer is willing to pay for an asset and the lowest price that a seller is willing to accept. This is a “spread” because it refers to a buyer or seller who has not yet made the deal, so there is a difference between those two prices.
If a buyer accepts the available seller’s lowest price, to buy at the ask, then a deal is done. The buyer in such a situation is said to have “crossed the spread.” For the same reason, the spread at any given moment is also called the transaction cost.
Parties who cross the spread are also said to be “taking liquidity,” accepting the transaction cost to get the deal done. Parties who, on the other hand, sit patiently on their positions and wait for someone else to cross, are said to be “offering liquidity.”
The Market Makers
Exchanges work in large part because of the activity of the market makers. These are traders who are solely focused on making money from the spread itself.
Suppose Amazon (NASDAQ: AMZN) is trading at 132.60 x 133.72. This means that some buyer is willing to pay $132.60 (that is the bid price), and a seller is willing to accept its “ask price,” a payment of $132.72. [Note the arithmetic. This is a spread of $0.12, or about 0.09%.]
A market maker would simply offer to deal with anyone willing to cross the spread from either side. It would buy at $132.60 and sell at $133.72. Every time it finds agreeable counterparties it makes $0.12, while defining the market price.
These market makers don’t want to own the stock or other asset in question: they simply want to make the market. They become so helpful to the exchange that many have formalized the role as “designated market makers,” responsible for maintaining quotes and facilitating trading.
A Trader’s Theory
This brings us to a special type of spread strategy: the use of options trading or futures contract trading to make the market in one exchange and “take the market” in another. A trader may act as a normal market maker on one exchange, generating buy and sell orders in the process, and use a second exchange and simultaneous buying there to offset the risks it takes on the first. In this case, the first mentioned exchange is called a “maker exchange” and the second is called a “taker exchange.”
This combines pure market making with arbitrage. It also means the spread trader is moving liquidity from the exchange where it is available to that in which it is not.
This answers our initial question. A trader might want the capacity to trade the spread between Bitcoin on Coinbase and E-mini S&P 500 futures on CME (Chicago Mercantile Exchange) Group simply because our traders sees that there is more liquidity in one then in the other, and there is profit to be made at minimal risk in piping liquidity to the desert.
A platform is not of course intended to ensure that a particular trader gets the theory right and creates alpha! Rather, a platform is designed to ensure that a trade with a theory has the flexibility, speed, and operational accuracy necessary to give that theory a proper trial.
To that end, Rival One has remarkable advantages. It brings together the cloud and modern user interface (UI) technology to allow traders a seamless experience. That seamlessness is in the service of market data feed handling, direct execution, enterprise trading, and risk management.
As Rob D-Arco, Rival Systems’ CEO, said early this year: “Traders are looking for a way to easily expand into new markets and institutions are looking for a single solution to provide access and manage risk across the firm. We believe Rival One is the first platform to truly fulfill their needs.”