In periods of great uncertainty the ability to take directional bets on markets is valuable. When those bets can be made in a highly commoditised and price-competitive environment, as is the case with US equity options, it is priceless. finds David Wigan.
Trading of US single name and index options hit record levels in 2011, surpassing 4bn contracts on an estimated 200,000 instruments for the first time in November. Year-to-date average daily options volume stands at 18.5m contracts, about 3m contracts per day more than 2010, and the past 12 months will be the ninth consecutive year to set an annual trading record.
Amid deep global economic uncertainty, investors have seen options as a toxic-free way of expressing directional views, mitigating risk and accessing leverage. Meanwhile intense competition among exchanges and advances in technology have spurred participation among hedge funds, retail investors and institutions. Higher volumes have encouraged new entrants, with Miami International Holdings in April saying it plans to open a 10th exchange in the second quarter of next year.
“We have an options space in which there is huge competition,” said Andy Nybo, principal and head of derivatives at Tabb Group, the research and strategic advisory firm. “Competitive pricing has led to tremendous organic growth.”
Whereas 2010 was a relatively low volume year for options, in which several smaller and mid-size market makers left the business, the opposite has been true over the past 12 months, with dealers such as Citi and Deutsche Bank increasing the size of the options market-making groups and larger players snapping up smaller operators. One such deal in March saw Charles Schwab agreed to acquire online options trading firm OptionsXpress for $1bn.
As competition has intensified, the key battlefield for market share is pricing models, and exchanges have this year continued to regale customers with pricing structure tweaks, fee rebates and commission increments, all designed to boost order flow.
The impact of competition has been a gradual levelling of market share, with the biggest operators ceding business to new entrants. Chicago Board Options Exchange had 25.5% of the market in November, compared with as much as 33% two years ago, while the International Securities Exchange (ISE), owned by Deutsche Boerse, had 18.4%, compared with more than 27% in 2009. CBOE’s all-electronic options exchange, C2, completed its first year of operation with 1.5% market share.
Nasdaq OMX PHLX ceded the gains it made in 2010 to command 17.9% of the market in November, down from 23% at the same time last year. NYSE Amex Options increased market share to 14.4% in November, compared with 11.9% at the beginning of the year.
In pricing, the exchanges can broadly be divided into two camps. The traditional camp uses a pro rata method, employing a payment for order flow system, under which the exchange assigns a certain portion of incoming orders to market makers, which pay for executions and lets customers trade for free. Market-makers competing for best price receive a portion of every order filled, giving them an incentive to improve prices to get a larger proportion of incoming flow.
The alternative camp uses a price time priority pricing system alongside a so-called maker taker model, and is winning market share. Here orders are executed at the same price in the order in which they were received, and liquidity providers are paid while those executing against that interest are charged a fee. The maker taker model is a lower cost model for the market maker because of the fee charged to customers, enabling it to offer tighter quotes.
“Maker taker is a great liquidity building mechanism and most exchanges are now using some form of that model to attract liquidity,” said Tabb’s Nybo. “At the same time exchanges as a group are making hundreds of rule filings, each trying to minutely tweak pricing structures, exchange rules and trading protocols.”
Among such variations, different access fees may be charged for individual option classes or market participants, as well as according to the size of orders. There are varying licensing fees, with minimum trading increments, different order types and auctions, individual option series and even time periods. That is aside from numerous “blue light specials” like discounted access for professional customers.
“What we are seeing is a result of the combination of electronic trading, which favours the maker-taker model, and an explosion of market data that enables investors to take advantage of the best deals,” said Harrell Smith, head of product strategy at Portware
One smaller operator that has resisted the move to maker taker is Boston Options Exchange, which uses its so-called Price Improvement Period (PIP) auction to improve customer prices once an order has been received. PIP is an automated trading mechanism which permits brokers to seek to improve executable client orders, by allowing trading participants to compete for orders.
BOX market share crept higher over the course of 2011, reaching 3.6% by November, compared with 3.2% in January.
“We made a strategic decision to focus on the retail space, and we have had a record year as the market place has adapted to the model we have bought,” said BOX chief executive Tony McCormick. “PIP volume has gone up 50% from a year ago.” Box plans to build on its model in 2012 by offering a real time interactive order book, McCormick said.
McCormick is among some in the industry who feel the maker taker model is becoming so competitive that it may eventually lead to a race to zero, and some exchanges were accused this year of losing money on contracts in order to build market share.
Away from pricing competition, exchanges are locked in equally ferocious battles, often conducted through the medium of regulators, over issues such as access fees, currently under consideration by the SEC, and flash orders.
The latter is a long-standing issue that, with regulators focused elsewhere, was not resolved in 2011. Exchanges use flash orders to give their own participants an opportunity to “step up” to the “National Best Bid and Offer” before routing orders to alternative exchanges, giving exchange participants a tiny window of opportunity to meet or beat the market.
The CBOE and ISE oppose a ban on flash orders, pointing to the system’s role in lowering trading costs, while Nasdaq OMX and NYSE Euronext support a ban.
Flash orders matter because of their association with high frequency trading, one of the big growth areas of the past year. High frequency trading uses flash algorithms to dip automatically in and out of markets hundreds of times a second, generating an estimated 20 percent of total trading volume at options exchanges.
The boom in high frequency trading is built on giant leaps in technology over the recent period, with growth in use of so-called field progammable gate-array (FPGA) technology enabling management of vast volumes of trades and data sets.
“I think 2011 will go down as the year in which if you didn’t use FPGA you really were challenged,” said Scott Hall, managing director, North America at Activ Financial. “The options markets are all about how many trades per second can you process – it used be 20,000 or 30,000 but now we are looking at 50,000 or even 100,000, and some of the big players are pushing out those volumes in peak periods.”
Alongside the focus on high speed is greater emphasis on analytics, with some of the abilities seen in the equity space, such as calculations of average volumes at every level of the price book, now moving across to options.
“One of the key trends in an ultra low-latency environment is that investors are spending money trying to identify uncorrelated alpha,” said Louis Lovas, director of solutions and business development at OneMarketData. “We are in some respects in an arms race in the options space, with the smartest fastest traders seen as having the best chances of succeeding.”