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The Rush to Alternative Investments

Extreme volatility and macroeconomic uncertainty are driving the buy side into alternative investments. But firms are using options to boost returns, not just hedge positions.

Exchanges Bet on Proprietary Products

Some of the biggest options exchanges are benefiting from the overall market volatility and higher volumes in alternative asset classes. The combination of NYSE Arca and Amex collectively held 26.4 percent share of the equity options market (excluding index options and options on ETFs) in August, while Nasdaq's Options Market together with PHLX OMX realized a 25.8 percent share and CBOE/C2 garnered almost 21 percent.

To capitalize on the growing interest in equity options, the Nasdaq OMX PHLX platform has added a complex order book and price improvement functionality. "Our growth has been in the customer area, and it's all two-, three-, four- and five-legged transactions where you've got more than one option against another option," says Tom Wittman, president of OMX PHLX. "More and more customers have been using it to hedge their portfolios."

To continue growing its business, Wittman says, the hybrid electronic exchange has renewed its commitment to developing proprietary products. In 2011 it rolled out the Alpha Index Series, which calculates the relative performance of stocks such as Apple, Google, IBM or Intel versus the SPY -- the popular ETF based on the Standard & Poor's 500 index of stocks. "Instead of buying an option just on Apple, you can say that Apple is going to outperform the S&P," explains Wittman. "We list options [calls and puts] around that value. We're actually trading options on that index calculation."

Though he hasn't tried the new PHLX contracts, Wilmington Trust's Davenport says the idea is an innovative way to think about alpha. When Apple was at $390 a share in late August, "The price of the stock isn't what people are buying -- they just want to buy the outperformance of the stock, so this gives them more leverage on the alpha," the investment manager explains. "If I can buy an option on just that alpha, it doesn't matter to me what the price of Apple is."

In Search of Options Liquidity

According to Andy Nybo, head of derivatives research at Tabb Group, "There is increased interest in just about any type of options strategy, whether it's liquidating positions, hedging positions or entering new positions." With their share of total options activity rising to 20 percent in 2011, asset managers accounted for nearly as much options trading as hedge funds, which accounted for 22 percent; by comparison, market makers accounted for 46 percent of options trading and retail trading accounted for 12 percent, Nybo reported in his recent U.S. Options Trading 2011 report.

However, "It's becoming harder to find the other side of the trade," according to Nybo's report, which noted that, based on OCC data, options liquidity is concentrated in the top 100 names. "Traders looking for liquidity in less- liquid options are still dependent on picking up the phone to call high-touch brokers -- or sending instant messages to their buddies -- for access to capital and contra-side flow," Nybo wrote. But, "The inevitable creep toward electronic adoption continues in 2011, with high-touch order flow accounting for 34 percent this year, off from 36 percent in 2010." Nybo's report is based on interviews with 51 head traders at asset management firms, hedge funds and proprietary options trading firms.

On the asset management side, Tabb Group estimates that 8 percent of options volume will be executed via electronic direct market access (DMA) in 2011, up from 3 percent in 2010; meanwhile, algos will account for just 3 percent of that volume, though they accounted for none of the volume in 2010. In 2011, according to Tabb, 89 percent of options volume from asset managers will be traded over the phone, down from 97 percent in 2010.

Hedge funds, however, have embraced electronic order channels more rapidly than long-only managers, Tabb Group reports. The research and advisory firm estimates that 38 percent of the options volume from hedge funds will be executed via DMA platforms in 2011 (about the same as in 2010), while algo usage will account for 30 percent of their flow, a substantial increase from the 23 percent in 2010. "The adoption of algos by hedge funds continues to grow, especially for short-term strategies in more-liquid names," according to the Tabb report.

M3 Capital's Netto points out that electronic trading has given professional traders direct market access to the options exchanges. While he won't comment on the technology behind his strategies, Netto acknowledges using three electronic platforms -- Bloomberg, CQG and Trading Technologies -- to access liquidity and enhance alpha. "I can trade algorithmically," he comments. "It's less sophisticated than it sounds."

And the ability to trade alternative investments will only become increasingly important as traders navigate uncertainty at the macroeconomic level, Netto predicts. "We're going to have more volatility," he says, "and those who prepare for it will do well."

Ivy is Editor-at-Large for Advanced Trading and Wall Street & Technology. Ivy is responsible for writing in-depth feature articles, daily blogs and news articles with a focus on automated trading in the capital markets. As an industry expert, Ivy has reported on a myriad ... View Full Bio

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