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.
“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.”
The biggest ETF product is the SPY, or the S&P 500 SPDR Trust. The biggest index product is the SPX. The index option is traded only on the Chicago Board Options Exchange, which holds an exclusive license. Both the SPY and the SPX track the S&P 500 Index, but, the size, or notional value, of the SPX contract is 10 times that of the SPY. That makes it popular among large money managers looking to hedge their portfolios.
According to Engmann, smaller institutions and hedge funds that might previously have hedged with the SPX have gravitated to the SPY because it is more liquid and easier to trade. The CBOE has kept the SPX in the pits while the SPY can be traded electronically across every exchange, he notes.
See Chart: Options Volume
During the first quarter of this year, an average of about 2.2 million SPY contracts traded every day. By contrast, the SPX traded an average of about 666,000 contracts every day.
The SPX is larger when notional value is considered, but the gap is closing fast. In the first quarter of 2007, before the meltdown, trades in the SPX were worth about $84 billion per day. SPY trades were only worth $4.7 billion. In the first quarter of this year, however, SPX notional value was at about the same level, but the value of SPY trades had climbed to about $28 billion.
According to Fischer, the popularity of ETF options over index options has a lot to do with their tighter spreads. That becomes apparent especially during periods of high volatility, he explained.
“In tough times,” the trader told the crowd at the annual conference of the New York chapter of the Security Traders Association, “you’ll see spreads on older products such as the SPX widen from 30 cents to $5. By contrast, spreads on options on the Spider ETF will move from 1 cent to 3 cents. Spreads on some products-single name indices, especially-are sometimes five times or 10 times wider than comparable ETFs.”
Actually, the spread on the SPY isn’t directly comparable to that of the SPX, as the strike price is 10 times larger. A move in the SPX spread from 30 cents to $5 equates to a move in the SPY spread from 3 cents to 50 cents. That’s still large, but the SPX quotes are indicative only, a CBOE exec points out.
“In volatile times, you can see a $5-wide quote, but you can go into the crowd and negotiate,” said Ed Tilly, a CBOE executive vice chairman. “Spreads can come in quite substantially.”
While the SPX is traded exclusively on the CBOE, the SPY is traded on all nine exchanges. CBOE has benefited from the rise in SPY option trading, but must share the wealth with competitors.
It is about to try to reclaim some of that SPY volume for the SPX. Sometime this year, its all-electronic C2 exchange will launch trading in the SPX. Today, the option is traded only in open-outcry fashion in the CBOE pits. The CBOE is hoping to reel in both high-frequency traders and money managers. HFTs have shunned the SPX because of the manual nature of the trading. Some institutions have shunned the SPX because of its morning settlement terms. They trade a similar product in the over-the-counter market where dealers’ afternoon settlement terms have more appeal.
As for the HFTs, “We have answered the access question by making it electronic,” Tilly said.
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