What Is the Trade-or-Fade Rule?

The trade-or-fade rule is an options exchange rule that required its market maker to either match a better bid found on another exchange or to trade with the market maker offering the better bid. The trade-or-fade rule was adopted in order to prevent trade-throughs, which are trades executed at a worse price than the best price available, essentially trading through or bypassing the better market price.

In 1994, the exchanges adopted trade-or-fade rules, which required a market maker to revise its quote if it is unwilling to trade at its published quote with an order sent to it by a market maker from another exchange. It was later revised to the firm quote rule.

Key Takeaways

  • The trade-or-fade rule says that a market maker needs to trade at the best bid possible.
  • A market maker or dealer who does not stand on their bid or offer for very long may also be said to fade their markets as prices turn against the original bid-ask.
  • The trade-or-fade rule, meant to prevent trade-throughs, had enough shortfalls that the SEC revised it in 2001.

Understanding the Trade-or-Fade Rule

Under this rule, if a better bid is posted on another exchange for an option, and a market maker is unwilling or unable to match it for a client order, the market maker may offer to trade with the other market maker. The market maker offering the better price must accept the offer and trade at the price offered, or else adjust the bid.

The trade-or-fade rule was laid out by the Securities and Exchange Commission (SEC) in 1994 by U.S. options exchanges to help facilitate trading. That is, to prevent trade-throughs. Trade-throughs are the orders that appear to “trade through” to better bids that are not real. Thus, to prevent the appearance of trade-throughs, the market maker with a better quote must trade at that price or change their quote.

In 2001, the SEC revised the trade-or-fade rule to a firm quote rule. The revision of the trade-or-fade rule was due in large part to the number of options classes being listed and traded on exchanges. The SEC cited that reliability and availability of accurate quotation information are basic components of a national market system and are needed so that broker-dealers are able to make the best execution decisions for their customers' orders, and customers are able to make order entry decisions.

The trade-or-fade rule didn’t directly improve market efficiency, as there were workarounds, such as phantom quotes.  

Shortfalls of the Trade-or-Fade Rule

Despite being introduced to deal with trade-throughs, the rule has faced some pushback from market participants. The biggest issue traders have is that the rule prevents efficient access and use to all markets. There’s also the idea that the rule doesn’t provide any incentive to shop for a better quote.

The trade-or-fade rule was introduced to prevent trade-throughs, but participants introduced workarounds. This includes phantom quotes, which creates a two-tier market to present prices depending on the buyer.