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August 1, 2010

Knight Seeks Retail Options Flow

By Peter Chapman

Knight Capital Group, in the process of expanding its options market-making activities, will start soliciting retail orders this quarter.

Matt Cushman

According to Matt Cushman, in charge of quantitative strategies at Knight, the big trading house plans to join the upper ranks of options aggregators and market makers.

"Our goal is to build a business similar to the one we operate in equities. We will be one of the largest, most competitive destinations for options," he said.

Knight is already one of the largest wholesalers in cash equities, a business that involves bringing in order flow from retail brokers and trading against it or routing it to the public markets.

It is one of the top five firms in this business, competing with such players as Citadel, Citi, UBS and E*Trade.

Consolidating retail flow in options is similar to wholesaling in cash equities, except that the orders are routed to exchanges, where they are "directed" to the consolidators' market-making units. Citadel, Citi and Timber Hill are three of the biggest players in this business.

Knight is already making markets in about 175 options, according to Cushman, and plans to ultimately trade all classes. There are about 2,000 options classes available for trading. Knight got its start last December, when it bought trading rights on the International Securities Exchange from TD Options. Knight also makes markets on Nasdaq OMX PHLX. It plans to establish market-making operations on all major options exchanges eventually, Cushman said.

This is not the first time Knight has pursued profits in options market making and order consolidating.

In 1999, it bought a firm based outside Minneapolis called Arbitrade for about $400 million. The business never delivered as expected, however, producing small profits or losses every year. Knight operated an options business for about five years before selling it to Citigroup at the end of 2004 for $237 million.

Knight's latest foray into options market making will be different in at least one crucial respect. Whereas the original operation employed about 200 people, many of them market makers, the new group will be highly automated, with less need for human interaction. Cushman manages the team at Knight that is responsible for strategy and trading on the equities side. The same group is building out the options market-making system.

Knight is not starting completely from scratch. It has a large customer base on the equities side that it plans to tap for the new options business. The same broker-dealer sales force that solicits equities flow will now target retail options flow, as well.

At least one large retail broker views Knight's pending entrée into options favorably. "Competition is always a good thing as it generally leads to better pricing in the marketplace," said Chris Nagy, a managing director in charge of order routing, sales and strategy at TD Ameritrade. "The last thing you'd want to see is a cap on the number of entrants. However, we need to ensure that the barriers of entry in this space don't get or are made so low that anyone can be a market maker or specialist."


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