Handing Over the Keys

The Sellside Puts Options Trading on Buyside Desktops

As institutional investors come to dominate options trading, a growing number are asking their brokers for electronic capabilities to do the trading themselves. That has some brokers scrambling to put direct-market-access tools and execution algorithms on buyside desktops.

“As brokers roll out better tools, more people join the marketplace, and exchanges present incentives to provide liquidity, institutions will be able to trade more electronically,” says J.P. Xenakis, vice president at Goldman Sachs Electronic Trading. “It’s cheaper and it’s anonymous.” Big-lot traders, he adds, will soon begin asking for more-sophisticated quantitative tools.

Goldman Sachs, Credit Suisse, UBS and other large banks are rolling out agency options execution algorithms for institutional customers. All plan to launch new algorithmic strategies this year. Banc of America Securities, Lehman Brothers, Merrill Lynch and Morgan Stanley have options algos in production. Many of these are geared toward options quoted in pennies as part of a pilot the Securities and Exchange Commission foisted on the industry more than a year ago. The algos aim to reaggregate increasingly fragmented liquidity across the six exchanges, often at different prices, and over a period of time.

Customer Demand

Agency brokers are also getting into the game. Instead of building their own options trading functionality from scratch, several have opted to buy existing options trading platforms. ITG last year spent $22 million to acquire RedSky Financial, a Chicago-based broker and listed derivatives execution platform vendor for institutional traders. BNY ConvergEx Group, which has a lot of hedge fund and institutional clients, bought Chicago-based options trading platform LiquidPoint last fall.

ITG grabbed RedSky to get a better foothold in the options market for its core customer base of indexers and passive funds. “We wouldn’t have done it unless there was strong customer demand to trade options,” says Tony Huck, who oversees ITG Derivatives, the renamed RedSky entity. Many of ITG’s traditional customers, which trade index futures as part of transitions or to put cash to work immediately, are now eyeing options. RedSky’s options trading platform is likely to be incorporated into ITG’s Radical EMS, which supports single-equity options but doesn’t have the same level of derivatives trading capabilities.

The immediate stimulus for bulge-bracket firms as well as agency brokers revving up their electronic trading capabilities is the penny pilot. Launched in January 2007, the pilot will absorb another 28 names later this month, encompassing a total of 63 options classes. Pilot options series priced under $3 are quoted in penny increments, while those $3 or higher are quoted in nickels. (The liquid QQQQs are quoted in 1-cent increments across all series.)

The pilot, these brokers are betting, will magnify the resemblance of options trading to fast-paced electronic equities trading. As expected, smaller quoting increments have already resulted in narrower spreads. For all but the most liquid options in the pilot, tighter spreads have also led to dramatically less liquidity at the inside market and more price movement. That represents fertile ground for algos that can capture liquidity dispersed across more price points.

“Options market structure is rapidly evolving, and options exchanges have adopted competing business models,” says Denis Medvedsek, director in charge of options in Credit Suisse’s Advanced Execution Services unit. “With the emergence of penny quoting, algos for options are becoming more relevant.” He adds that in a penny-quoting environment, “customers become more price-sensitive as spreads narrow, and the challenge is to execute on their full size.”

Broker-dealers and hedge funds have long done the bulk of options trading, along with independent professionals and former market makers who’ve moved upstairs, but traditional institutions are now stepping up their use of equity options. The International Securities Exchange and the Chicago Board Options Exchange, the two largest markets, say institutions as a group represent at least half of their options volume.

And that volume is exploding. In January, the industry’s average daily listed equity options volume was 15.7 million contracts-a 70 percent jump over the average daily volume in January 2007, according to the Options Clearing Corp., an industry organization. The average number of contracts per trade rose to 20.2, from 19.5 a year earlier.

High vs. Low

Still, most institutions are currently handing their orders off to brokers. The vast majority of institutions go the high-touch route-and that segment is growing. According to a November Greenwich Associates survey of 138 firms that used options last year, 81 percent of the institutions’ volume in the 12 months ending June 2007 was delivered to brokers’ sales desks over the phone, up from 75 percent the year before. The share of options volume sent electronically to brokers dropped to 8 percent in 2007, from 13 percent in 2006.

