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August 1, 2011

Beyond Smart Order Routing

Brokers Get Under The Options Hood

By Peter Chapman

Also in this article

Brokers are stepping up development of more sophisticated electronic tools for options trading. Hedge funds and professional traders using sophisticated strategies are the main beneficiaries.

"The more complex algorithms in the options space have only really started to come out in the last year," said John Duffell, Instinet's chief strategy officer. "Before that the technology was mostly some flavor of smart order routing. We've evolved well past that." Duffell was founder and head of Torc Financial, the options brokerage Instinet bought in 2009.

Although certain brokers-Investment Technology Group is a notable example-have offered advanced trading strategies for a few years, most have provided plain vanilla smart order routing to their customers.

But recently, as traders have grown acclimated to automated trading, there's been a rush of products out of brokers' laboratories. Sometimes they're described as "tactical" order types. Other times they're called "algorithms." There appear to be no strict definitions. 

John Duffell, Instanet

Instinet, Goldman Sachs and UBS have all announced more nuanced products in the last six months to a year. ITG is beta testing a "gamma scalper." Credit Suisse, Bank of America Merrill Lynch and others are incorporating volatility calculations into their tools, sources say.

Spread Trading

For the most part, brokers started supplying their clients with automated trading tools in 2007, the year options began trading in penny increments. The core technology was smart order routing, or systems that swept multiple exchanges to take liquidity. It is still the most popular method of automated trading.

More sophisticated traders, however, have requested tools to reduce some of the drudgery and market monitoring involved in their operations. Those needing to hedge or put on spread trades, for example, are now benefitting.

Spread trading, for instance, represents a significant chunk of industry volume. According to data from the International Securities Exchange, as much as 35 percent of exchange volume stems from traders using exchanges' complex order books. Those numbers include multi-legged options trades as well as tied-to-stock trades. The trick is in executing both legs simultaneously at the appropriate price.

"Options traders are becoming more comfortable with trading complex orders electronically," Gaurav Mundra, Credit Suisse's head of transaction-cost analysis in its portfolio strategy group, reported earlier this year. "These packaged orders can help eliminate leg risk."

Instinet launched its "Cobra Spread" algorithm late last year. A typical user might be working on a "special situations" desk at a money manager, Duffell told Traders Magazine. "We see a lot of spread trading from those institutions," he added. "So we are starting to get into the upper echelon of what truly would be considered an algorithm, instead of just smart routing."

Both Instinet and Goldman Sachs have also introduced algorithms that help the trader hedge his position in the stock market.