The increasingly complex options markets is resulting in a growing demand for tools and systems that can help make options trading more efficient, especially as traders are continue to adopt sophisticated trading strategies, says TABB Group in a new annual research study, “US Electronic Options Trading 2010: Algorithms, DMA and Crossing Networks.” The proportion of order flow moving through low-touch channels is projected to rise to 62% by 2011, as options traders turning to electronic trading systems to manage order flow.
According to Andy Nybo, a TABB principal, head of derivatives and author of the study, “Hedge funds are using direct market access (DMA) and algorithms as their preferred method of finding liquidity, not only because of their more complex strategies, but as a result of traders’ need to reduce execution costs with higher turnover activities.” He adds that TABB expects hedge funds to direct 31% of total trading to algorithmic tools in 2011, up from 9% in 2009.
The report details the proliferation of DMA platforms residing on the buy-side trading desk, identifying key functionalities that make the systems attractive to options traders. “Through more than 50 interviews, we identified 20 different platforms currently deployed to trade options electronically, with the most sophisticated offering a suite of tools that provide complex order-support and algorithmic-trading capabilities,” said Nybo. “We discovered that competition for low-touch flow remains fierce, that brokers are battling to attract customer flow through new functionality and tools designed to meet the needs of the larger number of firms using these low-touch channels.”
TABB also found that there are sharp differences between asset managers and hedge funds. Asset managers, Nybo points out, have been reluctant to use automated trading tools. “Asset managers are heavily dependent on the phone to get their trades done, since they tend to trade infrequently and in larger size, and prefer to rely on their brokers for access to capital and ease of execution. They have little need to learn the nuances of a trading platform.” However, he adds, “One begins to question the rationale of executing via high-touch channels and paying double or triple the going rate for electronic executions, especially for more liquid options. At some point, lower commission rates for electronic execution will become undeniably attractive.”
Electronic commission rates have remained relatively stable since 2009, averaging 89 cents per contract, a slight increase over last year’s rate. The buy side is increasingly negotiating blended options execution rates across voice, direct market access and algorithmic channels that fund commission-sharing agreements (CSAs) for research and other services.
The data, analysis and 26 detailed charts for this study are based on conversations with 51 traders at a broad variety of hedge funds, asset managers and proprietary options trading firms. Data is supplemented by informal conversations with a number of additional market participants, including multi-national exchanges, alternative liquidity pools, institutional broker options trading desks, electronic execution desks and independent options trading system vendors. Firms participating represent an aggregate $2.5 trillion in assets under management (AuM), trading an average of 14.3 million contracts a month. Hedge funds and asset managers make up the majority of participants, accounting for 61% and 33% of the interviews, respectively.
The study also examines the role of crossing networks for options trading. Although existing systems have seen little activity, the buy side is holding out hope for their potential application, Nybo said. “They’re always searching for ways to reduce trading costs, through lower rates or reduced market impact,” adding, ”These systems are competing against options brokers and market makers for order flow, and need to provide an attractive value proposition to succeed.”
The 34-page report with 26 charts can be accessed by TABB Group Research Alliance Derivatives clients and pre-qualified media at https://www.tabbgroup.com/Login.aspx. For an executive summary or to purchase the report, please visit http://www.tabbgroup.com or write to info@tabbgroup.com
Recent related TABB research includes: US Options Trading 2010: The Resurgence of the Broker; European Derivatives 2010: The Buy-Side Perspective on Equity Options, Futures and Swaps; US Options Market Makers: Evolution or Extinction?; US Options Market Structure: The Shifting Exchange Landscape; and Options Liquidity Matrix™, an exclusive TABB monthly report that analyzes execution quality at eight US options exchanges.