What Is the Trade-or-Fade Rule?

The trade-or-fade rule is an options exchange rule that requires the market maker to either match a better bid found on another market 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 processed at non-optimal prices, as a better price is available. It was later revised to the firm quote rule.

Trade-or-Fade Rule Explained

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.

Key Takeaways

  • The trade-or-fade rule says that a market maker needs to trade at the best bid possible.
  • Regardless of where, or by which market maker, the bid is offered, the trade should match the best bid.
  • The trade-or-fade rule, meant to prevent trade-throughs, had enough shortfalls that the SEC revised it in 2001.

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 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 push back 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.