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June 6, 2006

Whirling Derivatives: Options and futures blurring on the edges

By Mark Longo

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  • Whirling Derivatives: Options and futures blurring on the edges

Convergence is a buzzword these days, except in derivatives. In the futures and options markets, convergence is more than a buzzword. Many exchanges see it as the future, although this has not always been the case. For decades, the two halves of the derivatives world all but ignored each other. After all, futures and options are two distinct product classes that require two very distinct marketplaces. These marketplaces even have different regulators, with the SEC watching over the options markets and the CFTC guiding the futures markets. In just about every respect, futures and options are different worlds. However, the fence between those worlds may not last much longer.

Symbiosis

Of course, no financial product exists in a vacuum. In the case of options and futures, there has always been some overlap between the two product classes. Many traders hedge their options positions with futures, resulting in small volume correlations between related products. On a handful of occasions, options and futures exchanges crossed over into the same territory, usually with mixed results. Perhaps the best example of options and futures exchanges treading on the same ground is the competition/cooperation between the S&P 500 options pit at the Chicago Mercantile Exchange (CME) and the SPX options pit at the Chicago Board Options Exchange (CBOE). The two products are practically identical, with activity in one pit often used as a gauge for the other. However, despite the near redundancy of these two products, both exchanges have maintained thriving S&P options volume. In many ways, the two products have become complementary, with each helping to drive business on the other exchange. So far, successful crossover products between the options and futures markets have been the exception, not the rule. But a rash of new expansions on both sides of the derivatives world may finally prove that convergence has triumphed.

Blurring the Boundaries

Driven by rising competitive pressures, steep analyst expectations and diminishing opportunities for expansion in their core product lines, options and futures exchanges have begun eyeing each other's fiefdoms. While it may sound strange, expansion into the other side of the market actually makes sense. Each side offers something that the other side does not. For the options exchanges, the futures markets hold the lure of monopoly products and the chance to deal with a regulator that actually understands their business. For the futures exchanges, the options markets offer a chance to expand beyond the limited distribution of core commodity products. They also offer a chance to capture a piece of the exploding options pie. For both marketplaces, convergence also offers the opportunity to increase the volume in their core product lines. For example, if a futures exchange lists options on an existing futures contract, the options activity will in turn generate increased demand for the futures contract.

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