14 Questions, 14 Answers

How do options market makers provide value in low-volatility markets?

Option market makers provide liquidity to market participants and help clients navigate a complex and changing market environment. Volatility regimes impact expectations for risk premia and consequently affect the spreads market makers charge to facilitate transactions in the market. Low-volatility regimes are notable for stable market volumes, low bid/asked spreads, and low market impact. In such regimes, it is easier for risk takers to initiate new positions, and easier for liquidity providers to hedge their portfolios. In general, market-maker supply of liquidity has a dampening effect on volatility, and this is especially true in low-volatility regimes. Without market makers, realized volatility would be higher.

What is the most notable trend in the futures options market?

Options on futures continue to trend upward, as seen in CME Group’s options products substantial growth across multiple asset classes. There are varied causes triggering the volume uptick, namely liquidity, product breadth and robust technology offerings. We have seen noteworthy growth in our short-term options as market participants demand products that allow them to manage risk around economic events in a cost-effective manner. For example, our weekly equity options are growing faster than any other product in the equity index space, and our weekly treasury options have traded more than 3.1 million contracts since the January 2011 launch. The blue mid-curve options, introduced in December 2010, also continue to see record levels. Similarly, weekly grain and livestock options launched in 2011 and have steadily gained popularity with market participants interested in managing risk around weather events. We also continue to see much of the growth in short-term options via Globex, with many users attracted by its speed and functionality.

What is the latest in smart order routing technology in the options market?

Similar to equities, smart order routing of listed equity options is now a requirement for almost all active options participants. Slower markets, lower returns and lower volatility have increased the focus on fees, creating a need for efficient management of liquidity. Options exchanges aggressively jockey for volume through complex rate cards, often involving incentive programs that span multiple subsets of listings. We have spent considerable time and energy building dynamic smart routing logic in order to find liquidity while optimizing exchange economics across all markets. As an agency-only broker, our primary goal is to represent our client as efficiently as possible, so we pass along the economic benefits achieved by smart routing.

What is shaping up as the most important technological development for options traders in 2012?

At Symphono, we see the focus of options-related technology in 2012 continuing to be the problem of efficiently handling growing volumes of data in such a way that traders (and their algos) can make better and more timely decisions. With greater accessibility to complex order and depth of book feeds, there are more data for algorithms and users to consider and the opportunity for greater effectiveness on the part of traders and their tech teams. In the past, the problem was primarily how to handle the size of the Options Price Reporting Authority and all the quantitative demands in addition to it. Now, there are more available inputs and the key will be deciding where to focus tech investment on speed and scalability versus being more selective on which data to use and when.

How do options floor brokers add value in the age of electronic trading?

lectronic trading provides institutions with a quick and convenient method to execute options contracts. However, each technological improvement attempting to create a more efficient options marketplace seems to foster the misconception that floor brokers are, or will be, obsolete. What many institutions casually overlook is that when floor brokers are used properly, they can add significant value.
On the CBOE, where there seems to be a higher concentration of floor market makers, floor brokers can use their expertise to tap directly into a pool of liquidity which may or may not be as accessible to institutions. When an order is placed, the broker can represent the order on the floor, while the customer also can be represented in the electronic marketplace at the same time. This hybrid approach allows a customer to gain exposure to their interests in a way that pure electronic routing simply cannot.
Additionally, if a complex or large order is placed with a floor broker, it will be exposed to centralized liquidity yielding a much greater chance of price improvement. This is a natural byproduct from the instant communication and intense competition created when a large percentage of market makers are concentrated within a particular area.

How will electronic market making in options evolve over the next few years?

Electronic market making in options will continue to become more efficient and more sophisticated to meet the needs of an evolving and growing marketplace. As a firm, we’re very upbeat about the positive changes we’re seeing in options today.
Over the next few years, we expect the percentage of retail investors using options will continue to grow. New products, continued fee compression and education of the product will drive this. We’re also expecting substantial growth in institutional buy-side activity from mutual funds, pensions and hedge funds that are seeing options as a way to decrease risk and hedge large portfolios while increasing returns. In the past, the options markets did not support the liquidity needs or efficiencies of price and market structure to attract the institutional buy side, but this is definitely changing. These trends will create increased opportunities for market makers to meet a growing demand for efficient risk-transfer services.
We’ve also seen some new products being released by the major exchanges — this may provide opportunities for market makers to provide liquidity in new areas.

