Side effect trading is a phenomenon occurring in implied spread markets that can only take place when a product transitions* to a trading state, also called opening. Side effect trading begins during the pre-open when outright orders create an implied quote that would match with a resting spread order. Upon opening, the price of this implied quote can exceed the resting spread’s limit price, resulting in a price improvement. This price improvement, which must be allocated somewhere, is assigned to the resting spread on a price/time basis. The allocation to the resting spread, rather than to the outright bid or offer, has been determined to be the most defendable distribution for the price improvement.
*Transitions from a non-trading to trading state include scheduled openings, re-opening after a Stop Logic or Velocity Logic event, a re-opening after a Circuit Breaker event, or a re-enabling of implied functionality in a locked limit scenario.
|In the Pre-Open, the following orders are entered||Instrument||Bid Size||Bid||Ask||Ask Size|
|Buyer A enters order to buy 1 CLM5 at 100.15||CLM5||1||100.15|
|Seller B enters order to sell 1 CLZ5 at 100.00||CLZ5||100.00||1|
|Spreader C enters order to sell 5 CLM5-CLZ5 at 0.10||CLM5-CLZ5||0.10||5|
Upon opening, Buyer A’s bid in the CLM5 pairs with Seller B’s offer in the CLZ5 to form an implied bid in the CLM5-CLZ5, wanting to buy 1 lot at 0.15. This 1 lot is matched with Spreader C’s resting sell order at 0.10, but with the improved price of 0.15. Market data reports the match at 0.15, and the resting spread market is now 4 lots offered for sale at 0.10.
Watch this video for additional information and an animated depiction of Side Effect Trading.