Derivatives Trading:

Hedge Funds Lead With Equity Options Algorithms As Electronic Markets’ Liquidity Feeds Strategies

Originally published March 3, 2008 

NEW YORK — Equity options markets are exploding and increasingly require advanced algorithms to handle the growing complexity of the marketplace. Business is taking off on the coattails of the equity market’s growth. Already, options trading is the third-most utilized strategy in algorithmic trading after equities and foreign exchange (FX), according to a study by consultancy Aite Group.

A contributing factor is the huge uptake in electronic trading in the options business, which previously was heavily manual and voice-brokered. "It has spurred a tremendous amount of trading volume in the marketplace," says Sang Lee, Managing Partner at Aite Group.

People are looking at opportunities in asset classes beyond equity. "It is becoming increasingly tough to make a living trading only equities," says Lee. "So people are looking at other asset classes or derivatives of equities. They are studying the lessons learned in the equities market to figure out where they can apply algorithms to different asset classes. Options trading is certainly one, especially as the market goes more electronic and spreads tighten."

An industry benchmark study by The Tabb Group suggests that "a perfect storm is about to hit the US equity options market" given a more accommodative regulatory environment and improved understanding of the benefits of options strategies. Sourcing statistics from the Options Clearing Corporation, the study notes 2.8 billion equity options contracts were traded in the US in 2007, a 41 percent increase over 2006. "Long perceived as a financial flea market where naïve and uninitiated speculators attempted to get rich overnight, the options market is now a sophisticated bazaar where professionals ply their trade, using refined financial techniques that can no longer be viewed or portrayed as even remotely speculative," write Andy Nybo and Kevin McPartland, senior analysts and co-authors of the Tabb Group study, "Equity Options Trading 2008: Rising Out of Obscurity."

Nybo and McPartland estimate that only 30 percent of institutional investors are actively using options as part of their portfolio strategies. While the overall presence of algorithms in options is still far behind equities, some firms are aggressively developing options trading algorithms. Many of the strategies that are considered algorithmic at this point are designed to seek out the best price, for example, says Aite’s Lee. That would involve the ability to aggregate for different execution venues. These tools are the first generation of algorithms, which can be equated with order routing technology. Tabb Group forecasts that 35 percent of all order flow in equities options will be trading algorithmically by 2010 and more than 60 percent of all buy-side options trades will be executed through low-touch channels.

"The sell side and high-frequency-trading buy-side firms currently use options algorithms," says Lee. "Use of these options strategies is very much hedge fund-heavy. There are several reasons they would use algorithms. First is the operational issue. If it is a simple trade, they don’t want to do it manually. It saves them time so they can focus on tougher trades. Some hedge-fund traders say even if they don’t capture alpha, but just break even, that in and of itself is good. All they have to do is worry about making investment decisions. That is where they make their money."

Buy-side traders and hedge funds seek the ability to access different algorithms from multiple brokers on a single, broker-neutral platform.

Options-oriented algorithms are a natural extension of equities algorithms, says Frank Troise, Head of US Equities (equities and listed options) Electronic Trading Products at Lehman Brothers. "Over the past few years, we have seen increases in electronic options liquidity," says Troise. Exchanges, broker-dealers and other market participants have been upgrading their technology to support electronic trading. A few years ago, only a few brokers were able to deliver electronic trading capabilities for options trading. "In the last couple of years, brokers have launched next-generation trading tools by delivering options smart routers to clients," says Troise. "That is a more sophisticated market access tool than pure direct market access. In 2007, we launched our first, client-facing algorithm, Options Work and Pounce. It is one of many in our planned suite of options algorithms. Work and Pounce opportunistically looks to execute trades by reacting to price and liquidity changes in the market."

To date, the primary users of Options Work and Pounce are hedge funds. The development of options algorithms has been in direct response to customers in the hedge fund community, according to Troise. The users tend to be previous electronic equities trading customers of Lehman Brothers. Other adopters have been customers already trading options with Lehman via traditional means. Ultimately this is a complementary liquidity access tool.

The benefits of using options algorithms come down to liquidity access and operational efficiency, adds Troise. "Reliability is another extremely important aspect," he says. "We run a very extensive beta cycle on our desk for these algorithms." Lehman Brothers has products in beta testing that will take algorithmic options trading to higher levels. The next algorithm currently in beta is volatility-based and combines options and equities execution legs. "This type of algorithm gets more deeply into providing solutions in the options trader’s domain," says Troise. The algorithm is a natural extension as more liquidity becomes more electronic. But the volatility algorithm with the hedging capability also has a pounce component, which allows the trader to be more aggressive. If volatility falls into a more favorable range, for example, the algorithm will get more aggressive. Lehman Brothers expects to deliver the volatility algorithm by the end of March.

Advanced algorithms express market views such as magnitude, velocity and overall volatility, says Joe Corona, Vice President of Strategic Planning at LiquidPoint, an options executions platform acquired by BNY ConvergEx Group in July 2007. LiquidPoint offers several different platforms for different sides of transactions, such as TORCH for sell-side users and DerivatEx for buy-side users. LiquidPoint also offers several customized front-ends designed for different workflows.

LiquidPoint developed advanced algorithms such as Piranha, Shark and Angler, which are available through its platform and through several third-party applications. Six exchanges currently offer the same products, with different sets of rules and different infrastructures.

Soon, Nasdaq will be the seventh exchange to offer these products, according to Corona. "The first problem is how to get the orders routed to where traders can get the best price," he says. "That is solved through the use of smart routers that monitor all prices and send the orders."

Problems arise not only because there are six different exchanges, but also due to differences in how these exchanges deal with different order types. They are all linked through a system where orders will be routed from one exchange to another to allow an order to trade through the national best bid and offer. To navigate and access liquidity efficiently, traders must make use of algorithms that do more than an average smart router. "You have to be able to send orders so that they will schedule, slice and dice and route orders to complete the mission of the user in the most efficient manner," says Corona. "You can’t launch a large order at one particular exchange because it will get linked and sent to other exchanges and the trader will miss liquidity. You have to send it to several exchanges simultaneously. Traders may not get all the liquidity needed and may have to be in the marketplace multiple times in multiple ways. If too big a size is advertised, the trader is likely to frighten away liquidity."

Users of the Piranha algorithm include those who typically deal in names that trade in penny prices and large sizes. Their motivation is liquidity. They are not really price sensitive, but volume sensitive. Angler is used for a large order that displays only a little bit at a time and then periodically refreshes as it deals. There will be a large order that has been broken up into several smaller orders. Those smaller orders are working independently but are controlled by the large order. The Shark algorithm performs the same function as Piranha, except it is completely invisible. A trader can put an order in the market and it won’t show up anywhere, but if the price at which the trader is willing to buy or sell shows up, the algo will take it but remain hidden.

Options trading via algorithms is rapidly changing. As conditions change, providers either have to tweak algorithms or provide new ones. "We have already gone through several generations of different types as the exchanges change pricing models, as infrastructures change, as rules change, as they offer more order types," says Corona. "We are always trying to stay ahead of the curve, upgrading our system to be faster than everyone else. In addition to our own front-end, we offer connectivity so people can attach directly to our pipes. If they have black boxes that generate their own algorithms or go through a third-party vendor, they may come to us for speed."



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