A ‘perfect storm’ is about to hit the US equity options market, according to a new study, Equity Options Trading 2008: Rising Out of Obscurity, published by capital markets research and ad
A ‘perfect storm’ is about to hit the US equity options market, according to a new study, Equity Options Trading 2008: Rising Out of Obscurity, published by capital markets research and advisory firm Tabb Group.
With trading levels reaching record levels on a monthly basis, volatility flirting with historical highs, a more accommodating regulatory environment and an improved understanding of the benefits of options strategies, the equity options markets soared to 2.8bn contracts last year, according to the Options Clearing Corporation, a 41 per cent increase from 2006.
‘Long perceived as a financial flea market where naïve and uninitiated speculators attempted to get rich overnight, the options market is now a sophisticated bazaar where professionals ply their trade, using refined financial techniques that can no longer be viewed or portrayed as even remotely speculative,’ says Andy Nybo, a senior analyst at Tabb Group and co-author of the study with fellow senior analyst Kevin McPartland.
Although Tabb Group estimates that just 30 per cent of institutional investors currently are actively using options as part of their portfolio strategies, the market’s potential provides almost limitless opportunity, with the number of institutional accounts that will begin trading options forecast by the firm to double in the years ahead.
‘Nearly insatiable demand is emanating from every quadrant of the institutional asset management community, even staid pension funds that have long shied away from using derivatives,’ Nybo says.
‘Hedge funds and proprietary trading desks are developing and implementing new strategies that arbitrage incremental opportunities faster than the human mind can possibly comprehend. At the same time, institutional investors are increasingly using options as part of sophisticated portfolio management activities that seek to improve, maintain and enhance their alpha-generating opportunities.’
Unlike the retail and wholesale options trading sectors where most trading is done electronically, equity options trading is still predominantly a high-touch trading area. However, McPartland says, ‘buy-side players, specifically hedge funds, major technology adopters, are crying out for automation.’
The authors forecast that by 2010 more than 60 per cent of all buy-side options trades will be executed through low-touch channels. In addition, as adoption of algorithms gathers pace, Tabb Group says that 35 per cent of all order flow in equity options will be trading algorithmically by 2010, promoting greater electronic trading and efficiency in the trading process.
Many of the forces that will impact the market, ‘such as penny pricing, dollar strikes, alternative execution venues or the emergence of innovative options trading strategies, are themselves enough to shift market structure,’ McPartland says.
The study is based on interviews with 49 traders at hedge funds, asset management firms and proprietary options trading institutions, supplemented by discussions with participants at pension plan sponsors, options market-making firms, exchanges and other liquidity pools, as well as the institutional options trading desks of major broker dealers.
Founded in 2003 and based in New York and London, Tabb Group uses the interview-based ‘first-person knowledge’ research methodology developed by founder Larry Tabb to analyse and quantify the investing value chain linking the fiduciary, investment manager, broker, exchange and custodian.