The changes sweeping through the options markets are resulting in considerable challenges for market-makers, according to a research report from the Tabb Group, a research and strategic ad
The changes sweeping through the options markets are resulting in considerable challenges for market-makers, according to a research report from the Tabb Group, a research and strategic advisory firm focused exclusively on capital markets.
‘With daily volume regularly exceeding 15 million contracts and volatility in the underlying U.S. cash equity markets making 300- and 400-point intra-day swings commonplace, market-makers lacking sophisticated technological capabilities are at a critical disadvantage,’ says Tabb Group senior research analyst Andy Nybo in the report, entitled Trying to Make Change: Market Makers and the Evolving Options Market.
Nybo argues that regulatory initiatives such as penny increments and dollar strikes require changes to market-makers’ business models and technology infrastructure. ‘Penny-price increments result in an increasingly competitive business environment, forcing them into making tighter markets, sharply reducing their profit potential,’ he says. ‘Dollar strikes have another downside, increased quoting requirements.’
The evolving options market structure has attracted the attention of a powerful new class of trading institution. Rising liquidity, greater adoption of technology and structural changes have combined to create a fertile ground for these institutions, which use quantitative trading strategies perfected in the equity markets in the options marketplace.
These new players, Nybo says, ‘are leveraging the capabilities of technology to implement quantitative modelling with automated systems that mimic trading techniques long used by market makers.
‘Market makers must have the same powerful technologies at their fingertips in order to manage the evolving complexity of the buy side’s trading strategies. And as the buy-side continues to become more sophisticated and leverages technology to its advantage, market makers must invest in systems that are even faster than their customers.’
The introduction of new pricing models by exchanges is creating a market environment ripe for new trading strategies involving quantitative models that use electronic trading to achieve returns by exploiting fleeting arbitrage opportunities and market miss-valuations.
Although this is new to the options market, all of the ingredients are present for the successful implementation of these automated strategies, Nybo says, as technology becomes more powerful and affordable, trading volumes are rising and regulations are creating a favourable environment.
‘As exchanges fight for market share through new pricing schedules and trading protocols, market-makers will need to adapt and choose when and where to operate,’ he says.
In Europe, however, disparate exchanges and limited inter-connectivity are resulting in significant complexities for market makers with cross-border operations. ‘Managing a multitude of connections in different countries, all with different regulatory regimes, quickly becomes a full employment act for compliance departments,’ Nybo argues.
‘With the need to support a wide variety of proprietary protocols for each exchange and dramatically increasing bandwidth requirements, it’s clear that operating in multiple jurisdictions requires significant investments in both staff and technology.’
Internationally, Tabb Group believes Asia, Europe and South America as well as derivatives markets in other locations offer substantial promise for firms that can invest in the connections and systems that open up the market to existing clients seeking the next opportunity for alpha.
‘As these markets mature and electronic connectivity becomes a reality, the first movers will have extensive opportunities to profit before the masses move in and eat away at margins,’ Nybo concludes.
Founded in 2003 and based in New York and London, Tabb Group uses an interview-based research methodology developed by founder Larry Tabb to analyse and quantify the investing value chain linking the fiduciary, investment manager, broker, exchange and custodian.