What is the future of dark liquidity in the options market?

Transparency is the differentiating strength of the options markets – it is the quality that has propelled options to become one of the fastest-growing asset classes in the U.S. over the past decade. Transparency created competition for options order flow, and competition in turn led to tighter spreads, better liquidity and the attractive market environment that exists today for both retail and institutional investors. With over 375,000 different options products offered on the exchanges, having a lit, two-sided market for each and every series on the screen means that investors can trade with the confidence that they are entering a position at the best possible price and, importantly, will be able to access the liquidity needed to exit a position when they are ready to do so. Removing retail flow from the exchanges negatively impacts the quality of lit markets and, in the long run, hurts the price-discovery mechanism that is so important to the capital markets. In the future, we must uphold that model in order to preserve the foundation of a healthy market. In order to keep the lights on, we need to keep the options markets out of the dark.

What is the primary appeal of the VIX Index in a low-volatility market?

Even in lower-volatility markets, we see investors using CBOE VIX Index products to hedge volatility risk while the market is regrouping or building to potentially higher volatility levels. Issuers of exchange-traded notes and exchange-traded funds pegged to the VIX index represent a significant user group that hedges volatility exposures daily with VIX futures and options in all types of markets.
What’s encouraging for us is that even as volatility levels subside, trading in VIX futures and options tends to display healthy growth. In 2011, VIX Index futures and options trading volume rose 174% and 57%, respectively, over the previous year even as the VIX Index level hovered between the teens and low 20s during the first six months of the year.
Along with growing media coverage, CBOE’s educational efforts have been successful in raising the profile of the VIX Index and the utility of VIX Index options and futures in a variety of market environments.

Has the evolving regulatory landscape attained much clarity over the past year or is there still substantial uncertainty?

While we feel there is more clarity coming from the regulators as some regulations move to rule making and implementation stages, the combination of continually evolving rules and uncertainties in how new rules are to be enforced is making many market participants reluctant to expand and invest. Considering the number of regulatory changes that are coming, we are likely to see this environment maintained for several years with a potential for this to create a continuing drag on business growth.
One of the core philosophy at SpiderRock is process automation. Since we’ve always had a technology-heavy approach, we try to build in regulatory compliance and risk management into our trading tools and algorithms at the most basic levels. This helps us meet the compliance related needs of our clients as well as ourselves relatively efficiently. However our dependence on technology solutions for the bulk of our compliance needs versus significant people resources creates some challenges for us as a small, growing firm, particularly when the requirements for new evolving rules are not clearly defined.

How have options evolved as a risk- management tool since the 2008 financial crisis?

Since 2008, the investment world has become much more aware of risk. Specifically, risk is something that needs to be addressed in all portfolios since traditional asset allocation did not work to protect investment portfolios from life-changing loss. Traditional asset allocation of 60/40 stocks to bonds had losses of 30% in 2008.
A few money managers using options limited the downside in 2008 by a substantial amount. For example, our Defined Risk Strategy was down only 4.5% after fees versus a negative 37% for stocks. In the 2009 rebound, Swan DRS matched the market on the upside. We did this through the use of options to hedge the portfolio and through the use of options to generate monthly income. As investors and advisors have become aware that you can use options to protect to the downside, and you can use options to generate income that helps to pay for that downside protection, more and more have begun using them to manage portfolio risk. We have had a 10,000% increase in the number of advisors who are asking for our help over the past few years. All advisors need to look at option strategies as a way to protect their portfolios.

What are the challenges executing options from the exchange floor versus electronically?

