Bruce Goldberg, Chief Marketing Officer, ISE:
"Among our membership, there's anticipation that the advent of pennies is only likely to fuel algorithmic and automated trading."
Deep in the bowels of the US Securities and Exchange Commission's New York headquarters, enormous quantities of options market data are being analysed. This thankless task will decide whether and how the US options market is to follow equities into the decimal era. Following the SEC's six-month penny pilot scheme, the regulators must now map out a plan for the options market's future growth. Their decision could have a big impact on the attractiveness of US options to algorithmic and automated traders.
The US options market has experienced astonishing growth already this decade and the penny pilot scheme is expected to prompt further expansion. At year end 2006, open interest stood at 218.8m contracts, a 29 per cent increase on December 2005. Research firm Aite Group predicts option volumes will climb by nearly 40 per cent in 2007 over last year. Growth has been fuelled partly by the flood of capital into hedge funds that rely heavily on options-based strategies but also by the growth of electronic trading. Ravi Jain who, as head of Avir Capital, runs a volatility and correlation-based options trading strategy, says the launch of the International Securities Exchange, the first fully electronic options trading platform, "revolutionised" the market.
"Firms could suddenly make markets in 300-400 names with just 3-4 traders through use of volatility management systems that could create volatility surfaces in real time for hundreds of names; a human trader can only actively look at 20-30 names at most," says Jain. While the sell side overwhelmingly uses algorithms to generate options prices, Bruce Goldberg, Chief Marketing Officer, ISE, expects the penny pilot scheme to further increase algorithmic and automated trading on the buy side. "Among our membership, there's anticipation that the advent of pennies is only likely to fuel algorithmic and automated trading. DMA providers are already creating the mechanisms to automatically send business to the exchanges," says Goldberg.
Joe Mecane, Managing Director and Head of Broker
"… the increase in liquidity as more algo traders and black box shops begin to enter the market will stimulate greater trading activity by institutional investors."
The penny's progress
The Securities and Exchange Commission's sixmonth penny pilot scheme began on January 26, 2007, when six options exchanges started quoting options on Whole Food Market, Inc. (WFMI) in pennies. Twelve more option classes were phased in during February including the highly liquid Russell 2000 Index (IWM) and NASDAQ-100 Trust Shares (QQQQ). The thirteen issues in the SEC pilot represent around 15 per cent of market volume. Prior to the pilot, no US exchanges quoted options in pennies. During the scheme, options priced below $3.00 were quoted in pennies; options priced $3.00 and above were quoted in nickels. Announcing the pilot, which brings options in line with US stocks, quoted in pennies since 2001, SEC Chairman Christopher Cox said, "Quoting in penny increments has the potential to permit investors to trade options at better prices." The SEC said the pilot would provide valuable information on spreads, transaction costs, payment for order flow, and quote message traffic, thus guiding "the Commission's future decisions regarding penny quoting in options".
During the pilot, the New York Stock Exchange's ARCA options exchange witnessed a narrowing of spreads in the order of 50 per cent, according to Jon Werts, Vice President, Derivative Products, NYSE. Volume increased overall, but primarily in the two largest issues (QQQQ and IWM). ARCA's market share also grew significantly. From January 1 to April 30, 2007, ARCA achieved a 31 per cent increase in its share of trading in the SEC penny pilot issues. Average daily volume in the penny pilot issues increased to 297,000 contracts per day in April, up from 220,000 contracts per day in January 2007.
Subject to the final findings of the SEC, it appears a clear distinction can be drawn between options classes where spreads have narrowed from the previous nickel restraints and others in which spreads have remained at perhaps 10 or 15 cents. While most volume growth was experienced in the QQQQs and IWM classes whose strikes were previously limited to the nickel spread, six of the 13 classes experienced virtually zero or decreased volume during the test period.
NYSE's Werts expects the SEC to sanction an expansion of the pilot scheme. "The industry has handled it very well. There really haven't been any problems at all. The tightening of spreads means customers benefit. The SEC will decide on the scale of the expansion but I'd expect it to be fairly significant. Fast forward 12 months I think we'll see the majority of the volume of the US equity options market traded in penny increments."
While expansion seems likely, the precise nature of the next steps is less clear. According to some observers, the SEC's view is that if all options are converted to penny pricing, market forces should be allowed to determine the appropriate spread for each issue, be that nickels, dimes, or pennies. An alternative view is that some issues should remain in nickels because their volumes do not justify the switch to penny increments. However the equity markets' full migration to penny pricing suggests that staged minimum quoting increments in options is unlikely.
