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May 1, 2011

ETFs Outpace Indices

By Peter Chapman

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Trading in options on exchange-traded funds is soaring. Based on data provided by the Options Clearing Corp., volume in ETF options is ripping this year, outpacing that of rival index products. Market volatility and good liquidity play a large role. 

Kevin Fischer

"We've seen a huge influx recently into ETF products because of volatility," Kevin Fischer, head of block trading in the options department at Interactive Brokers/Timber Hill, said at a recent industry conference.

Volatility spiked in mid-March due to the crises in Japan and Libya, sending options on the SPY ETF, for instance, soaring. But the recent cycle in volatility has been under way since June 2007, according to analysts at MKM Partners. That's spawned interest in ETF options for hedging and speculating.

For the first three months of 2011, ETF option volume is up by 37 percent, compared to the same period last year, according to the OCC. At the same time, volume growth in index options, a competitor product, has been considerably slower, coming in at about 6 percent. ETF options and index options are similar-the underlying ETFs often track indices-and compete with each other to a certain extent.

See Chart: ETF Surge

The surge continues a multiyear trend. Trading in options on ETFs took off in 2007 in the midst of the financial crisis, rising from an average 1.8 million contracts per day in that year's first quarter to 6 million contracts per day in this year's first quarter. Daily ETF contract volume now dominates index volume, which hit 1.2 million contracts a day in the first quarter.

Sources say much of the rise in ETF options trading is due to worried retail customers hedging their portfolios. Others note the contracts have become popular with hedge funds or high-frequency traders due to the ability to trade them electronically. OCC data suggest it is the largest traders that are driving volume. During a recent week in April, trades of 50 contracts or more made up two-thirds of all customer volume.

Doug Engmann, formerly head of equities at Newedge and a 30-year veteran of the options industry, attributes the growth in ETF options to two factors: strong growth in the underlying ETFs themselves and a preference for trading the options on the S&P 500 ETF over those on the S&P 500 Index.

Strong demand for the underlying ETFs stems from investors feeling more comfortable trading in entire sectors rather than individual securities, Engmann explained. All the activity around ETF trading, in turn, has generated interest in trading ETF options. "The fact that there's so much interest in the underlying creates interest in the option," Engmann said. "It appeals to people taking opinions about the ETFs and the volatility in the ETFs."