Money manager moves into options are spurring new trading models and technologies that market experts said will help support institutional investors’ growing interest. According to estimates from exchange executives, institutional investors now account for 50 per cent of options trading, up from an estimated 35 per cent five years ago. Options volumes have set one record after another since 2003, reaching 2.86 billion contracts globally in 2007.

The trend is not abating as 1.16 billion contracts already changed hands through April this year, a 44.5 per cent increase from the same period in 2007. “Institutions behaved differently during the recent market downturn than during the bursting of the Nasdaq bubble. Instead of letting a chunk of their assets melt away, more managers sought to protect their portfolios by hedging with options,”

Phil Gocke, managing director at the non-profit Options Industry Council, Chicago, said. Hedge funds’ explosive growth “was started by the Nasdaq bubble when a lot of former sell-side traders used their expertise in derivatives in a difficult market environment. These people know the market and want sophisticated trading solutions,” Gocke added. Hedge funds with more than US$1 billion in assets under management accounted for the bulk of institutional options trading, while 40 per cent of traditional asset managers said they have favourably changed their attitude toward these investments, according to a February report from the Tabb Group.

The report was based on interviews with options traders at hedge funds, asset management firms and proprietary trading groups. To meet the rising institutional demand for options trading, exchanges and brokers are starting to adapt the same technology that has already propelled stock trading into the 21st century — algorithms, order crossing, smart routers and liquidity aggregators.

The new solutions were the focus of the Options Industry’s annual conference held in Las Vegas earlier this month. “Over the past six months, I have seen significantly higher interest in trading options on the asset managers’ side due to the high market volatility that managers need to hedge against. They often ask if we offer an API (application programming interface) because they want to plug their own algorithms into our trading system,” according to William McGowan, managing director at Interactive Brokers . “Traditional investors may not want to put options positions on their books, but they certainly deploy their capital to gain exposure to that market via funds-of-funds, which are very sophisticated in their handling of options trading.

They want the best technology,” McGowan said, adding that some clients want their servers in the same location as their brokers to reduce the time required to access servers handling orders on exchanges. Another factor pushing the adoption of the latest technology is the Securities and Exchange Commission’s ongoing pilot program to quote options in pennies instead of five- or 10-cent increments. This has already led to an explosion of data across the seven US options exchanges, including the Nasdaq Options Market, launched on March 31.

In an electronic format, options exchanges are now adopting some of the incentive programs to lure liquidity that the stock markets introduced, such as NYSE Arca’s “maker-taker” model, which first surfaced in the world of electronic communications networks. Participants who “make” a market by posting orders on an exchange receive a rebate for the fees they are charged when they execute a trade and thus “take” liquidity from the order book. The model is particularly appealing for hyper-active traders armed with smart technology to jump from market to market, contributing to the volume increase. But this model also helps electronic arbitrageurs tighten spreads.

As options trading mirrors more and more the equity markets, it will face some of the same challenges — in particular the hunt for liquidity spread across exchanges, the over-the-counter market, internalisation on brokers’ institutional desks and possibly the development of options “dark pools.” Yet, substantial differences remain between the equity and options markets, so that some of the stock trading models might not apply to derivatives. For instance, institutional investors have embraced equity dark pools for medium- to small-capitalisation stocks. But finding a match for an illiquid out-of-the-money options contract may be far more challenging.

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