Options Move Beyond Vanilla

Terry Flanagan

CBOE, Nasdaq and other exchanges seek to diversify offerings to meet investor demand for OTC-like products

CBOE’s C2 exchange, a fully electronic platform launched in 2010, began offering SPXpm index options series, known as Long-term Equity Anticipation Securities (Leaps) last fall. They resemble the Standard & Poor’s 500 Index options series traded on the CBOE but instead settle in the afternoon. On March 1, the C2 began trading Super Leaps, which extend expirations to five years from three. The CBOE notes that Super Leaps were created for insurance companies, pension funds and other institutions that use the OTC market to hedge longer-dated equity exposures.

“We’re exploring expanding the maturities of the SPXpm out further,” said Paul Stephens, vice president and department head of institutional and international marketing at the CBOE.

Flex options, as the name suggests, provide flexibility in terms of strike price and expiration — now as far out as 15 years — that is similar to OTC contacts. CBOE says it trades nearly half of all flex options, a claim that’s difficult to verify. However, the exchange has long held exclusive licensing agreements with S&P to offer stock index options based on the benchmark S&P 500. The Chicago-based exchange company is also well known for its 20-year-old proprietary Volatility Index (VIX), which could only be traded against using OTC derivatives until 2004 when CBOE began trading VIX futures. VIX options were launched two years later.

Due largely to those indices, CBOE dominates the index options arena, capturing more than 90% of trade volume as of late March, according to the Options Clearing Corp. By extension it trades the most flex options based on the indices.

“The flex option is the closest thing we have from the exchange community to look-alike OTC products,” said Bill O’Keefe, director of derivatives and customized options at Chicago-based online brokerage TradingBlock. Most equity derivatives are tied to the SPX, O’Keefe said, and because billions of dollars of notional value are traded every day in SPX options, liquidity is strong and the bid/offer spread is tight.

Despite the increasingly flexibility of flex options, OTC remain far more complicated, with more moving parts. For instance, an Asian option’s payoff is determined by the average price of the underlying asset over a specified period of time, rather than the price of the underlying asset when the option is exercised.

Asian options’ averaged price lowers the risk of volatile markets and presumably could be useful to institutional investors such as insurance companies seeking to hedge investments. Likewise, barrier options can be used to cap losses on all or part of a portfolio.

Flex options can hedge exposures more accurately than conventional options. Stephens at the CBOE said insurance companies are increasingly using flex options, and the exchange company has devoted two full-time staff members to educating prospective customers from those institutions.

“We’ve recognized that insurance companies are particularly interested in long-dated options,” Stephens said. “The most common thing they’ll do is tie products to the S&P 500…offering customers exposure to that index with limited downside risk.”

CBOE has been fortunate to have the S&P 500 become the main U.S. equity benchmark, and SPX options and futures have benefited from its deep liquidity. CBOE’s VIX options are also abundantly liquid. The exchange company has had less luck with credit default options (CEBOs), which as binary options pay a fixed amount if the underlying credit defaults. Launched in 2007, shortly before OTC securities catalyzed the global financial crisis, they were re-launched in March 2011 and have since seen limited trading in only nine corporate names, mostly large banks.

Most new options classes take time to build liquidity and require significant effort by the exchanges to educate potential users. CEBOs may also be overly standardized, at least for the traditional users of credit default swaps who often customize the OTC version to meet the specific characteristics of each bond offering. That ability to customize is part of what makes the OTC market attractive for sophisticated investors and the trading firms that act as their counterparties.

“The CBOE has been great to offer more flexible strikes, duration and factors like that, but where the OTC market is much more compelling is in the different types of product available,” said Stephen Solaka, managing partner and co-founder of Belmont Capital Group, which uses derivatives to manage portfolios for wealthy individuals and financial advisors. “You can be protected if the market falls up to 20% but any further and you get zero — things like that.”

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