Since the first standardised equity option rolled off the conveyor belt in the US in 1973, the growth of the industry can safely be described as impressive by almost any standards. Each year, with only 2002 as an exception, the US equity options market has seen growth in the number of contracts it trades.

Going from strength to strength, it has reached one milestone after another, particularly over the last 10 years. No sooner had the US Options Clearing Corporation reported in 2004 that it had cleared a record 1bn contracts that year, than it went on to clear 2bn contracts in 2006.

And in 2009, despite analysts’ predictions that the global financial crisis would create a decline of 15% to 20% in contracts traded, instead the industry recorded another increase, if modest at 0.84%, to clear 3.62bn contracts.

But as the economies of the world recover from the global financial crisis, the question remains: Is there still room for growth in the US equity options market? Given the shake up of world financial markets, what will be the new ‘normal’ in the growth volumes the industry can expect in the future?

Historical perspective

The establishment of the Chicago Board Options Exchange (CBOE) by the Chicago Board of Trade in February 1973 heralded the first milestone in the development of the US equity options market. The new exchange acted as a testing ground for trading standardised options on common securities.

It initially traded call options on 16 companies’ stock, with put options introduced in 1977. Before this advent of a venue to bring together buyers and sellers, options existed, but were typically inconsistent in their contractual terms, had little liquidity and came with little to no historical trading information making it difficult to determine a market price.

Inevitably, the market for listed options grew, with numerous exchanges throwing their hat in the ring to trade the instruments.

In short order, the American Stock Exchange (AMEX), Pacific Stock Exchange (PCX) and the Philadelphia Stock Exchange (PHLX) all entered the market to trade standardised equity options using their traditional floor exchange models and trading only their own listings.

In 1990, however, when the US Securities and Exchange Commission abolished the practice of listing an option on any one stock on only one exchange, it took time for option exchanges to embrace the competition, with most unwilling to compete with each other on high volume options. It was not until 1998 when the newly formed International Stock Exchange (ISE) announced its plans to cross-list 600 of the most traded options that a listing war began.

“Electronic trading and multiple listings were the mark of the modern era of the US options industry,” says Jim Binder, a spokesperson for the Options Clearing Corporation. “The ability to open a position on the CBOE and close it on ISE meant people could take advantage of fungibility offered with the OCC. From that point on we saw reduced spreads, reduced costs and an influx of institutional investors that had not been as active in the marketplace beforehand.”

Nearly 100% of equity options were cross-listed on multiple exchanges by the end of 2001. Each subsequent year, except 2002 in which the markets took a beating as a result of the bursting of the dotcom bubble, US equity options have experienced phenomenal growth.

Much of the growth of the last decade can be explained in the context of the tech explosion on Wall Street, says Tony McCormick, chief executive officer of the Boston Options Exchange (BOX), which began trading options in February 2004.

“The technology driving ‘point and click trading’ that previously wasn’t available to retail investors was extremely conducive to growth. Customers could see the market quote and size and instantly access it which created the opportunity for the market to proliferate,” he says.

What will be the new normal?

Today, in the wake of the global financial crisis, a deep US recession, and a dearth of public confidence in the equity markets, the question of what will drive the US equity options market going forward and what level of growth it can reasonably expect is still waiting to be answered.

Complicating the answer to this question, however, are a number of factors.

These factors include regulatory issues such as a proposed 0.25% tax on options transactions. Widely considered a populist move by a Congress keen to have Wall Street pay for its bailout, such a tax, many in the industry believe would severely damage the viability of the US equity options market and end up simply hurting mainstream investors.

Another factor is the continuing impact from the introduction of the Penny Pilot programme in January 2007 and the entrance of new conduits into the marketplace, threatening to impact the business of market-makers.

However, the ever mounting race between options firms to arm themselves with yet faster trading technology and the competition among exchanges to attract order flow through changes to market structure, pricing models and ever changing protocols suggests that the market will continue to thrive, albeit, at a more modest pace.

Even now, with seven US options exchanges now in play in what some consider to be an already over-saturated market, an eighth was launched in the form of BATS on February 26, and a ninth, the CBOE’s C2 venture is set to begin later this year.

So what growth and why?

Derivative-like options are a derivative to equities not only in name and function, but also in terms of volume. As such, the growth of options will depend on renewed public confidence in the mainstream equities market.

“A lot of people left the marketplace altogether in late 2008 and early 2009, so as long as they are not trading equities, there is no need to trade options,” says Binder of the OCC.

So while a return to 30% annual growth is unlikely in the foreseeable future, some analysts nevertheless believe there are a number of factors that will propel options volume to grow.