Among institutions, the share of low-touch volume shrank. The Greenwich survey found that institutions, while trading more options volume overall, sent 11 percent of their order flow directly to exchanges for automated electronic execution in 2007, down slightly from 12 percent in 2006.

Options experts say traditional long-only institutions new to options are often more comfortable giving trades to brokers’ sales desks for execution. For large orders, brokers may commit capital or search for the other side. Traders may also not have the time to work large options orders electronically themselves, or they may not yet have the systems and connectivity required to do so.

The natural progression for institutions is to work the phone with a broker who has options expertise, says Anthony Saliba, president and CEO of LiquidPoint, the options trading subsidiary of BNY ConvergEx Group. “As they learn the ropes,” he says, “they get to the point where they’re comfortable using the technology to reduce slippage, time to market and execution costs.” He expects many plan sponsors and long-only funds to veer toward the electronic markets in the coming years.

“If it’s a large order, where the trader doesn’t need merely to hit a bid or lift an offer, they may call it in,” says Goldman’s Xenakis. “Or it may be an order attached to stock or part of a complex trade.” He adds that all full-service buyside orders sent to brokers’ upstairs desks “don’t require capital commitment or crosses.”

Options DMA

Until recently, most buyside traders weren’t thinking about trading options themselves. Connectivity through brokers’ or independent EMSs and sponsored access to exchanges weren’t readily available. That’s changed. “Once the technology is there in an asset class like equities, it’s easier to apply that in other asset classes like options,” says Vijay Kedia, president of FlexTrade Systems, an EMS vendor. “It’s not like starting from square one.”

Invesco, a global asset manager with more than $500 billion, increased its options investing over the last several years, with traders executing options electronically on their own as well as through brokers. Diane Garnick, Invesco’s investment strategist, anticipates a “quick adoption” of electronic trading tools among traditional institutional investors because traders are used to similar products in equities.

“There isn’t the same educational hurdle as there was with equities,” Garnick says. Indeed, she adds, “the buyside has so much experience now that some large firms with their own quantitative groups are more likely to build tools in-house rather than rely on brokers’ tools.” Invesco has a 50-person quant group that focuses on volatility as well as investing and allocation strategies. Invesco’s traders look for color from brokers, but control their own execution decisions.

Smaller buyside shops that aren’t new to options have also increased their use of direct-market-access products. John Spitman, a vice president and portfolio manager at AIC Ltd. in Canada, a $6.5 billion value-focused investment manager, says his firm’s trading desk now uses DMA tools for 40 percent of its U.S. equity options volume, compared to 10 to 15 percent two years ago. The firm relies on brokers to execute the rest of the flow, mainly on an agency basis.

Spitman says his firm’s U.S. options trades are typically in large-cap financial names, which tend to be liquid. Trading several hundred contracts at a time in those names therefore hasn’t been a problem. He adds that he doesn’t expect his use of options to change as electronic trading grows. “If we sell a put,” Spitman says, “it’s because we want to own a name and not because the volatility premium went up.”

Electronic tools may also become more important to institutions as competition heats up in the options arena. “As there’s more competition in options and more active investors, opportunities to capture alpha will become smaller,” Invesco’s Garnick says. “The net result is that transaction costs will jump dramatically in terms of relevance and importance.” That, she adds, will heighten the institutional appeal of electronic trading.

Capital Commitment

But while self-service options trading is picking up steam, there are some who say the explosion in options volume won’t-and can’t-answer the liquidity needs of institutional investors. The chief hurdle those investors face is executing in size, since liquidity in an underlying name is often spread across multiple strike prices and expiries.

“The real name of the institutional options game is liquidity provision,” says Aaron Hantman, global head of sales at Susquehanna International Group, one of the largest liquidity providers in U.S. options. “It’s a very capital-intensive business. We haven’t seen an electronic or algorithmic offering yet that addresses the capital issue.”

In Hantman’s view, those who liken the options industry to equities, and who predict that options trading will go the way of equities trading, ignore a fundamental aspect of how institutions use options. Options are an “entirely different animal,” he says. Institutional options trading frequently involves multi-leg trades, volatility-based trades and customized hedges. On average, Hantman says, Susquehanna “commits between 60 and 100 percent of the capital behind client transactions.” The firm currently has 22 derivatives sales traders, up from 14 two years ago, handling primarily listed options business.

