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Published in Automated Trader Magazine Issue 37 Summer 2015

Gary Stone and John Gardner of Bloomberg Tradebook on buy side challenges in US equity and index options.

Gary Stone, Chief Strategy Officer, Bloomberg Tradebook

Gary Stone, Chief Strategy Officer, Bloomberg Tradebook

Regulations are having a negative effect on the liquidity of US equity and index options. As banks and traditional market makers deleverage and decrease capital commitment to facilitate trades, it is becoming more and more challenging for the buy side to find the other side.

According to Andy Nybo of the TABB Group in his January 2015 report, "US Options Trading 2014/2015: The Buy side's Insatiable Thirst for Liquidity," 42% of the buy side traders he surveyed said that the lack of liquidity impacted their trading in 2014. Like a surfer on a wave, during 2014, Bloomberg Tradebook saw dramatic shifts in buy side trader behaviour as they tried to adjust to the changing liquidity landscape. Traders were clearly taking greater control over their orders, trying new technologies and execution implementation strategies to get the liquidity they need. Bloomberg Tradebook's algorithm usage statistics tell this story.

In 2014, Tradebook saw more institutions empower their traders. With traditional service and support levels and capital commitment declining, Execution Consultants guided more traders in taking greater control of their executions and working them electronically. Tradebook's experience was consistent with the TABB Group's observations. Again, according to Nybo, "Asset Managers executed 31% of their total volume through electronic tools, up from 15% in 2013." Hedge fund share of volume traded electronically in 2013 / 2014 stayed constant at 62-63%.

In response to growing frustration over the appearance that liquidity faded when they sought to sweep the market, traders increasingly picked their spots - making others act on their liquidity rather than aggressively trying to chase the market. Additionally, passive algorithms are good at extracting liquidity in illiquid options. In 2014, 43% of orders were passive, a 49% increase from the 29% of orders that were passive in 2013.

Trader patience, not surprisingly, was also reflected in the shift of the algorithms used. In 2014, algorithm usage remained strong - at Tradebook, about 44% of trader's single (leg) option orders and more than 62% of complex multi (leg) option orders used an execution algorithm (Figure 1).

Evolution of Electronic Trading Sophistication

Figure 1

The use of pegging to the bid/ask, dynamic delta or volatility doubled during 2014, while the use of more aggressive Discretion algorithms with intelligent Trigger and Fire Quantity dropped about 25%. The use of automated benchmark algorithms plummeted. TWAP, for example, dropped from 15% of orders in 2013 to around 4% in 2014.

The US options market has 12 (soon to be 13) exchanges. Liquidity is extremely well-distributed or fragmented (Figure 2), with no options exchange clearly dominating the market. Traders' response to being traded around - having their order represented on one option exchange only to have trading occur on a different one - has been to leverage tactical algorithms that "work" orders.

Figure 2

For example, Bloomberg Tradebook's B-Smart was the most used algorithm in 2014 by US option traders - with almost 23% of all orders leveraging the algorithm's intelligent liquidity heat-mapping and dynamic order posting/positioning capabilities to seek more optimal placement of orders on the most active exchanges. B-Smart intelligently layers orders and posts liquidity simultaneously on multiple (most active) exchanges. Additionally, when one exchange becomes active in filling an order, B-Smart will pull the child orders represented on less active exchanges and (re)post the liquidity on the more active ones.