Andy Nybo, a principal and head of derivatives at The TABB Group, a research and advisory firm based in Massachusetts, predicts growth of 5% to 10% annually in the immediate future. Chief among the factors that Nybo believes will contribute to future growth will be a renewed surge, in the wake of the economic malaise, for retail investors, pension and mutual funds, to use options to mitigate risk exposure.

Over 2009, the efforts on behalf on the Options Industry Council (OIC) to inform investors of the versatility of options in all kinds of markets, whether they be up down or stable, have begun to produce fruit.

“Options still have growth left in them because retail and institutions have not been using equity index options to their full extent,” says Ed Boyle, the executive vice president and head of US options at NYSE Euronext, which runs two options exchanges, the NYSE Amex Options and NYSE Arca.

“Many people still look at options as a tool to use as a gamble on the market, but through the education process, people are beginning to understand that they are better used for managing risk using collar strategies. So instead of being a high risk product, they are seeing them as a product to lower risk.”

The OIC, educational webinars run by the likes of optionMONSTER and optionsXPRESS are understood to be well attended and aim to take investors beyond covered call writing.

Proof that investors are looking beyond basic options strategies can be seen in the fact that there is now more spread trading, according to Richard Hagen, the president and chief operating officer of online broker, Trade King. “The market tsunami has driven retail investors to be more sophisticated than in previous few years by looking at such strategies to control their risk parameters,” he says.

Retail resurgence

Traditionally, the retail investor has been the bread and butter of the US equity options industry. Until the entrance of electronic trading and multiple listing in the late 1990s, it was widely estimated that retail traders in options accounted for approximately 85% of the market.

Today, while no official figures are available to calculate the split between the percentage of investors using equity options that are retail versus institutional, it is acknowledged that the last decade has seen an increase in institutional investors as a percentage of users.

Nevertheless, retail investors remain a major driving force of the industry.

One of the reasons retail investors are expected to continue to grow as the life blood of the industry is due to the rise of the equity adviser in the US. According to McCormick at BOX, the equity adviser world is the next big area of growth for US equity options. “There is a new younger generation of advisers who are taking a greater hold of active management and are more conversant with equity options than the previous generations of advisers. This will really help drive retail investors into options in the future,” he says.

As a result of education directed towards retail investors informing them how to implement more sophisticated options strategies and the proliferation of equity advisers joining the ranks of those educating individual investors, it is more than likely that there will be a change in the profile of the typical retail investor over time.

A sneak peak of what we might expect in the future may come in May when the OIC’s latest study profiling retail options users is released. The study, which was last completed and released in April 2005, revealed options investors when compared with equity-only investors, to be more active traders, more affluent, middle-aged and male.

The implementation of the Penny Pilot programme, which many predicted would result in an increase in volume, is also a factor that may lead to a renewed resurgence in retail investors using options, according to Boris Ilyevsky, the managing director of ISE.

“From our point of view, the advent of penny pricing has had a very negative impact on liquidity in the options market. However, there has been a benefit to the retail community — spreads have tightened and rates at discount brokers remain very competitive,” says Ilyevsky.

The Penny Pilot Programme, which began in January 2007, aims to quote US options classes in pennies to reduce spreads and payment for order flow.

Institutional uptake

This effort to attract retail investors, however, has come at the expense of institutions, say many in the industry. “The Penny Pilot has been a major negative for the purposes of tracking institutional interest. In terms of that effort, we believe that decimalisation has taken us a step back,” says Ilyevsky.

The Penny Pilot has meant an adjustment period for institutions, especially in terms of their trading parameters.

According to Nick Wood, the head of equity derivatives at Susquehanna International Group, a market-making firm located in Pennsylvania, the Penny Pilot has made it difficult for institutional investors because even though the markets are tighter, there is no longer the same level of market depth.

“You don’t really know where the liquidity is anymore, so while it is a good idea in principle, in the end there is going to be more slippage now for institutional clients,” says Wood.

Nevertheless, Wood expects institutions and hedge funds to continue to re-enter the options market in force when the economic uncertainty subsides. “Right now a lot of hedge funds are still on the sidelines and our volumes have gone down because of that,” says Wood.

Many believe institutions will continue to be attracted to the options market, despite the negatives of the Penny Pilot Programme, due to factors such as high frequency trading. This is because many prop trading firms that specialise in high frequency trading models are looking to expand into other asset classes, with options being that potential new asset class to plug into their model.

“High technology firms that have traditionally traded equities, foreign exchange and futures are looking at options and realising that there is a lot of electronic trading, a lot of connectivity and a lot of exchanges inviting them to go and play in their sandbox,” says Nybo.

These investors are looking for very specific at-the-money transactions that take advantage of small incremental rates of change in underlying option values and are very active in trading during the day. “This is very different to what has traditionally driven growth in the options business,” says McCormick from BOX.

