Global equity markets are under stress -- for good reason. Many observers consider the markets to be broken, with structural inequities that favor professional investors over the uniformed. Add to that slowing global growth, continued political uncertainty and new regulations that threaten to indelibly shift market structure, and you can explain today's depressed U.S. equity trading volumes, which are off nearly 14 percent in 2012.
The impact can also be seen in U.S. options markets, where trading is off 6.0 percent this year. Even though options trading volumes may be down across the industry, however, buy-side firms continue to be captivated by the potential of using options in their trading strategies. Tabb Group expects options volume to decline by as much as 10 percent in 2012; yet a combination of greater buy-side adoption and increased focus on managing risk will set the foundation for future growth in options, especially when investors refocus their attention on equity markets.
The buy side is becoming more sophisticated in its options trading strategies, as traders at both asset managers and hedge funds become comfortable with more-complex options strategies. Multilegged options trades comprise a growing proportion of trading volume, as the buy side looks for cheaper and more efficient ways to manage exposure. And as buy-side trading activities become more complex, investment managers are investing in more powerful technology systems to support the growing complexity of both front- and back-office derivatives activities.
Buy-side firms are upgrading to newer versions of OMSs that can support options and provide real-time pricing, analytics and FIX connectivity to broker trading desks. And traders requiring more sophisticated functionality are deploying best-of-breed execution management systems alongside existing trading platforms in order to support complex orders and algorithmic trading capabilities.
Options strategies have moved beyond traditional covered-call writing programs into strategies that include "collars," "straddles" and "strangles." Buy-side traders are becoming more adept at trading options, and they are learning the nuances of positioning risk exposures through the most-effective combination of options.
A Cure for Volatility?
As buy-side firms seek ways to improve returns, they are exploring new products and ways to use options in strategies. It's no surprise that volatility-related products are gaining attention, especially as investment managers seek better ways to hedge and manage exposure in today's highly correlated markets.
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Volatility has become a much more important metric for buy-side traders, and although most do not use it as a trigger to trade, they do monitor and analyze volatility as a part of the trading process. This greater focus on volatility is part of the reason firms are investing in more technology to support options trading. As they refine strategies, they are much more attuned to the impact of volatility on the success of a trade.
The Relevance of the Broker
Despite the increased complexity and growing role of technology, full-service brokers are not quite yet destined for extinction. Brokers bring a broad suite of services critical to the buy side's options trading success, including execution expertise, research and market color, strategy advice, and technology support. A broker's most important service, however, is its balance sheet.
Providing capital to clients trading in size or in illiquid options is the most important criterion that buy-side traders evaluate when determining with whom to trade. Low-touch channels may suffice for more-liquid options with significant electronic liquidity, but the buy side depends on its top brokers for capital in hard-to-trade names.
Regulation's Impact on Liquidity
The buy side also is keeping a close eye on the potential impact of the Dodd-Frank Act on options market liquidity. Many firms Tabb Group spoke with identified a notable decline in liquidity from proprietary trading strategies that were once emanating from the sell side, even though the final rules governing this type of activity are months away from fruition. The buy side is significantly concerned about what will happen when the rules are finally implemented and how the liquidity profile of the options they are trading will be impacted.
But where there are challenges there are also opportunities. More than a few funds are optimistic concerning the ultimate impact of regulatory changes, especially when they trade using aggressive strategies around volatility. As bank proprietary trading desks exit the market, these funds sense a significant opportunity for greater profits as spreads widen.
Future growth in U.S. options trading is a foregone conclusion. Buy-side firms are moving beyond building out the basic technical infrastructure to support options trading and are expanding their trading capabilities and horizons to include new products, new markets and more-complex strategies. Investment managers are always on the hunt to find new ways to both earn alpha and hedge exposures. And as these strategies are implemented and evolve over the coming years, options will become a bigger part of the buy-side's trading activities and will contribute to growing volumes.
Andy Nybo is a principal and head of the derivatives practice at Tabb Group, the financial markets strategic advisory firm. Reach him at firstname.lastname@example.org.