Options Trading is Not Dead, Institutions Ramping Up

Courtesy of TABB Forum

Options trading volumes may be down across the industry but the buy side continues to remain captivated by the potential of using options. TABB Group expects options volume to decline by as much as 10 percent in 2012, yet a combination of greater buy-side adoption and increased focus on managing risk will set the foundation for future growth, especially when investors refocus their attention on equity markets.

Global equity markets are under stress and for good reason. Many observers consider the markets to be broken, with structural inequities that favor professional investors over the uniformed.

Add to that slowing global growth, continued political uncertainty and new regulations that threaten to indelibly shift market structure and you have most of the reasons that can explain today’s depressed U.S. equity trading volumes, which, this year through July, are off more than 14 percent compared with the same period in 2011.

The impact can also be seen in U.S. options markets. However, the drop has been less severe, with trading off just 7 percent this year, through July. A number of factors are contributing to this phenomenon, including greater adoption of options strategies by the buy side as well as replication strategies that use short-term options as a proxy for the underlying security. But perhaps the biggest factor contributing to the disparity can be observed in the new ways that buy-side firms are using options in their strategies.

Growing Sophistication and the Rising Complexity of Strategies
The buy side is becoming more sophisticated in its options trading strategies with traders at both asset managers and hedge funds using more-complex strategies in their trading activities. Multi-legged options trades make up a growing proportion of trading volume, as the buy side looks for cheaper and more efficient ways to manage exposure. And as buy-side trading activities become more complex, investment managers are investing in more powerful technology systems to support the growing complexity of both their front- and back-office derivative activities.

Buy-side firms are upgrading to newer versions of order management systems that can support options and provide real-time pricing, analytics and FIX connectivity to broker trading desks. Traders requiring more sophisticated functionality are deploying best of breed execution management systems alongside existing trading platforms in order to support complex orders and algorithmic trading capabilities.

Strategies have moved beyond traditional covered call writing programs to strategies that include collars, straddles and strangles. Buy-side traders are becoming more adept at trading options and are learning the nuances of positioning risk exposures through the most effective combination of options.

Product Innovation and Greater Adoption to Come
As buy-side firms seek ways to improve returns, they are exploring new products and ways to use options in strategies. No surprise that volatility-related products are gaining a bigger share of attention, especially as investment managers seek better ways to hedge and manage exposure in today’s highly correlated markets.

Volatility has become a much more important metric for buy-side traders and although most do not use it as a trigger to trade, they do monitor and analyze volatility as a part of the trading process. This greater focus on volatility is part of the reason firms are investing in more technology to support options trading. As they refine strategies, they are much more attuned to the impact of volatility on the success of a trade.

Buy-side firms are also looking at trading in ETF and index products as they refine exposure and look to hedge more targeted strategies using options. They are looking to use ETFs that allow them to express a directional position in foreign markets, as it is more efficient to trade that option in U.S. markets than to establish the capabilities to trade in the foreign market itself or through a bespoke over-the-counter trade with a broker.