According to TABB Group in a new research report published today, "Trying to Make Change: Market Makers and the Evolving Options Market," the changes sweeping through the options markets are resulting in considerable challenges for options market makers. "With daily volume regularly exceeding 15 million contracts and volatility in the underlying U.S. cash equity markets making 300- and 400-point intra-day swings commonplace, market makers lacking sophisticated technological capabilities are at a critical disadvantage," writes Andy Nybo, senior research analyst at TABB Group.
For market makers, Nybo explains that regulatory initiatives such as penny increments and dollar strikes require changes to business models and technology infrastructure. "Penny-price increments result in an increasingly competitive business environment, forcing them into making tighter markets, sharply reducing their profit potential. Dollar strikes have another downside, namely increased quoting requirements."
The evolving options market structure has attracted the attention of a powerful new class of trading institution. Rising liquidity, greater adoption of technology and structural changes have combined to create a fertile ground for these institutions, which use quantitative trading strategies perfected in the equity markets to leverage the evolving options marketplace. These new players, he says, "are leveraging the capabilities of technology to implement quantitative modeling with automated systems that mimic trading techniques long used by market makers."
Nybo adds, "Market makers must have the same powerful technologies at their fingertips in order to manage the evolving complexity of the buy side’s trading strategies. And as the buy side continues to become more sophisticated and leverages technology to its advantage, market makers must invest in systems that are even faster than their customers’."
The introduction of new pricing models by exchanges is creating a market environment ripe for new trading strategies revolving around quantitative models that exploit fleeting arbitrage opportunities and market miss-valuations to leverage electronic trading in order to achieve returns. Although it is a nascent phenomenon in the options market, all of the ingredients are present for the successful implementation of these automated strategies. Technology has become more powerful and affordable, trading volumes are rising and regulations are creating an environment that is favorable to the execution of these automated strategies. "As exchanges fight for market share through new pricing schedules and trading protocols, market makers will need to adapt and choose when and where to operate," says Nybo.
In Europe, however, disparate exchanges and limited inter-connectivity are resulting in significant complexities for market makers with cross-border operations. "Managing a multitude of connections in different countries, all with different regulatory regimes, quickly becomes a full employment act for compliance departments," writes Nybo. "With the need to support a wide variety of proprietary protocols for each individual exchange and dramatically increasing bandwidth requirements, it’s clear that operating in multiple jurisdictions requires significant investments in both staff and technology."
Internationally, TABB Group believes Asia, Europe and South America as well as derivatives markets in other locations offer substantial promise for firms that can invest in the connections and systems that open up the market to existing clients seeking the next opportunity for alpha. "As these markets mature and electronic connectivity becomes a reality, the first movers will have extensive opportunities to profit before the masses move in and eat away at margins, says Nybo."
The research can be downloaded by TABB Group Research Alliance Derivatives clients and qualified media at https://www.tabbgroup.com/Login.aspx. To request an executive summary or to purchase the report, please visit http://www.tabbgroup.com/ or write to info@tabbgroup.com.