Ravi Jain, Avir Capital:
"Funds that use options for speculative or hedging purposes will be able to trade a lot more efficiently,…"
Options at the crossroads
ISE's Goldberg says the pilot has shown that there is an argument not only for limiting penny pricing to options with specific characteristics (i.e. high liquidity, low volatility, low underlying value and high retail appeal), but also for imposing a $3 price cap. "The quote-to-trade ratio on options priced above $3 is very high; if you look at the QQQQs barely two per cent of the trades took place above $3 but 65 per cent of the quotes occurred there. The cost to the exchanges and other market participants of disseminating all those quotes is very high," he says.
Furthermore, Goldberg says the scheme could dampen the interest of institutional investors that have been attracted to the options market in recent years by greater liquidity in large order sizes. "We've seen mixed performance volume-wise, spreads have reduced by a third and top of the book has decreased by 78 per cent, which is a cause for concern for institutional investors that typically trade in larger sizes," says ISE's Goldberg. "We really think there's need for further study of the impact on all different constituents - from market data vendors to retail and institutional investors to market makers - before there can be an expansion," he adds.
Joe Mecane, Managing Director and Head of Broker Services, UBS, says the penny pilot scheme is a "pivotal" time in the development of the options market. Although it seems clear that options will pursue a similar migration to that pioneered by equities, from a quote- to an order-driven market following decimalisation, its route is harder to predict. "Although the pace and magnitude is not yet clear, we're anticipating a shift by institutional investors - which have traditionally favoured block trading and limited DMA - toward accessing markets directly and increasing use of algorithms as the market structure evolves," says Mecane.
Mecane says parallels can be drawn with the increase in liquidity that accompanied penny pricing in the US equity markets. "In the equities market it took around a year to evolve from the pre-decimal era to today's order-driven market in which algo traders and black box shops trade actively. In the options market, there hasn't always been the liquidity historically to enable institutional investors to take large positions," he observes. "But the increase in liquidity as more algo traders and black box shops begin to enter the market will stimulate greater trading activity by institutional investors."
ISE's Goldberg agrees that the scheme can act as a catalyst for the introduction of new players. "Pennies certainly have the potential to bring new participants into the options market. For the people that have crafted the algorithms for the equity markets, it's natural to turn their attention to options to understand the opportunities that exist. One of the reasons why the options market has grown so rapidly over the past few years, is that electronic trading has already drawn in new participants from both the retail and institutional side."
Breaking the nickel
Pre-pilot pricing practices put US equity options at a disadvantage to other asset classes from an algo and auto trading perspective, according to Avir Capital's Jain. "The minimum spread in the options market might be a nickel, but more typically it's a dime. That's 0.5 per cent on a $20 stock or 0.2 per cent of a $50 stock, compared with a typical FX option spread of 0.05 per cent. That's a huge difference." Jain expects the advent of penny trading to have a major impact on the ability of electronic market makers to offer competitive pricing. "With decimalisation you'll be able to actively show inside spreads, i.e. the actual price. Right now, if your automated system generates the price of an option of $2.17 you have to round it up to $2.20. If you really want to show a bid-offer spread of $2.11-$2.18, you'll still end up showing $2.10- $2.20. The current situation does not encourage the retail investor, but (under decimalisation) the options market will be more competitive and attractive because you will be able to offer a better price than the guy at $2.10-$2.19, rather than both quoting $2.10-$2.20."
The ability of market makers to price more competitively will not only attract the retail, semiprofessional market, says Jain, it will also encourage hedge funds. "Funds that use options for speculative or hedging purposes will be able to trade a lot more efficiently because they won't have to cross these huge spreads," he says. "It's long over due and it'll be fantastic for the market."
"If you look at where the algorithmic trader can benefit, breaking that nickel allows an algorithmic trader to better that $1.00-$1.05 rather than joining it; going to $1.01 or $1.02 for their bid and exploring the benefits of trading in between that nickel," says Chicago Board Options Exchange Executive Vice Chairman Edward Tilly, who suggests that the attractions of different options classes to algorithmic traders will vary widely as the pilot is expanded. "Can an algorithmic trader really find benefit in going from $1.00-$1.15 to $1.01-$1.16? Algorithmic trading has been most successful in very liquid, transparent, highvolume classes or underlyings, not in markets you can drive a truck through," he says.
Edward Tilly, Chicago Board Options Exchange:
"Algorithmic trading has been most successful in very liquid, transparent, highvolume classes or underlyings, not in markets you can drive a truck through."
