Options and Equities: All Together Now
One consequence of increasing market fragmentation has been the continual challenge of combining a holistic view with a holistic execution environment that includes all the right tools. While this fragmentation effect now applies across many market segments, it is particularly acute in US equities and equity options. Most solutions currently available here can at best only deliver a partial solution. Gary Stone, Chief Strategy Officer at Bloomberg Tradebook, takes a look at what's needed to deliver the complete package - and how to get it.
While there's no shortage of solutions available claiming to provide consolidated visibility and execution for US equities, anyone currently looking to trade equities/options or options/options has an extremely limited choice. The individual market environments for equities (14 exchanges and multiple dark venues, largest single market share 20%) and equity options (9 exchanges with the largest single market share around 28%) are tough enough in their own right. But try to consolidate across both complexes and the challenge becomes exponentially greater.
A further consideration is the change underway in option markets. The penny pilot program has enabled high frequency trading strategies to proliferate, which for those accustomed to the certainties of an environment where there were clear market maker obligations represents a whole new layer of execution complexity.
The exchanges are obviously aware of the difficulties confronting traders wanting to operate across equities and equity options and have tried to assist with mechanisms that allow one stop package trades including both. They offer traders "spread" books that allow quoting and trading in "pre-packaged" spreads. While this offers a measure of certainty (i.e. no "leg" or "slippage" risk from operating in the two different securities independently), in order for a trade to execute, the exchange has to have sufficient liquidity in both instruments simultaneously, which is by no means a given. In effect, greater certainty comes at a significant opportunity cost of vastly reduced access to liquidity. In this fragmented world, it is a lot to ask of an exchange to have not only the best bid/offer in two securities at the same time but also sufficient liquidity for the trade to be material. This is inadequate for an equity/option arb/hedging world where potential
P&L per unit is often small and the efficient use of capital depends on the ability to execute trades in sufficient size.
One stop shop
Although the spread books do have some liquidity, in this fragmented high frequency world, finding the best possible execution in sufficient size requires a platform that can aggregate the largest possible number of liquidity sources for both equities and options. Moving from trading the "package" to managing aggregated liquidity across multiple venues introduces additional execution risks. The right algorithmic execution tools are needed to negate "leg" risks. Although it is possible to manage such an option/option or equity/option spread pairs by swapping between execution screens for each leg, executing in this manner also increases the potential for sub-optimal execution from "leg" or "slippage" risk. Optimal execution requires a single consolidated transparent interface and sophisticated execution algorithms.
Figure 1: Tradebook Equity/Option Pair ticket launched from Bloomberg Professional OMON screen
A good starting point for this sort of platform could be an equity pairs trading interface that already incorporates execution algos; adding option functionality to this would then deliver optimal flexibility across multiple strategy types - vol trades, option/equity pricing arbs, as well as pairs strategies combining both equities and options. It also has the virtue of making the most efficient possible use of available desktop real estate. Furthermore, access to the very significant dark liquidity available in US markets provides the further opportunity of maximising profit per trade, particularly when combined with the ability to specify minimum/maximum prices for any leg of a trade.
However, while existing pair algos may work well for equity pairs, a different approach is often required for equity options. Liquidity in the options market can have a very different profile than equities; naively applying a conventional equity pair algo to the options market is susceptible to market impact by continually pushing to execute. For example, an algorithm that constantly trades when the pair hits the desired spread may hold the market from providing price improvement and potentially signal to the market that there is an algorithm at work. By contrast, adding a TWAP overlay to the execution has the effect of elongating the executing time by systematically pausing the execution and randomly re-engaging, allowing the spread to "breathe", thereby enabling the often large (for capital efficiency/P&L reasons) equity/option and option/option trades to execute more gradually and minimise impact.
Legging, pegging and pausing
While sourcing equity and option liquidity across multiple venues has implicit legging risks, these can be minimised with the right tools. Most applications have a rather limited response when a leg gets hung up; they either immediately go to market or pop up an alert. Neither response is particularly helpful; the first increases execution costs (perhaps substantially), while the second compels the trader to react (possibly prematurely).
Figure 2: Example of Option/Option pair from Tradebook's PAIR platform
Better alternatives include allowing the trader to specify a time limit before further action, in case the market drifts back in the right direction of its own accord. If this doesn't happen, a second stage would be to enable the trader to grant the application a specific degree of price discretion.
A further method of maximising control of a multi-legged trade that includes equity options is pegging. In an ideal world, the trader needs the facility to peg each leg of a trade to a benchmark, which could be volatility or delta or just a target spread value.
Upper and lower bounds set on either side of these benchmarks can then be used to control the execution algorithm behaviour, such as pauses. A further advantage is if the pegging is in line with a market benchmark. (For example, in the Tradebook, peg to volatility is completely synchronised with Bloomberg's OMON (Option Monitor) values.)
The ability to control algorithm behaviour automatically in this manner is particularly important in the case of equity/option and option/option trades, which often have a lot of moving parts. Even a relatively small movement in a single component part can wipe out the entire trade's P&L. For example, the sale of a call vertical (option/option) has a short delta component to it which has to be hedged by buying the underlying. As the underlying equity rallies, the trade becomes less attractive. By the same token, a buy/write (buy stock, sell call options) may become suboptimal when the net absolute premium of the options being sold drops below a certain level.
Strategies that combine equities and options can easily create a risk management and book-keeping nightmare. Therefore any trading application needs to be tightly integrated with both the trader's blotter and middle and back office systems. A common situation where this degree of integration is especially valuable is where the trader is working in the same name across multiple strategies. A very simple example of this would be selling multiple calls delta neutral against the underlying stock but where only half of these were a vol sale, while the remainder were part of a vertical spread. The ability to both separate and combine the view of these transactions hugely simplifies risk management and back office admin, as well as minimising operational errors. By the same token, being able to access the application's functionality in another trading application (such as an execution management system) also adds significant workflow value.
Integration in a different sense also plays a part in efficient equity/option and option/option trading. For example, many traders like to be able to run a potential strategy in simulation mode and then activate it with real capital if performance proves satisfactory. Particularly with more complex strategies that may involve multiple option legs, a simple record of simulated P&L is insufficient, as it gives no indication of the scale of the risks incurred with respect to the option Greeks.
Therefore the trading application needs to be tightly integrated with analytical and graphical tools that will allow the calculation and display of all risk factors associated with the strategy, both historically and in real time.
For further information, contact: Gary Stone, Chief Strategy Officer, Bloomberg Tradebook +1-212-617-2297, email@example.com
Historically many traders of equity/option strategies have seen the packaged transactions available from individual markets as the "safe" option. While there might once have been a measure of truth in this, times have changed. Now traders have the opportunity to access the liquidity needed for a single trade across multiple venues and maximise P&L through better execution, while simultaneously tightly managing any associated risks.
That opportunity is called Tradebook Pairs...
Options involve risk and are not suitable for all investors. For more information, please read the Characteristics and Risks of Standardized Options. For an updated copy please visit the OCC's website (http://www.optionsclearing.com/) or contact us at 212.617.3917.
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