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Of pits and puts: the case for options algos

Published in Automated Trader Magazine Issue 30 Q3 2013

Eva Szalay examines prospects for execution algos in the complex, liquidity-strapped options world.

Hazem Dawani, Options City

Hazem Dawani, Options City

With about a quarter of options now executed electronically in the US, European markets are expected to increasingly move to screens in the coming years. But challenges in both markets remain as pit traders still rule execution in complex contracts.

In the US, there are 11 exchanges to execute options on equities, while new products on treasury options launched by CME Group have exploded in terms of volumes in recent years. Late last year, electronic options trading on treasury options at the CME outstripped pit traded options for the first time. Since 2009, the share of screen-traded options has nearly quadrupled.

The change is driven by buy-side firms with sophisticated technology. In a survey of buy-side options research, Tabb Group found that some 58% of hedge funds now incorporate one-week expiry options into their portfolios. One-week contracts can be traded on the Intercontinental Securities Exchange and the US options trading arms of BATS and NYSE Euronext.

In the US, there are companies offering algorithms for executing even complex, multi-leg contracts.

Hazem Dawani, CEO and founder of Options City, describes his company's software as pioneering in the effort to make complex strategies such as butterflies and condors easier to trade. "(The software is) helping a lot of traders to quickly price them, RFQ them and trade them electronically. This has had a role in assisting the transition of these options products to the screen," he says.

The most advanced market is options for equities, where the US has seen double-digit growth accompanied by declining cash equities volumes. One reason for the push is that, like currency markets, options markets fared relatively well in the height of market stress and volatility in 2007 and 2008.

Greenwich Associates, a US-based consultancy, pointed out that in Europe shifts are coming, but the extent of fragmentation across markets could slow the process significantly. The consultancy highlights in a report structural features such as currency and country fragmentation issues, and illiquidity in small -and mid-cap stocks within national markets as the main hurdles to overcome.

"While the move to centralised clearing and other factors are helping speed the transition of futures trading to electronic platforms, the global equity derivatives market is not rushing to electronic execution en masse," the report said.

The changing regulatory structure of the derivatives space is still littered with unknowns. But the desire for low-cost execution is driving both buy-side and sell-side participants.

"In the current environment, electronic execution is a way to lower costs of execution and client coverage," said Jay Bennett, one of the authors of the study.

For buy-side traders, the biggest challenge is efficient use of Smart Order Routing of options and the execution of complex, multi-leg options algorithmically to achieve price improvement. A further challenge is the ability to exploit low-latency arbitrage opportunities in the US between the 11 exchanges where options for equities are traded.

With a multitude of underlying instruments, strike prices, expirations and a range of call and put options, there can be a dearth of liquidity and this makes the low-latency arbitrage play difficult to execute effectively. The challenge is especially acute in options on fixed income products in Europe, where there is an even broader range of instruments because of different sovereign issuers.

"The vast variety of underlying instruments in the space makes it very difficult to manage data efficiently," said Chris Hollands, head of European sales for TradingScreen.

"Option strikes are dynamic and when the price of the underlying instrument moves and the array of instruments have different expiry dates, it becomes very tough to manage complex options with algorithms," Hollands added.

Complexity is even more of a problem for market makers in the space. Sell-side traders need to be able to require execution of positions at current bid-ask prices such that the bid-ask spread widens and depth declines.

"Large supply side option orders challenge the ability of a potentially thin market such as options with many strikes, expirations, and exchanges to consistently provide liquidity," said a study called The Effect of Algorithmic Trading on Liquidity in the Options Market, by professors Suchi Mishra, Robert T. Daigler and Richard Holowczak.

Chris Hollands, TradingScreen

Chris Hollands, TradingScreen

"The vast variety of underlying instruments in the space makes it very difficult to manage data efficiently."

Regulation both drives and inhibits change

While regulation aimed at migrating over-the-counter derivatives to exchanges is undoubtedly driving the shift, the raft of new rules that firms have to comply with in all areas of financial trading is putting pressure on companies and reducing the appetite to venture into new areas and make new investments.

"In Europe there isn't enough liquidity to execute options and with all other regulatory changes kicking in, people have a lot on their plates and very little appetite for investing in new areas. It takes a long time for people to adapt to new trading styles so we see demand picking up perhaps at the end of next year," said Mark Suter, CEO of Digital Vega, a company offering screen trading solutions for FX options.

In the US, the deeply liquid debt futures market means that there is enough depth to run strategies in options. In Europe, the lack of a central clearer for futures decreases liquidity and increases fragmentation, and as a result the costs of trading options.

