Beyond Smart Order Routing
Brokers Get Under The Options Hood
Traders Magazine, August 2011
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.
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.
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.
For its part, Goldman introduced functionality that automatically hedges options orders. The technology supports all of Goldman's U.S. options tools.
The program came about as clients normally would have to manually hedge the underlying equity positions after they place their electronic options trades. Now the equity hedge can be done automatically and almost at the same time the options order is placed. Users are traditional market makers and hedge funds.
Called "Delta Hedging," the tool hedges the trade at a price based on the existing stock-option delta. One of the so-called "greeks," the delta is a measure of the change in price of the options vis-Ã -vis the change in the price of the underlying stock.
According to Vishal Gupta, head of U.S. listed options business development in Goldman's electronic trading department, once the parent options order is entered, the program automatically buys or sells (hedges) the underlying equity of the option. The equity order is then routed through the broker's equity smart order router and Goldman's crossing network, Sigma X, to get the fill.
Pegging trades to some level of the greeks is a large part of the new wave in automation. At ITG, however, it's old hat. ITG has provided strategies that track delta levels for a few years, said Bob Fitzsimmons, the head of that company's derivatives unit.
The broker recently introduced what it calls a "gamma scalper." Gamma is an estimate of how much the delta of an option changes when the price of the stock moves by a dollar. ITG's order type permits traders to hedge entire portfolios of stocks, making trades as gamma changes. The intent is to make money as the market moves up or down. The hope is that the amount of money offsets the time decay of the option.
Most of the more advanced automation tools are geared toward sophisticated short-term traders. The strategies would be less likely to be used by a stock-oriented fund manager using options to hedge or derive income.
Spread traders, volatility arbitrageurs and professionals seeking to hedge options positions are the targets. That may not be such a large market. Credit Suisse reported that most of the automated trading done by its customers is via smart order routing. (Although it did report a spike in spread trading at the end of last year.)
In fact, Greenwich Associates noted last year in its survey of buyside use of equity derivatives that the amount of options volume executed through electronic means declined. Greenwich's data covers the period June 2009 to June 2010. It showed that only 13 percent of volume was traded electronically, down from 16 percent in the prior yearlong period.
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