I want to thank everyone involved for giving me the chance to guest edit the John Lothian Options Newsletter this week. I’m continually amazed by the quality, quantity, and most importantly the relevance of the content produced by the JLN team and I find this newsletter to be a true time-saver in the quest for intelligence amid the fragmented mass of news out there- a quest very much in-line with how my firm handles option data for option professionals from Wall Street to South LaSalle Street (nice segue huh?)
I’ve been involved in listed options for a full 25 years now and I’ve spent plenty of time on trading floors, trading desks and, more recently, inside data-center cages. Even those ‘newbies’ who recently entered our markets have seen significant change, with clear consequences to those who fail to adapt as our markets evolve.
In my career I’ve seen many milestones that have had a massive impact on today’s business climate. When I started on the CBOE in the late 1980s long scrolls of paper printed with the tiniest possible font provided an ‘edge’ over old school traders who relied on relative pricing to guide their markets. These ‘sheets’ were followed quickly by the first trading screens that displayed live values to traders using top secret codes that were quickly deciphered by the rest of the pit. Touch screens came next, allowing clerks to update portfolios in near real-time, and finally hand-held computers began to make their appearance, despite buggy hardware and short battery life.
In terms of market quality, the ‘gentleman’s agreement’ that kept issues single-listed through the 70s and 80s fell quickly in the early 90s, greatly increasing competition and improving the prices customers received on their orders. Internalization became much more prevalent at the same time, with the market-making community reluctantly giving up participation in many trades in order to stay in the good graces of the upstairs desks that had the power to direct future orders their way. The emergence of the all-electronic ISE in 2000 was a game-changer as the first new options exchange in decades and, more-importantly, the first truly instant and anonymous market for options trading- which quickly attracted the most technologically advanced traders. Decimalization of both equity and option markets tightened quotes further, while payment for order flow and complex fee structures created a new job title on Wall Street: “feeologist.”
If that sounds like a lot of change in a few decades, it’s nothing compared to the pace of change more recently. Seven additional options exchanges have launched since 2002 (and they are talking about #13 now), the most popular trading names now trade in penny increments, and nearly 1/3 of the average daily volume is in short term ‘weekly’ options.
While these changes have clearly led to winners and losers among participants, it seems clear customers have generally benefitted, evidenced in an explosion of market volume from 1 billion to 4 billion contracts in the past ten years. New offerings, especially in the class of ETPs and Volatility-based products, have breathed new life into the market.
While volume growth is a positive for the industry overall, many participants are finding it hard to realize profits in today’s market. The steady escalation of technology and compliance costs is decreasing the returns to scale and forcing consolidation. Many small-scale market-makers have transitioned to a ‘market-taker’ proprietary model in order to survive, and many fear the Volker rule curbing proprietary activity could significantly impact volumes.
Concentration of volume is also a concern; 5% of the 4100 listed products provide 80% of the average daily volume. In fact half the listed names average fewer than 100 contracts per day. Of course the low volume names wind up with very wide markets and a vicious cycle ensues.
I believe the next few years will be pivotal for the options markets, with firms large and small trying to find their footing amid intense technological and strategic demands. Pure market-making for ‘edge’ has gone the way of the dodo, but a healthy community of niche players with myriad strategies can result in a level of liquidity as good as, if not better than, the depth quoted by the pits of 200 screaming guys (and a few brave ladies) that were the foundation of our markets not long ago.