Trade-or-Fade Rule Definition

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Trade-or-Fade Rule Definition

What Is the Trade-or-Fade Rule?

The trade-or-fade rule is an option exchange rule that requires its market maker to either match a better bid discovered on another exchange or trade with the market maker who offers the better bid. The trade-or-fade rule was implemented to avoid trade-throughs, which are transactions conducted at a lower price than the best available price, thus trading through or skipping the better market price.

The exchanges enacted trade-or-fade regulations in 1994, which obliged a market maker to update its price if it is hesitant to trade at its published quote with an order submitted to it by another exchange’s market maker. Later, it was changed to the firm quote rule.

Key Takeaways

  • According to the trade-or-fade rule, a market maker must trade at the best bid available.
  • A market maker or dealer who does not hold their bid or offer for an extended period of time is said to fade their markets as prices move against the initial bid-ask.
  • The trade-or-fade regulation, which was designed to discourage trade-throughs, had enough flaws that the SEC changed it in 2001.

Understanding the Trade-or-Fade Rule

If a superior bid for an option is placed on another exchange and a market maker is reluctant or unable to match it for a customer order, the market maker may offer to trade with the other market maker under this regulation. The market maker who offers the better price must accept it and trade at the provided price, or else alter the bid.

The Securities and Exchange Commission (SEC) established the trade-or-fade regulation in 1994 to assist U.S. options exchanges in facilitating trading. To avoid trade-throughs, that is. Trade-through orders are those that look to “trade through” to stronger bids but are not. To avoid trade-throughs, the market maker with a superior quotation must either trade at that price or adjust their quote.

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The SEC changed the trade-or-fade regulation to a firm quote rule in 2001. The increase in the number of options classes posted and traded on exchanges prompted the adjustment of the trade-or-fade rule. According to the SEC, dependability and availability of correct quote information are fundamental components of a national market system and are required so that brokers may make the best execution choices for their clients’ orders and consumers can make order entry decisions.

Because there were workarounds, such as phantom quotations, the trade-or-fade rule did not immediately increase market efficiency.

Shortfalls of the Tr´╗┐ade-or-Fade Rule

Despite being implemented to address trade-throughs, the regulation has received some criticism from market players. The regulation, according to merchants, limits efficient access and usage of all marketplaces. There’s also the argument that the regulation provides no incentive to shop around for a better deal.

To prohibit trade-throughs, the trade-or-fade regulation was implemented, although players devised workarounds. This includes phantom quotations, which establish a two-tier market in which prices are presented based on the buyer.

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