US Options Trading 2013: Looking for the Edge

It is getting a lot harder to find a profitable edge in options markets. Not only is volatility range-bound, but traders are challenged to find liquidity in less actively traded options. Brokers continue to rein in capital as part of efforts to rationalize the level of service they provide to clients, and the issue will only get worse as the regulatory focus on bank balance sheets continues to build. Meanwhile, in options where there is liquidity, competition has whittled away the easy opportunities.

Range-bound volatility is creating challenging market conditions for options traders and forcing them to be more aggressive in their search for returns. Traders are refining strategies by using options with more precise strike prices, looking for new opportunities and adjusting expectations to encompass a new environment with lower returns. Not all trading revolves around volatility, however, with many strategies used by asset managers, hedge funds and retail accounts based on price and yield enhancement targets. Although lower volatility impacts these strategies, it does not necessarily obviate potential opportunities.

The buy side is also craving more volatility products, with hedge funds identifying volatility options and to a lesser extent volatility futures, as areas with potential for future growth. Asset managers are more sanguine on these products. Hedge funds also see slightly more opportunity in short-term options with weekly expirations which fit with their more-aggressive trading strategies, although the popularity of weekly options continues to grow in strategies used by asset managers (see Exhibit 1).

After several years of steady investment in technology and systems to support options execution on the trading desk, the buy side has taken its foot off the gas and is increasingly utilizing what they have at their fingertips. The focus has shifted away from deploying new order and execution management tools towards back office systems to manage the trade after it hits the blotter.
Options brokers are facing a challenging revenue landscape as commission rates for options trading continue to decline. It is not pressure from the buy side that is driving rates ever downward. Instead it is competition for order flow among the crowded brokerage arena. Commission rates for electronic flow keep falling as brokers lower rates to attract flow from more active trading accounts that need little other than a fast pipe to exchanges. High touch trading desks are also facing competition, as agency brokers with lower cost structures offer lower commissions to get the trade done.

Even as volatility has waned and equity markets have seen relatively little growth, options have remained as an important tool the buy side uses in strategies to generate returns, to earn premium income and to manage exposure. Volumes may have declined in recent years, but the buy side has adopted strategies and trading processes to manage the new market environment. The buy side’s willingness to adapt to shifting market conditions bodes well for future growth as options become an integral tool to use in any market condition.