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January 2, 2012

Bit Players

High Frequency Traders Struggle with Options

By Peter Chapman

High-frequency trading may have transformed the country's stock exchanges into ultra-fast, high-volume marketplaces, but it has had little impact on U.S. options exchanges. Five years into the penny tick/maker-taker revolution, high-frequency traders are bit players at best in options.

The four maker-taker exchanges, those most attractive to speedy, high-volume shops, control only about 20 percent of industry volume, barely more than they did five years ago. Two of them even took steps last year to better accommodate market makers, of whom they were previously indifferent. Both Nasdaq Options Market and BATS Options began offering bulk-quoting technology to traditional dealers in a bid to attract more liquidity. In equities, most liquidity is provided by HFTs.

The dearth of HFTs in options has largely been attributed to market structure barriers. That includes rules that maintain market-maker privileges, keep professional traders at bay and keep exchanges slower than they might otherwise be. While the marketplace is dealer-centric, some high frequency traders say the biggest problem is actually the product itself. The instrument involves too much risk, offers too few price points and can lack liquidity.

Peter van Kleef

"The only strategy you can run in high-frequency trading is market making," Peter van Kleef, chief executive officer of Lakeview Arbitrage, said at a recent industry conference. "Because once you go beyond the in-the-money strike, spreads widen out. So you can't just keep lifting the offer and hitting the bid. The spread will just eat you up."

HFT strategies are varied, but perhaps the most popular--at least in equities--are market making, arbitrage and momentum. HFT market making typically centers on highly liquid instruments with big volume and thin spreads. In options, that translates into contracts in near-term months and with strike prices that are close to the price of the underlying stock. Most options market makers are not high frequency traders, although proprietary trading house Getco has moved into the market in recent years.

While trading highly liquid options contracts may be no different from trading highly liquid stocks, other forms of high-frequency trading are more problematic, especially for the small hedge funds that dominate the field. "When you trade options, you're trading volatility," Mark Holt, head of systematic implementation at BlueCrest Capital Management, said at this year's High Frequency Trading World conference in New York. "Thus, it's a lot more risky for high frequency traders."

British hedge fund BlueCrest, Holt said, trades heavily in futures, less so in options. Actually, most high-frequency trading of exchange-listed derivatives is in futures. According to the Aite Group, in 2010, about 25 percent of global futures volume was done by HFTs. The research house predicted that figure would rise to 40 percent by 2015, noting the industry is far ahead of the options industry when it comes to electronic trading.