Gena Ioffe, CEO of trading systems vendor EGAR Technology and IVolatility, which supplies analysis and trading tools to the US options market, is more sanguine on the buy-side opportunities resulting from smaller spreads "Only a relatively small percentage of options traders just trade spreads. Most firms are using much more sophisticated strategies, so they will be looking at opportunities for spreads in terms of more advanced models, such as dispersion trades (i.e. trading on the difference in implied volatilities between an index and its components) or calendar spreads," he says.
The penny pilot scheme has already introduced new players into the US equity options market as well as increasing the trading activity among existing participants, according to NYSE's Werts. "We're seeing a number of different firms, from proprietary shops and hedge funds that are increasing their options volumes to broker/dealers and larger equity shops that previously only traded equities and that's good for the entire industry."
UBS's Mecane expects an increase in the use of automated trading models that straddle the options and equities markets. "Anecdotally, there's a lot of high volume equity shops that are reevaluating their strategies in the light of changes in the options market and which will become much higher volume players here too." Avir Capital's Jain also predicts a growth in cross-asset automated trading strategies once options fall into line with other markets. "Once the options market improves its price spread efficiency, it should be easier to do cross-asset trades. Right now if I were to trade equity options against FX options, I'd lose so much on the bid offer spread of the equity option it would take away a lot (of my profit) from the trade," says Jain.
Jon Werts, Vice President, Derivative Products, NYSE:
"… professional traders do not have customer priority and cannot float to the top of the order book by hitting cancel/replace all day long,"
Pay your money, take your choice
In part, the response to the penny trading pilot programme is
just another skirmish in the ongoing battle for liquidity between
the major US options exchanges. With six exchanges in
competition, innovation is key. For example, CBOE is one of only
two exchanges to run a complex order book, i.e. it takes strategy
orders that involve more than one strike price, and the only one
that has a mechanism to offer price improvement for complex
orders. NYSE ARCA is the first and so far only exchange not to
levy charges on market participants for cancelling and replacing
prices. "We took that decision for two reasons. First, speed and
capacity are not issues for us," says Werts. "Second, we're a
price time model where 'professional traders' do not have
customer priority and cannot float to the top of the order book
by hitting cancel / replace all day long."But ARCA does combine
its price time model for matching trades with the use of a lead
market maker (LMM). "We think this provides the best of both
worlds," says Werts. "The LMM ensures there's liquidity available
at all times, and the price time element ensures this is a market
in which speed and aggression in pricing is rewarded." ARCA has
also introduced new order types from NYSE's equity platforms into
the options market, such as reserve orders. But perhaps the most
significant difference between exchanges is the fee structures
for price takers and price makers. Specifically for the penny
pilot scheme, ARCA introduced a new pricing model in which market
participants are paid by ARCA for providing liquidity and
correspondently pay out to ARCA as takers of liquidity. "The
economic benefits of this model have driven a lot of business to
our platform," says Werts.
CBOE's Tilly believes ARCA's 'maker-taker' model is having an impact on algorithmic trading in the options market. "Prior to the pilot, options customers have not paid fees to trade, so the burden fell on liquidity providers, but there's been interest from algo traders to capture some of that maker-taker incentive as well," he says. Factoring in the likely expansion of the penny pilot scheme, exchanges must consider any changes to fee structure both from a revenue and a quality of market perspective, according to Tilly. "If the liquidity provider that traditionally pays fees in the options market now receives fees for posting liquidity, his cost model has changed. If it costs him the same to push a dollar bid at CBOE as it does to push a $1.01 bid at NYSE ARCA, there's a market quality issue that's putting pressure on maker-taker vs the traditional fee structure. And that's a situation we're measuring every day."
Under the traditional fee structure used by options exchanges, the customer effectively gets all of the benefit of being able to trade 'between the nickel' on the penny pilot scheme, while the cost of compression of the bid ask is being borne by the liquidity provider. As such Tilly does not rule out CBOE following ARCA's lead in redistributing costs between market participants. "What NYSE ARCA has done is reintroduced a customer fee. I don't think wrongly; it's a very bold move and one that we're all going to have to examine," says Tilly. "If we see a switch in market quality we will have to contemplate how best to lower the liquidity provider fee and that probably means reintroducing a customer fee."
ISE's Goldberg, however, believes his exchange's model will remain attractive. "Are we thinking about moving to maker-taker? Given the pilot results we've seen, we believe our pro rata market structure enables us to maximise liquidity in terms of the quality of the quotes and the sizes available. We have seen no change in the quality of the ISE best bid-offer compared to other markets."
Nevertheless, if CBOE does follow ARCA the pressure might intensify. "If, during an expansion of the pilot, liquidity does migrate to exchanges that offer that rebate, the others will very quickly reevaluate their models," says UBS's Mecane.