Meanwhile, high transaction costs are deterring sophisticated high frequency traders from becoming more active in the space in Europe. The situation was similar in the US until the advent of low-cost offerings from brokers that declined further once demand for algorithms picked up.

Interactive Brokers - a US-based company - was one of the first brokers to offer low-cost execution in options to its clients in 1993. Now the company is seeing a surge of interest from sophisticated investors and high frequency trading firms not just in the US but also in Asia.

But as the space becomes more saturated, profits are now eroded by increased competition, said Steve Sanders, executive vice president of marketing and product development at Interactive Brokers.

"The options market making industry is in a cyclical downturn at the moment. We are seeing an increasing number of firms piling into the space, which means the share of the pie is decreasing for everyone," Sanders said.

Investors using standard broker algorithms in the US are also struggling with staying competitive against nimble high frequency traders who create their own algorithms.

"Some brokerage offerings on the algorithm front may be too widely used for users to be profitable. If everyone is trading with the same strategy the competitive advantage element disappears," he said.

While relatively mature, the structure of the US market is by no means perfect. High frequency options trading is generally controlled by a group of people not obliged to post prices at all times. Market makers on the other hand need to provide prices at all times.

"Regulators need to fix this discrepancy," Sanders said.

Steve Sanders, Interactive Brokers

Steve Sanders, Interactive Brokers

"We are seeing an increasing number of firms piling into the space, which means the share of the pie is decreasing for everyone."

Mental Block

Market making activity tends to be concentrated among a small group of companies. The founder and CEO of Interactive Brokers, Thomas Peterffy, has argued that the move to electronic options trading has been hindered by reluctance from market makers.

In a CME publication, he was recently quoted as saying: "It is true that traders in the pit used to be able to earn more money than they do with computerised trades Traders have an entrenched interest in the old-fashioned way of doing it."

Peterffy believes electronic trading of options makes the market more transparent and less risky. He also has noted that electronic execution would reduce the margin for error arising from human mistakes in pit trading, with around 1% of all pit-traded options affected by human error, and he estimates spreads have tightened and commissions are sharply below what they were in pre-electronic trading times.

(Click here to read what Peterffy told Automated Trader about electronic options trading trends.)

Overall trading costs are also reduced by contracts moving more easily from trading desks to the back office if the trades are conducted electronically.

Suter agrees that traders are struggling to shift trading styles due to entrenched habits but he believes demand for option execution algorithms will pick up in Europe once the worst of the regulatory storm is over.

But pit trading is unlikely to disappear entirely. Some contracts are too complex to absorb the vast amount of both static and market data in a way that strategies can execute.

In Europe, it's especially hard to find brokers offering multi-leg execution strategies. But even in the US, the execution of complex options trades tends to happen through pit traders as computers struggle to deal with some of the issues. While computers may be able to calculate far faster than humans, they can't handle low-liquidity scenarios as well as humans since humans can customise deals and negotiate.

In Europe, pit trading will likely continue to dominate options trading for now, but a sea-change might be on its way sooner than some think.

Options for options

In the US, more and more brokers are building on their single-leg execution algos to roll out more products capable of executing multi-leg strategies. As options are rarely listed on one exchange only, the space is a nice potential playground for high-frequency traders.

A trader could execute a vertical spread arbitrage strategy between the Chicago Board of Options Exchange and the International Securities Exchange. Every options exchange and brokerage firms offering options trading capability must be a member of the Options Clearing Corporation, which is the clearer and issuer for all options trades.

As more and more options exchanges open up their complex order books, liquidity is expected to gather steam in products for automated multi-leg options executions. The CBOE offers a Complex Order Book where traders can generate the price and size of CBOE top-of-the-book resting complex spread orders, such as Combos, Diagonals, Straddles, Pseudo Straddles, Ratio-, Vertical- and Time Spreads, in real time.

Among the companies that provide options algorithms or options trading platforms are ConvergEx Group, FlexOpt, Interactive Brokers and Options City.

ConvergEx's options technology business this year launched a suite of multi-leg algorithms that can trade simultaneously on all COBs. The suite includes Complex Order Book Sweep, Reserve, Hidden and Pulse. Another example of an options-friendly algo is the Accumulate Distribute algorithm from Interactive Brokers, which slices an order into smaller randomly sized orders and can work with a variety of asset classes.

Traders can deploy options algos on trading systems such as FlexOpt or Options City, where it's possible to automated gamma scalping and pseudo-market making, and to trade spreads, butterflies and condors among others strategies. These systems provide direct access to option exchanges and support multi-leg exchange defined spreads and slice-and-dice user defined spreads.