Hedge Funds Invade the Options Markets

Discussion in 'Wall St. News' started by archon, Feb 14, 2007.

  1. archon

    archon

    http://www.theoptionsinsider.com/industry/?id=127

    Hedge Funds Invade the Options Markets
    2/8/2007
    by Mark S. Longo

    CLOAK & DAGGER
    For decades, they have been the cloak and dagger arm of Wall Street. These mysterious entities trade on behalf of secretive clients, concocting elaborate strategies that move markets and occasionally destroy them. Like most unregulated entities, they prefer to stay in the shadows, emerging on occasion to unwind or increase their positions.

    Every few years, one of these entities becomes so big that it can’t help but draw attention to itself. Such was the case in 1998 when Long Term Capital’s highly leveraged spread trading threatened to implode the global financial system. The from that near-disaster reverberated throughout the financial markets and focused the attention of regulators on the shadowy world of hedge funds. This cloak and dagger world would never be the same, and neither would the world of options.

    DON'T CALL THEM "HEDGE FUNDS"
    Today, you would be hard-pressed to find a fund that refers to itself by the sinister title “hedge fund.” The term carries with it far too many memories of the rogue funds of the late 90’s. Instead, they now refer to themselves as “private investment funds,” and their influence is being felt across a number of financial markets. Although most funds primarily trade equities, they were also among the first customers to understand the hedging power of options.

    At the turn of the century, hedge funds made up only a small percentage of trading volume in the options markets. The inefficiencies of the options pits made cross-product trading extremely difficult, shutting a large number of hedge funds out of the options business entirely.

    However, over the past five years, the relationship between hedge funds and the options industry has evolved. The rapid onset of electronic trading has allowed these funds to implement their strategies across a wide variety of options products. This has led to an explosion of hedge fund activity in recent years.

    “Six or seven years ago, the hedge funds were almost nonexistent in the options business due to the market’s inefficiencies,” says Ed Boyle, VP of Equity Derivatives at TD Securities. “Now they’ve built or acquired sophisticated technology while learning how to use options to decrease risk and enhancing returns. I’ve heard numbers that as much as 50% of our customer volume can be tied back to hedge funds.”

    GOING TO THE DARK SIDE
    Once seen as little more than a hedging tool, options have now become lucrative profit centers for many funds. So lucrative, in fact, that several funds have made the transition into options market makers. The largest fund to make the transition so far has been Citadel Investment Group.

    “A few years ago, we made a decision to become options market makers instead of just options customers,” says Matt Andresen, President of Citadel Execution Services. “The two main reasons for this were the increasingly competitive nature of the listings in the options markets and the increased efficiencies provided by electronic trading. We believe that the strength of these two trends will continue well into the future.”

    This is definitely an odd time to be entering the options fray. The options markets are locked in a state of flux as they transition away from open outcry and into a new era of electronic market making. Many large trading firms, such as Knight Trading, have decided that the high risk, low-margin world of options market making is not worth the effort.

    However, while the evolution away from open outcry has been difficult for many traditional option firms, hedge have always been early adopters of trading technology. Their affinity for technology makes them uniquely suited for this new era of electronic market making. “The last few years have been a period of rapid evolution in the options industry,” says Andresen. “There are opportunities today to add value in the marketplace by applying quantitative research and cutting-edge technology. However, in order to capture those higher levels of efficiency, and to capitalize on the cost structure of the business, you have to make a substantial investment in technology.”

    A FRAGMENTED MARKETPLACE
    Unfortunately, funds that are used to the efficient execution of the equity markets may be in for a rude awakening. Although the fragmentation that once plagued the options industry has been mitigated by the linkage system, execution in the options markets is still far from ideal.

    “The intermarket linkage between the options exchanges is woefully outdated and needs to be addressed” says Andresen. “When there is a superior advertised price on an away market, we are required to get it for our customer. However, the level of service on those away orders is spotty at best. This issue can’t be fixed with technology. It’s a problem of incentive. What is the incentive for an away market maker to give me a fast, efficient and reliable fill? The answer is that he has none. If anything, he has a disincentive, and that underlying problem has yet to be addressed.”

    TRUE LIQUIDITY?
    The transition of hedge funds into market makers has raised more than a few eyebrows in the industry. Some skeptics question the motives of these new players, believing that their true intention is to internalize their substantial order flow without providing any real value to the marketplace. It remains to be seen whether the onset of these powerful players will result in tighter markets and better execution for customers, or yet another round of fervent internalization and payment for order flow.

    “It is a complex issue,” says Andresen. “Payment for order flow and internalization are, at least for now, the competitive reality of the marketplace. We are faced with a situation where all of our competitors do it, so we have to as well. While we don’t pay for orders directly in the options world, we do participate in the programs at the options exchanges. On the ISE, for example, the exchange collects the funds from us and the other market makers, and then distributes those funds as the specialist directs. It is just another cost of doing business in the options industry today.”

