The bar to succeed as an options market makers keeps rising, as tepid order flow damps  profit opportunities at the same time deeper pockets are needed to stay in business.

“Cost continues to go up while market makers struggle to compete in this low-volatility environment,” said Kevin Murphy, head of U.S. options electronic execution at Citigroup. “Options market makers love volatility, so they’re getting the worst of both worlds right now.”

U.S. options volume was little changed through the first two months of 2013 compared with the year-earlier period. Full-year 2012 trading declined by 12%, breaking a string of nine consecutive annual increases. Activity remains strong on a historical basis, but the options industry had expanded along with volume, so a retrenchment does not come without dislocation.

The difference between the bid price and the offer price has narrowed to as little as a penny for some of the more actively traded options. “In a way it’s amazing that these guys are trading with markets as tight as they are,” said Jason Stamer, director of business development at MEB Options in Chicago. “It’s a tough spot right now, but it’s great for the retail customer.”

The business of making options markets has been in flux for almost a decade. The evolution from floor-based to electronic trading was a major shift, and new regulations opened up competition and fragmented the exchange landscape. The changes have served to reduce the number of options market makers and bifurcate the space, squeezing out smaller players and putting more influence in the hands of Bulge-Bracket banks and other large firms.

Large options market-making firms spend an average of $28.8 million annually on technology, while small firms spend an average $2.9 million, or 90% less, according to Tabb Group. A market maker ostensibly could have managed with such a comparatively tiny tech spend in a floor-based era, but much less so since technology has become so critical for best trade execution, which entails low latency and high speed.

“It takes a significant amount of capital to compete in today’s complex electronic option marketplace,” Murphy said. “There are a number of factors working against smaller option market makers — one is the cost of technology to compete as an options market maker across multiple exchanges.”

SEE THE FULL ARTICLE IN MARKETS MEDIA’S 2013 OPTIONS REPORT, WHICH WILL BE DISTRIBUTED AT THE APRIL 24-26 OIC CONFERENCE IN LAS VEGAS