Lynn Strongin Dodds talks to Charlie Ryder, Manager, Regulatory Affairs at the World Federation of Exchanges about the drivers behind the popularity of index options.
It is easy to see why index options have captured the imagination of both retail and institutional investors over the past three years. Shifting macro conditions and rising geopolitical tensions have forced market participants to change gears and look at strategies that help navigate uncertain and tumultuous conditions.
The momentum is reflected in the latest figures from the Options Clearing Corp. It shows that index linked options in the US alone – the largest market – jumped by 4.1% to $86.2m in February from $82.6m last February. The fastest growing category was equity options where $645m contracts changed hands, an almost 25% hike from $521m during the same time period. Separate research from Nasdaq reveals that retail investors are helping drive the trend.
They spurred a hefty 62% growth in average daily volume from 2022 to 2023, and 38% rise from 2023 to 2024 year to date in August 2024. The figures for their institutional peers were a 57% and 41% increase, respectively.
To gain a further insight into these instruments, we interviewed Charlie Ryder, Manager, Regulatory Affairs at the World Federation of Exchanges (WFE) about the drivers and outlook.
Q: As a starting point can you please describe how these indices linked options work?
A: These are financial derivatives that give the holder the right, but not the obligation, to buy or sell the value of an underlying index, such as the S&P 500, Nasdaq 100, EURO STOXX 50, Nikkei 225, or ASX 200, at a predetermined price (the strike price) before or on a specific date (the expiration date). Unlike options on individual stocks, which may involve physical delivery of the underlying asset, index options are generally cash-settled – making them useful for investors who do not want to deal with the complexities of physical asset transfer. They can be either European-style, exercisable only at expiration, or American-style, exercisable at any point before expiration. There is a broad array of products available, catering to different investor needs. For example, a 1:1 ratio option, which is based on the entire index, or mini and nano options, which are 1/10th or 1/100th the size of a standard contract, and more accessible due to their affordability.
Q: Why have index options become so popular?
A: Their popularity cannot be attributed to just one thing, it is likely a multitude of factors driving this trend Barriers to entry have certainly lowered, but one of the big themes, which is not discussed as much, is how the broader market has changed. There was a lot of focus on idiosyncratic risk in individual stocks following the pandemic, before an inflection point in 2022 which led to a greater focus on inflation, job data, and interest rates. Index options were an affordable and flexible way to gain exposure to broad market movements, as well as the volatility in the market.
Q: You mentioned there is a wide array of products, but I noticed that zero days to expiration (0DTE) options are really gaining traction. Why is that?
A: 0DTE options enable investors to take positions on whether a particular index will rise or fall by the end of the day. Following the addition of daily expires for the Nasdaq 100 and S&P 500 0DTE options contracts in 2022, Cboe have now introduced daily expiries for Russell 2000 index options and exchange traded funds (ETFs), while Germany’s Eurex exchange offers 0DTE daily options on the EURO STOXX 50 and DAX index. Their main benefits are a much more targeted and precise exposure to an index, as well as a quick and efficient response to sudden market movements due to specific events.
Q: Why do you think retail participation has grown?
A: Several factors have removed frictional costs and increased accessibility for end users, such as new technology, contract size flexibility, reduced bid-ask spreads, and quicker onboarding. But there are differences across jurisdictions and demographics. For example, in developed markets, one cannot assume that significant option volume comes from retail participants, or younger demographics. The likes of liquidity providers and bank flow desks use index options to manage risk in ways that are not mutually exclusive, and products such as defined-outcome ETFs with embedded optionality have grown in popularity with older investor segments who want exposure to indexes with the ability to tailor their exposure over a certain time-frame.
In some emerging markets, you may see a younger, more tech savvy generation develop interest in products with smaller contract sizes. This often coincides with a rise in discount brokers, and the entrance of high frequency traders. This was the case in India, where weekly contracts boomed in popularity during the pandemic, The regulator – the Securities and Exchange Board of India (Sebi) – has since clamped down on these markets. Last year, the regulator proposed raising the minimum trading amount by over three times, reducing the number of contracts expiring each week and hiking trading margins.
This year, Sebi proposed that only indices with at least 14 stocks should be eligible for options and that no single stock should dominate the benchmark. This means that the top three stocks together cannot have more than 45% weight, and no single stock can have more than 20%.
The regulator is seeking to protect lesser experienced market participants, as it considers institutional and more sophisticated retail investors as those with access to more advanced risk management tools, and therefore potentially more appropriate users for these products. However, this may not always be the case in all jurisdictions. As trusted and neutral infrastructure, our members continue to work on a multitude of initiatives to build education and resiliency in their markets.
Q: What are the challenges overall with using index options?
A: Brokers need to match investors to products that are suitable for them. Investors need to have the requisite knowledge and understanding of the exposures they are taking. For developing markets, every-day challenges also include lengthy approval processes for new products, as well as facilitating access to markets (which likely require investors to move funds onshore and convert into local currency).
Q: What is your outlook? Will the momentum continue?
A: Given the multitude of factors at play, there is less reliance on one particular trend to continue the momentum of and demand for index options. These products enable a wide variety of investors to capitalise on different types of market movements with targeted exposures, and there may be space for further innovation with optionality built into other products as we have seen with ETFs. Many investors want greater flexibility and more risk management tools, not less.
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