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Market focus: US equity options

02 September 2011

Equity options in the United States are booming. In the first half of the year, over 2bn contracts were traded, with 376m contracts changing hands in June, at 21% increase on 2010. Daily equity options volume had an average of 16,039,382 contracts per day in July, a 31% increase on July 2010. As the US equity options markets rocket to their eighth consecutive record year, there are some clear lessons that can be learned from their success.

Options trading in the US is the nirvana of global derivatives. Fungible contracts are traded across nine competing exchanges, in both electronic and open outcry, cleared through one clearing house, while market structures tailor to both retail and institutional investors. Spreads are tight and costs are low.

The current competition in the market has its roots in spin off of the CBOE Clearing Corporation, which became the OCC, a utility, not for profit clearing house owned by the exchanges. The horizontal model, now perhaps a missed opportunity for Europe, enabled fungibility of contracts while keeping clearing costs down.

Recent growth in the US equity derivatives market has been down to three key areas: reduced costs and exchange innovation due to the fierce competition between the exchanges; the introduction the Penny Pilot Programme (see box) and the increasing institutional interest in US options markets.

The intense competition between exchanges is unrivalled in any other ETD sector. Nine exchanges offer equity options trading facilities with exchanges Bats and C2, CBOE’s all-electronic exchange having opened their doors for trading in the past 12 months.

Maker/taker vs the world

According to Jamie Selway, managing director and head of liquidity management at ITG, markets can broadly be split up into two camps: those with a maker/taker pricing model with price-time priority and those with the more traditional pro-rata model with priority for customer orders.

The maker/taker pricing model has been instrumental in shifts in market share over the past 12-18 months. New entrants to the exchange market can rapidly gain market share, as Bats has proved gaining a 4% market share since it launched its options market last year with a maker/taker pricing model.

The maker/taker model has also proved a significant benefit for incumbent exchanges’ bids to grow market share. Take the example of Nasdaq’s PHLX market, which has grown its share from around 17% in 2009 to 25% so far this year since the introduction of a flat maker/taker fee structure.

Institutional investors can place large orders without being penalised in fees for the size of the order. As a result the exchange has become a hotbed for dividend arbitrageurs, much to the chagrin of ICE, which has called for such trades to be removed from published order flows as they give a distorted impression of liquidity.

Bats and C2 have both launched over the past year with the maker/taker model, gaining a market share of 4% with just over 58m options contracts traded to date this year and a 1% share with 22m contracts respectively.

However, the early progress of the two exchanges suggests that gaining significant market share in options is a greater challenge than in equities. Compare Bats’s performance in cash equities where it has surged to become the third largest market in the US with an 11% market share. Selway, who sits on the board of Bats says that there are different issues in options that mean that such rapid growth is more difficult to achieve:

“It is hard to imagine a block crossing system between two institutions in options. There is a high level of retail investment in equity options and a high degree of dealer intermediation required in less liquid option contracts. However, if competition is built for SDPY contracts or other highly liquid indice, then we might wind up with MTFs/ECNs making good progress in options,” he said.

However, the growth of the exchanges is far quicker than that of Turquoise in the UK, which launched in June and traded just 450 of its FTSE 100 futures contracts in its first month of operations. Turquoise had a maker/taker model but was unable to agree fungibility with NYSE Liffe’s FTSE 100 futures contract.

Innovation

The competition between exchanges breeds innovation. While many single name contracts are fungible, other innovations are limited to trading on the exchanges that brought the products to market.

Leading the field in innovations in the eyes of many market participants is the CBOE, which brought the hugely popular VIX product to market that enables investors to trade volatility. Another factor in the growth in volumes has been the introduction of weeklies on the CBOE.

Weeklies are options with an eight day expiry, enabling investors to increase the payouts and take positions on short term strategies. CBOE currently trades around 400,000 weeklies a day, accounting for over 10% of its total monthly volume. The weeklies can now be traded across a range of indices and single names as well as ETFs including the SPY, the most actively traded EFT, which traded over 75m contracts in June, accounting for almost 19% of all equity derivative trading in the month.

Institutional interest

Product innovation, education and enticing pricing structures have led to increased interest from institutional investors. US equity options have traditionally been traded by retail investors. However, according to Jim Binder of the OCC, this is now changing.

“We have seen increased interest from institutional investors. Since the financial crisis, a lot of funds such as pension funds that previously were not trading options are getting involved as they realise how they can use options to hedge against a downturn.”

A recent survey by the Options Industry Council found that 94% of financial advisers with more than $500m of assets under management used options to hedge their positions, that percentage fell to 36% for those with $50m under management but the study found that only 7% of respondents used options less frequently over the past year and just 3% planned to use less in the future.

Binder says: “Options are becoming more mainstream and we are likely to see more growth.”

Russell Rhoads , an instructor with CBOE’s Options Institute, says that continued education is key to growth: “Some institutions still don’t take advantage of options, one of the big hurdles for the industry to overcome is to educate people about the benefits of hedging positions with options. Some retail investors have a negative view of options too but for both institutions and retail investors even the most conservative strategies could utilise options.”

Counting the pennies

In January 2007, the SEC launched the Penny Pilot programme, which enabled the reduction of one cent orders down from the five and ten cent increments that had been offered by options exchanges.

The penny trading increment applies, in almost all circumstances, for options that trade at less than $3 and five cents for those trading above that level. Despite the pilot moniker, the programme is now unofficially permanent (with official approval expected soon) and has since expanded from an initial 13 option classes to 360 today covering a range of options across a range of single names and indexes.

The scheme initially met with some hostility in the industry who feared that it would fragment liquidity and thwart institutional investors looking to source large orders. However, the proposed benefits of tighter spreads and a more transparent pricing system won out.

Exchanges initially urged caution as they were concerned about quote loads. The drive to expand the range of the programme was led by NYSE Arca and was opposed by a number of exchanges including ISE , which argued that the expansion of the number of symbols covered could overwhelm systems while the benefits of the scheme would only be seen in the most actively traded symbols.

The programme has resulted in spreads on actively traded symbols in the Penny Pilot contracting while volumes have soared. Market makers margins were affected by the narrowing of spreads but the key challenge was for the exchanges to keep on top of the increased volumes.

Russell Rhoads , an instructor with CBOE’s Options Institute, says: “On an average day 2m electronic messages per second are sent to update on trading on all options classes. The concern with the pilot was adding names too quickly might over stretch the system.”

Jim Binder of the OCC adds: “The Penny Pilot Programme has had some negative effects on the ability of large institutions to get into the options market, however it has not wiped out the benefits of options and there has still been a large upturn in institutional investment in equity options.”

According to Rhoads, the introduction of Penny options has changed investors’ strategies with more options contracts being closed out before expiration than was previously the case.