    THE STATE OF THINGS TO COME...
    If the success of Citadel is any indication, then the transition of funds into market makers will have profound ramifications for the options markets. Citadel is already the largest liquidity provider on the ISE and they’ve made substantial investments in the PHLX and BOX.

    Given their growing market share, it won’t be long before other large funds follow their lead and enter the options fray. “We are one of the only private investment funds that I know of that currently makes markets in options,” says Andresen. “I’m sure that many other funds use the options markets as customers, but I’m not aware of many that make markets in these products. Certainly not to the extent that Citadel does.”

    If the past truly is prologue, then they won’t be alone for long.
     
  2. Hedgies also being options Market Makers???

    What if an order came in for 1000 calls for XYZ, from a known savvy firm?

    Wouldn't this position them to know to expect probable buying in XYZ?

    Isn't there SUPPOSED to be a "Chinese Wall" between Buy-side and Sell-side? :confused:


    I must be missing something or I'm too naive... :D
     
  3. asap

    asap

    options are by far the most lucrative industry per transaction due to high operating margins either for exchanges and market makers. in the near future options will become as widely available and tradeable as the most liquid eminis which will narrow b/a spreads and slash coms across the board.

    with the current b/a spreads of 10% or so there are extremely lucrative option funds that make returns of 50% p.a. selling otm index options. if any of these big players become market makers they will increase their edge while assuring a new revenue stream to their bottomline. i wouldnt be surprised to see many more to join the bandwagon until the options markets maintain the status quo. yet, when the option markets reach full maturity, only those tailored to be market makers will stay in the game.
     
  4. This says a lot about the idiots trading options.

    Semi-intelligent n00bs with a good grasp of high school math...
    Invariably chose the "sexiest" market like options...
    And then proceed to bleed to death...
    Real slow over time.

    The variance they are up against...
    Makes it impossible for most to ever figure out how it all went wrong.
     
  5. <i>"The variance they are up against... Makes it impossible for most to ever figure out how it all went wrong."</i>

    From the long side of options, good stock pickers who use back-month contracts out three months to LEAPs can outperform straight stock plays... if they are really good at stock picking.

    Long index options are tough to consistently profit from due to rich premiums going out a few months. Buying May index options now, for example, requires a pretty big move to profit from before expiry. The indexes tend to chop sideways for long periods, interrupted by brief times of directional burst.

    Plenty of short option spreads make sense for skilled retail traders. Only good stock pickers are making money with long calls or puts... everyone else learns an expensive lesson about the reality of options.
     
  6. asap

    asap

    retail usually buys premium while professionals sell premium. mm's just manage inventory and exchanges pump volume.

    in the end, the best business is to become an exchange followed by being an institutional player or a market maker.

    just forget about the other group, in the end of the day, someone has to get slaughtered.
     
  7. Great post.

    But from a purely mathematical point of view...
    I would dispute some basic premises:

    "good stock pickers... really good at stock picking"

    The underlying premise...
    Is that large cap stocks are traded inefficiently...
    And that these "inefficiencies" can be exploited medium to long term...
    By "skilled retail traders".

    Very likely FALSE.

    "can outperform straight stock plays"

    Marginally outperforming the stock market will get you no where...
    Unless you are managing huge sums...
    And running a ** skimming operation ** in order to capture 2-3% in fees per year ** risk free **...
    Which is what the entire mutual fund industry is all about.
     
  8. You are absolutely correct.

    But market volatility has plummeted in recent years to ** historic lows **...
    So anyone selling volatility has had outsized, windfall profits for about 4 years.

    This is not predictable...
    So I would completely ignore the great performance of people like Niederhoffer on one hand...
    And the dismal performance of Taleb disciples on the other hand.


    S&P 500 Volatility

    2006 >> 0.101
    2005 >> 0.104
    2004 >> 0.112
    2003 >> 0.168
    2002 >> 0.260
    2001 >> 0.214

    Is this a paradigm shift?
    Because technology has made large cap pricing more efficient?

    Hard to believe. More likely... the calm before the storm.
     
  9. archon

    archon

    Now you know why so many people are skeptical of hedge funds acting as liquidity providers. Unlike a true options market maker, they always have another agenda which may or may not conflict with their market making.
     
  10. archon

    archon

    I don't agree with that. You can't simply look at options margins per transaction and compare them to other products like stocks. That is like comparing apples to alligators. Options margins may be slightly wider than stock margins, but there are a host of inherent risks involved in trading derivatives that simply do not apply to stocks. Therefore, on a risk-adjusted basis, options are much less profitable than stocks.

    I agree with the poster who said that, at the end of the day, it's best just to be in the volume business. If you look at all of the "smart money" in the options markets, most of them have transitioned away from providing liquidity to providing order flow. Take a couple of cents per contract and churn out millions of contracts. It's a much safer and more reliable business model than trying to fight against shrinking spreads and exploding market risks.
     
    #10     Feb 15, 2007