Electronic trading and open outcry offer advantages and disadvantages, requiring brokers to be flexible in order to offer maximum efficiency and utilization. Fragmented exchange-posted electronic markets, though extremely fast, may not be conducive to price discovery when executing large, institutional-style orders. Electronic market makers, by spreading pricing metrics across multiple exchanges, can adjust their quoting interests in milliseconds by responding to ‘trade footprints’ on any one exchange. Subsequent routing attempts can subsequently increase option volatility, thereby inflating execution costs. Accessing off-floor liquidity, then, by transacting as one single trade, can be extremely price-effective.
Accordingly, large voice-brokered market-impact strategies can significantly lower total costs. Electronic facilitation / solicitation crossing transactions assume the possibility of contra replacement. Crossing intentions can immediately encounter professional electronic interaction, as opposed to trade negotiation. A voice-brokered market probe will best ensure a successful cross.
The need to source liquidity and facilitate orders will continue to be a staple of floor-based brokerages. On Point Executions offers both electronic and voice strategies to create innovative, high-powered solutions. We acknowledge the advantages inherent within both execution formats; the challenge is to capably employ both configurations to reap the highest-quality result.

What are the challenges in getting options orders filled?

One significant hurdle in getting orders filled is determining which exchanges to route orders to. Exchanges operate under a maker-taker model or a payment-for-order-flow model, but the fees and rebates constantly change. Fees change whether you are providing liquidity or taking it, or even depending on the symbol. For example, ISE recently announced it was extending its complex order pricing from three symbols to 10. All this change requires frequent programming in order to pay the lowest fees.
Another area of importance is determining which algorithms to use for best execution. Market volatility is a key factor, but different strategies will employ different execution. Smart orders, volatility orders, sweep orders, or spread orders will all be used in various situations.
Wave Options also trades local emerging-market options and there are significantly more challenges there. You have to be cognizant of fluctuating borrowing rates, and dividends and interest rates can be a bigger component of option prices. But liquidity is the biggest impediment in getting orders filled. It can be difficult to trade the desired size upon entry or exit without significantly moving prices, so discretion in execution and conviction in the trade are quite important.

Has it become more important for equity traders to also be adept at trading options?

Today’s markets are so intertwined — we believe that equity traders need to, at the very least, have a basic understanding of how options can directly affect views in equities. Significant buying or selling activity in a stock can be directly attributed to traders hedging off the risk associated with high-delta options trades, which often occurs around events such as earnings, company news, world events and options expiration.
Equity traders can leverage options market signals when determining price levels in stocks for entry, profit taking or stop-loss points. These signals can be tracked well before these specific events and can provide early color for traders who are looking for a competitive edge. Credit Suisse offers classes to educate clients on identifying these signals early. If signals are interpreted correctly, it can be very rewarding.
Like equity markets, options markets have become fragmented with nine options exchanges in the U.S. and the implementation of penny pricing. Technology providers offer electronic execution capabilities for multiple asset classes, market data and streamlined workflow from front to back office. This development, with the importance of understanding what is happening in multiple markets, means traders should be adept in trading different asset classes.

How has the competitive dynamic among options exchanges heated up (or not) amid tepid overall trading volumes?

I wouldn’t necessarily describe trading volumes as tepid. Given that last year the U.S. options industry was up around 17% from the previous record year, options volumes continue to be relatively strong.
We’ve seen some aggressive pricing moves from some of the newer entrants lately, as well as some innovation in pricing structures from some of the established exchanges. At NYSE Amex Options, we just introduced tiered pricing for our high-volume market makers. This follows a year in which we also introduced a significant competitive monthly firm fee cap for open-outcry business. We’ve also seen increasing competition for QCC business using rebates— an order type that didn’t exist in early 2011.
The genuine innovation, though, seems to be focused on new products and novel auction mechanisms. That’s an area where there have been some interesting developments over the last several months. Inherent in that experimentation and the subsequent search for the appropriate balance, there’s a risk that innovation takes the marketplace in an unintended direction. That, however, shouldn’t stop the drive for innovation and at NYSE Amex, we have a number of plans for new products and services that we expect will create some interesting discussion in the coming months.