More Capital

Statistics from Greenwich’s survey bear out institutions’ need for capital. Among the surveyed buyside institutions that used options, 85 percent said they required brokers to commit capital last year, up slightly from 83 percent in 2006. In volume terms, institutions said 56 percent of their executed flow needed broker capital in 2007, down from 58 percent the previous year.

“Capital commitment is important in options,” says Credit Suisse’s Medvedsek. “Institutions need it, and it’s one of the rationales for price tiering. But capital commitment and electronic trading are distinct businesses and both can grow in a growing market.”

Medvedsek adds that over time electronic trading will make further inroads into upstairs trading. “Complexity is not an enemy of electronic trading,” he says. “It changes the timeline. If something is more complex, that means we need more time to make it algorithmic.”

Kevin Fischer, manager of the block execution services desk at Interactive Brokers Group, which handles agency flow, notes that capital commitment eases the burden on buyside traders, especially for urgent orders, but that traders “don’t want to pay up for it.” He argues that a “more mature” electronic options environment will lead to greater liquidity and tighter spreads. “We’ve seen this in every asset class,” he says. “Eventually, it will probably be the case that all trading takes place electronically and there won’t be a need for a human broker to find it.” Fischer previously worked as an options trader on the Philadelphia Stock Exchange for 19 years.

Fischer says traders may eventually wind up going through multiple price points to get penny-priced executions in options, but that the aggregate price will be a better-quality execution than it would have been before penny pricing. In his view, maker-taker pricing at exchanges will boost transparency in market making by incentivizing liquidity providers to make tight markets and price-improve orders. His desk currently helps institutional customers find the other side for big orders and get price improvement from market makers and floor traders. Interactive Brokers Group handles about 18 percent of the U.S. equity options volume through its brokerage and market-making divisions.

Algo Efforts

New tools have already become necessities in the penny environment. Many big brokers have options sweeping functionality, which lets brokers capture liquidity resting on multiple exchanges, and smart order routing, which decides how to execute orders by breaking them up into smaller pieces over a period of time. Some brokers have time-weighted-average-price or volume-weighted-average-price algos, although VWAP is largely considered irrelevant in options because some series don’t trade or have only shallow order flow.

Some of the broker-dealers now expanding their algorithmic offerings have execution tools that try to capture liquidity quietly as it shows up, or that pounce on flow within certain parameters. Other execution strategies post bids and offers in the market, working orders in the natural stream of flow. Some, including Goldman, Credit Suisse, UBS and ITG, have delta-adjusted strategies, which alter the options limit price as the price of the underlying security changes. The more dynamic the tools are, the more useful they are to volatility traders.

The biggest brokers ramping up their options execution tools have turned, in part, to the quantitative groups that built their equities algos and smart order routing. Credit Suisse, Goldman, UBS and others are mining the brainpower of these analysts, as well as upstairs options traders and market makers who understand mathematically how options values shift over time and relative to changes in the price of the underlying name. Goldman’s Xenakis notes that while his firm’s current algorithms and execution strategies focus on gathering liquidity, it is working on tools that will enable traders to trade based on implied volatility or the changing relationship between various Greeks.

More Math

But even as brokers unveil new products, there are some who say that the more-sophisticated products institutions need are still on the drawing board. “Options are derivatives, and the parameters for algos must be more quantitative,” says FlexTrade’s Kedia. “Someone may want to get an order done only if the implied volatility is between 15 and 17 percent,” Kedia explains. “Or the person may want to trade multi-leg options in delta-adjusted or volatility terms. In equities, the parameters for algos are simpler.”

“There is a need for some participation-type algos, but what people want on the options side is different from equities,” says ITG’s Huck. His firm is considering launching a volatility algorithm for traders trading off implied-volatility levels. Interactive Brokers, LiquidPoint and other firms that have long specialized in options trading have offered volatility-based trading algos to customers for several years.

Interactive Brokers’ Fischer points out that many of the execution capabilities coming to market now are rudimentary tools. These can’t meet the demands of options traders who need to put on, for example, call or put spreads that must be delta-hedged against the stock. Fischer says his firm allows traders to trade based on implied-volatility levels rather than the option’s price, converting vol levels into premiums before orders are sent into the market. Interactive Brokers also enables multi-leg complex trades across markets, with the legs executing in different markets simultaneously-along with an assurance that all of the legs will be executed when the order is filled.