Further growth in options usage by institutions is likely to be driven by the introduction of innovative products from the exchanges.

“The real growth is going to come from new product development. We are going to see new index products and new order types which help institutions interact with the market via a cross market execution venue,” according to Boyle from NYSE Euronext. “There will be functions currently done at a trading desk that in the future you are going to see the exchanges developing products to execute in a more automated fashion.”

In addition, the education about the downside protection provided by options is not lost on institutions. As a result, as asset managers recover and their assets under management grow there will be a greater call for options to more effectively manage risk in these larger portfolios, says Nybo of TABB Group, who in 2009 wrote a number of reports on the US equity options industry, including “US Options Market Makers: Evolution or Extinction?” and ‘US Options Market Structure: The Shifting Exchange Landscape.”

Exchanges: ever-increasing competition

Whether it is the implementation of the Penny Pilot Programme or catering to the increased demand of high frequency trading firms, options exchanges have been in the front lines of much that is driving the industry. As a result, exchanges have been forced to find ways to stand out from the pack so as to attract order flow and give themselves the edge over the already significant and growing competition.

Today, the US options exchange landscape is populated like never before. Based on 2009 figures, the exchange attracting the largest share of equity options volume was ISE (28.1%), followed by the CBOE (27.1%), Nasdaq OMX PHLX (17.9%), NYSE Arca (12.5%); NYSE AMEX (7.3%); BOX (4.08%); and Nasdaq Options Market (3.09%).

Adding to the exchange cocktail in 2010 will be BATS, which began trading options this February, and CBOE’s C2 which, after postponing its launch in 2009, has announced it now plans to launch in late 2010.

The number of options exchanges that has proliferated over the past few years, from five in 2003, to six in 2004, to seven in 2008, and now nine in 2010, has in part been driven by one of the central debates in the US options industry: how best to price options.

The drive to find the perfect solution to allow an exchange company to attract enough order flow and increase volumes so as to maintain viable liquidity, which in turn attracts investors, has led exchanges to experiment with alternative methods of market structure and pricing.

Rewards

Ascribing to the traditional method of options pricing — or pro rata pricing — are the CBOE, ISE, NYSE Amex, Nasdaq OMX PHLX and BOX. Using this method of pricing, market-makers are rewarded for having the best bid or offer. Market-makers competing for best price receive a portion of every order filled, giving them an incentive to improve prices so as to get a bigger proportion of incoming flow.

Traditional, or pro-rata exchanges, as they are known, typically augment their efforts to attract liquidity by payment for order flow programmes which programme cash payments to brokers routing to their exchange. Customers typically trade for free.

The other exchanges — namely, the NYSE Arca and Nasdaq Options Market — employ a price/time priority structure coupled with a maker-taker model, which divides the market into liquidity makers and liquidity takers. A maker of liquidity is one available to trade and posts a range of prices on a range of options, which can be hit by any incoming order. A taker of liquidity is one who lodges orders.

Under the maker-taker model, liquidity makers are paid for providing liquidity to the market, whereas liquidity takers are charged a fee. As such, this model has been criticised for subsidising liquidity makers at the expense of liquidity takers.

In the future, whether an exchange uses a traditional or maker-taker model, the one constant in the battle to attract order flow will likely be the necessity for change. Exchanges are constantly in a state of flux, changing their rules, protocols and adding new products to get an edge on the competition.

BOX changed from a maker-taker to a more traditional pricing model in late 2009 to focus its sights more firmly on retail investors — a community less likely to see benefit in getting paid to provide liquidity.

Convergence

Most industry insiders don’t believe there will be an ultimate winner in the war between traditional and maker-taker exchanges, but rather that exchanges will ultimately converge the two models, marrying aspects from each.

Nasdaq OMX PHLX, the old Philadelphia Stock Exchange acquired by Nasdaq in 2008, this January launched what it calls a bifurcated model, incorporating a pro rata, maker-taker model. Using this model, market-makers are paid for posting their limits which results in tighter pricing.

Then using the pro rata methodology, anybody who added liquidity at those price points would be rewarded with an allocation of the trade based on the size that they are displaying. “It is unique, no one else in the space is doing it,” according to Tom Wittman, the president of Nasdaq OMX PHLX.

Since its introduction this year, the exchange’s market share in the Spider Option has gone from around 7% to 22%, says Wittman.

There is some agitation in the industry, however, from some exchanges that are less than convinced that the competition has the health of the industry at heart.

Competitive struggle

One exchange spokesperson, for example, said that some of the exchanges engaged in price cutting in an effort to out-smoke the competition, without even preserving the ability to make money themselves.