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.
“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.
Holt explained that most high frequency traders are small and undercapitalized. That makes the firms think twice about taking positions in options as opposed to stocks. “Your full risk is far less predictable than just trading on pure price,” Holt said. “It’s a far more complex marketplace. You’re not just taking that single price and making the best of it.”
Predicting Price
Holt’s point is that the added dimension of implied volatility, or the degree to which the underlying asset is expected to bounce around, makes predicting the future price of an option much harder. Traders can’t simply rely on time and sales data to make their bets. For old-line market makers and proprietary traders, that’s where options pricing models come in. Black-Scholes is a popular choice, but there are others, and many traders construct their own models.
But for an HFT, the statistical work necessary to price an option has not been part of the tool kit. For the most part, these shops have focused on three things: speed, speed and more speed. Being the fastest meant being first. That may work in simple markets such as futures and equities, but does little good when trading options.
“During the early days, shaving latency-first milliseconds and then microseconds-was the name of the game,” Yuri Balasanov, head of research and trading at AQ Strategies, told attendees at HFT World. “There wasn’t much incentive to invest in complicated strategies.”
Most HFT operators have been technology specialists, Balasanov said. Firms may employ a token statistician, but the business has been geared toward being first.
Those days are over, he believes. There is very little room to cut latency any further, as trading now happens in microseconds, or millionths of a second. That has forced shops to move toward more sophisticated strategies. Some groups have even been merging with old-line statistical arbitrage shops, the Chicago-based executive noted.
Balasanov, who is also a professor of financial mathematics at the University of Chicago, recognizes the problems of dealing with risk in options. He says high frequency traders entering the options market must devise better risk management strategies. “You have to be able to quantify the risk of the volatility structure,” he told conference-goers. “You have to quantify the risk of how puts move relative to calls. Existing concepts are inappropriate for high frequency trading.”
Getting a handle on volatility may not be enough. Another stumbling block is the tick regime. Because high-frequency trading typically involves making small amounts of money on hundreds or thousands of trades per day, the increment structure of options works against HFT strategies. In contrast to futures contracts, whose pricing closely matches that of the underlying assets, options strike prices are set at wide intervals.
Whereas a stock has 100 price points within one dollar, an option on that stock may have only one strike. And because a typical options strategy involves constantly adjusting a hedge, the cost of continually crossing the spread will eat into any profits.
“If the definition of options trading is volatility trading, then you only do so with a delta hedge,” explained van Kleef. “You have to trade via the underlying. And if you do so with every tick, it’s cost-prohibitive.”
Margin Killer
Trading volatility, or volatility arbitrage, generally involves taking a position in options and neutralizing it with a countervailing position in equities. This so-called delta neutral strategy yields a profit to the trader if the realized volatility of the stock is closer to his forecast than the implied volatility of the marketplace.
“In options, the problem is, you have this one position, either long or short, and you can’t change it as you can in futures,” van Kleef said. “In the futures market, you can go long or short on the turn of a dime because you have a zero spread. Whereas with the options contract-even in the most liquid contracts-you keep running through the spread. It kills any margin you might have.”
Despite the challenges facing high frequency traders, the practitioners are optimistic that workable trading strategies can be devised. Van Kleef notes that while traditional volatility arbitrage may be unprofitable, a trader can take advantage of the fact that there are thousands of contracts that trade off of the underlying. Those contracts are not always “perfectly priced,” he said. So a trader can trade one contract against another over time. “You might hold your original position for months,” he explained, “but you can still trade a couple of times a second because it’s such a big universe of related instruments.”
Balasanov is also optimistic about the future. With the race to zero latency winding down, “many high-frequency shops are looking for the next thing. There is a very high probability that options trading will be next,” he said.
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