05.08.2014
By Terry Flanagan

Options Traders Weigh In on Innovation

For Invesco Senior Trader John Burrello, new products rolled out by options market operators should be user-friendly and easy to understand first and foremost.

“Transparency and relative simplicity typically win over complexity when innovating with derivatives,” Burrello told Markets Media.

Options with weekly expirations have been a big success as an innovation, as volumes for S&P 500 Index (SPX) contracts about doubled from 2012 to 2013. Burrello expects further expansion in this area.

For institutional investors, the primary options strategy has been selling call options to generate income on some long equity positions. That will likely continue to gradually gain adherents, and aside from that “it would not be surprising to see faster growth in various downside-protection strategies that utilize options as liquid alternatives,” Burrello said.

In a broad sense, the economics for options market operators is such that innovations should continue to be rolled out to market participants.

“We need to start by looking at the primary incentive that drives the behavior of exchanges — growing volumes,” Burrello explained. “Increased volumes leads to better liquidity, tighter bid/ask spreads, and easier price discovery. It’s hard to argue that the exchanges have failed to increase volumes through innovation in the past decade.”

Added Burrello, “the current market structure is far from perfect, with probably too many venues available for options execution and the lack of market-making obligations to prevent predatory behavior by certain participants, but the U.S. options market structure is still efficient enough to, on balance, marginalize expensive and complex innovation and allow increased volumes to benefit the end users.”

Weeklies and options linked to the CBOE Volatility Index (VIX) have been notable hits in the area of innovation, while mini options have fallen short of expectations, according to Dan Carver, options trader at Fidelity Capital Markets.

“The short-term VIX (VXST) is a great example of a new product,” Carver said. “VIX provides a constant 30-day look at implied volatility by using a weighted-average methodology between the front two monthly SPX option chains.”

VXST compresses the volatility look to nine days, using the same weighted-average methodology, but applying it to SPX Weekly options instead of monthly options.

“Before the introduction of VIX, there was no way to isolate implied volatility risk through an exchange-traded product. VIX options average daily volume is nearly 800,000 contracts per day, which demonstrates the importance of hedging volatility risk,” said Carver. “Besides product innovation, technological innovation has introduced several price-improvement auction mechanisms that have resulted in better execution prices for customers.”

 

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