BNY ConvergEx’s Saliba agrees that many of the “so-called algos” now coming on the market aren’t really algos that enable complex options trading but execution resources. Most smart order routers and sweep algos from big brokers “wade through the jungle of six exchanges and penny pricing” and decide where and when to execute an order, he says.

In Saliba’s view, these algos don’t address the needs of institutional traders putting on complex trades to implement investment ideas. Brokers that want to make a stand in the growing world of listed options, Saliba says, must be able to support spreading and multi-leg capabilities. And they must do it soon, he adds, since more buyside institutions are getting ready to wield greater control over their own trading.

 

SIDEBAR#1

 Exchanges Eye Institutional Traders

Options exchanges are pitching their wares to the institutional trading community. Exchanges’ technology platforms have made electronic trading easier and faster. Plans are now afoot to roll out depth-of-book feeds, electronic complex trades and other products geared toward the growing audience of electronic institutional traders. All this is occurring as the penny pilot is being expanded and several exchanges are experimenting aggressively with equities-like market models and pricing.

In December, exchanges reduced the maximum turnaround time for intermarket linkage orders to three seconds, from five seconds. Driving that down to one second would be great, says Edward Tilly, executive vice chairman of the Chicago Board Options Exchange. If a market doesn’t respond to an order from another exchange within the allotted time, the away exchange can ignore the market’s better-priced quote with no trade-through liability.

Some believe this isn’t sufficient in a fast-moving penny environment. Last September, NYSE Arca Options and the International Securities Exchange asked the Securities and Exchange Commission to approve a Regulation NMS-type set of rules for options that would either replace or provide an alternative to the current Options Linkage Plan, which the six exchanges control. Key to the new plan is a modernized trade-through rule, an intermarket sweep exemption to that rule, and private linkages between markets. Making these changes would allow investors to access liquidity faster, the exchanges contend.

Several exchanges are also working on depth-of-market products. Depth of information is necessary for algorithms to discern where and how to execute smaller pieces of large orders, particularly in a penny environment. This information could also help investors and algos decide how to access liquidity across multiple strikes and expiries, if the liquidity they need isn’t immediately available.

Currently, only the ISE has a depth-of-market feed. Arca has said it plans to unveil a depth-of-book product, and the CBOE is considering doing so. “They’re six stores selling the same product, and right now all they have to compete on is price and speed,” says Anthony Saliba, president and CEO of BNY ConvergEx’s LiquidPoint. “All the exchanges will need to have depth of book very soon.”

 

SIDEBAR #2

Traditional Managers Opt In to Options

On the buyside, hedge funds for years have been the dominant users of options. They were more likely to have the quantitative skills needed to trade volatility, analyze the Greeks, and put on complex spreads and multi-leg strategies. They also had the leeway to pursue alpha wherever they spied it.

“Traditional institutions are now looking at their charters and are more willing to trade options, such as overwriting strategies, to obtain a greater return,” says Aaron Hantman, global head of sales at Susquehanna International Group. Ironically, he adds, hedge funds may have driven them to it.

Hedge funds in recent years competed more aggressively with traditional asset managers, and their ability to trade across asset classes in pursuit of higher returns won them a growing market share among plan sponsors and other traditional institutions, Hantman says. To compete, many long-only managers altered their investment strategies. “Hedge funds have pushed traditional institutions to change their charters to allow options trading,” he notes. “There’s a higher level of sophistication in the marketplace now that’s lending itself to more options trades.”

Diane Garnick, investment strategist at Invesco, a large global asset management firm that manages more than $500 billion, agrees. She points out that traditional institutions are turning to listed options to pick up additional income for their portfolios or to hedge risk.

“Traditional managers look at options overwriting to generate incremental yield, especially when forecasted returns on equities are flat or negative and volatility is high,” Garnick says. “We’re now in that environment.” She adds that institutions’ focus on mitigating risk in their portfolios can be seen in the shift of investment dollars from indexing to enhanced strategies, which use tactics such as options writing to improve returns while reducing risk.

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