Hedge Funds Invade the Options Markets
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 canít help but draw attention to itself. Such was the case in 1998 when Long Term Capitalís 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 ìhedge fund.î The term carries with it far too many memories of the rogue funds of the late 90ís. Instead, they now refer to themselves as ìprivate investment funds,î 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.
ìSix or seven years ago, thehedge funds were almost nonexistent in the options business due to the marketísinefficiencies,î says Ed Boyle, VP of Equity Derivatives at TD Securities.ìNow theyíve built or acquired sophisticated technology while learning how touse options to decrease risk and enhancing returns. Iíve heard numbers that asmuch as 50% of our customer volume can be tied back to hedge funds.î
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.
ìA few years ago, we made a decision to become options market makers instead of just options customers,î says Matt Andresen, President of Citadel Execution Services. ìThe 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.î
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. ìThe last few years have been a period of rapid evolution in the options industry,î says Andresen. ìThere 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.î
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.
ìThe intermarket linkage between the options exchanges is woefully outdated and needs to be addressedî says Andresen. ìWhen 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 canít be fixed with technology. Itís 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.î
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.
ìIt is a complex issue,î says Andresen. ìPayment 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 donít 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.î
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 theyíve made substantial investments in the PHLX and BOX.
Given their growing market share, it wonít be long before other large funds follow their lead and enter the options fray. ìWe are one of the only private investment funds that I know of that currently makes markets in options,î says Andresen. ìIím sure that many other funds use the options markets as customers, but Iím not aware of many that make markets in these products. Certainly not to the extent that Citadel does.î
If the past truly is prologue, then they wonít be alone for long.
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