Options’ electronic frontier

Not too long ago, David Kalt was a software geek with a retail options account. Today he’s a geek with a booming retail options brokerage, optionsXpress, which has amassed more than 160,000 customers in just five years.

The key to the company’s success is an electronic platform for stock options geared to retail traders, and it’s no coincidence he and his two partners launched it within months of the International Securities Exchange’s (ISE) debut in 2000. “It’s not that we started because of ISE,” he says. “But rather we and ISE were looking at the same developments.”

Specifically, they saw faster computers and a neglected retail niche with most options trading open outcry at the Chicago Board Options Exchange (CBOE). Now, just five years later, every American securities options exchange has implemented some form of electronic trading. The result: volumes are soaring even in times of low volatility; transaction costs are lower than ever; and strategy trades like butterflies and straddles can be executed electronically.

So, what’s the story with options on futures? “Disappointing,” says Paul Ehrhardt, who runs PM&F Investments, a boutique brokerage in downtown Chicago. “Let’s say you have a big number due. The quotes on Globex widen, because market-makers are afraid of getting caught out if there is a big move. But you call to the floor, and they can make a tighter market for you on the spot.”


The Chicago Board of Trade (CBOT) and the Chicago Mercantile Exchange (CME) promise that will change through time as their platforms gain functionality and as users get accustomed to trading online — but what will it take for electronic futures options to replicate the success of securities options?

“Technologically, there is no reason futures options shouldn’t be as successful as stock options,” says Jan Tilfors, who is in charge of the trading technology product line for Sweden’s OMX Technology, which developed ISE’s trading system. “The issue is market models, which are an overlooked aspect of trading.” As it turns out, exchanges are focusing on both developing new market models and letting the models drive the new technology.

In January the CME appointed former CBOT business strategy boss Neal Brady as director of products and services two years after buying his Liquidity Direct Technology (LD), which essentially adds a sophisticated pretrade Request for Quote (RFQ) front-end to options trades.

The exchange has since enhanced the system and rechristened it the Enhanced Options System (EOS), which as of August comes in two parts.

The first part, the old LD front-end, acts as an optional ISV for customers looking to trade options. The other part has been integrated into the Globex trading engine itself to handle complex options strategies.

Supporting EOS are five designated lead market makers (LMMs) who are required to stream indicative quotes on outright options and 13 different strategy trades. If a user wants a binding quote, he submits an RFQ and receives a binding bid or offer. In addition to the LMMs, roughly a dozen so-called Responding Market Makers (RMMs) are required to post binding bids and offers on designated strategies once a customer RFQ comes in.

Although electronic options still average well below ten percent of daily options volume, the system is growing in popularity. On Jan. 27, the exchange announced a record-breaking 183,672 Eurodollar options trading electronically on Globex out of 1,013,983 total option contracts traded on that day. Compared to the top day a year ago, that means the percentage of options traded electronically surged more than three-fold, to 18% from less than 5%.

The exchange is currently in the process of adding more spread types, and by the end of the month will have 16 strategies plus generics and outrights representing nearly 120,000 permutations, top order functionality for any participant who betters an existing market and engine-level protection mechanisms to shield market-makers from systemic breakdowns. And by summer they plan to offer delta-neutral strategies combining futures and options.

Both CBOE and ISE also offer strategy trades such as butterflies, straddles, and strangles and each creates a spread in response to market demand. But the mechanics of creating the spread are different. ISE simply lets a trade exist in its order book while CBOE creates a completely new security representing the spread in response to a market order. The CME will precreate spread contracts on designated strategies but will create spread contracts on the fly in response to demand once the delta-neutral capability kicks in.

As in straight futures, the screens and floors will both remain open until one of them wins; the goal being to avoid a repeat of the London fiasco where a thriving market for options on Euribor futures was essentially banished from the floor in the late 1990s. Since then, options as a percentage of futures volume has fallen by roughly 30% as the electronic market became little more than a bulletin-board for trades agreed on in the call-around market. Today, just two market-makers — Icap and Man Financial — dominate the once deep and liquid products.


By shifting from open-outcry to designated market makers, the exchange is lifting a page from the securities book, but it’s a book with two editions on the market. For example, the CBOE runs a hybrid of floor and computer combined in one system, while the ISE has been fully electronic from day one. CBOE Vice Chairman Ed Tilly says the hybrid system is gradually becoming more electronic. “Every trade defaults to the electronic system, while it used to default to the floor,” he says. “Only if the customer specifically designates it as being for open outcry, or if the floor broker can improve on the price quoted electronically, does manual intervention happen.” And 92% of the time option orders on CBOE are filled electronically.

But the 8% of trades that go open-outcry account for 45% of the volume, indicating that big customers are drawn to what Tilly calls “negotiated” trades of “chunky” orders. “By ‘chunky,’ I mean larger orders, or strategy-based trades, or rolls from one expiring month to the next,” he says. “When volatility rises, so does the percentage of open outcry or negotiated trading.”

What’s more, index options, like the SPX and OEX, trade in giant open outcry pits jammed with 100 to 300 traders — although the question arises on whether the pits are full because those contracts have more than 1,000 active strikes and thus need a hands-on approach? Or is it because the CBOE has monopolies on them?

An indication of the answer lies in three contracts given multiple listing status in the last few years — the NASDAQ-100 (NDX), the Russell 2000 (RUT) and options on DIAMONDS (ETFs based on the Dow Jones Industrial Average). Volumes in all three more than doubled once multiple listing was allowed, with NDX surging to 60,000 from 25,000; RUT to 10,000 from 3,800; and DIAMONDS to 79,000 from 33,000. And the lion’s share of the new volume is trading electronically.


When Tilfors and others talk of market models, they are going well beyond simply electronic vs. open-outcry. “When we accepted the order from ISE we had to completely tailor our technology to their model, which included incentives and obligations to market-makers,” says Tilfors. “The success of that model speaks for itself and now everyone is going that way.”

But a measurable percentage of floor traders say electronic systems should mimic open-outcry step-by-step, with all traders getting the same access and earning the right to trade big or act as market-makers based on their achievements.

Richard Lane is one of them. A former London-based Euribor market-maker, he’s now a principle in a software company called Communicating, Ltd., which offers a trade-matching engine called Aquarius, which among other things essentially imports a slew of market-making functionality into the exchange’s trade-matching engine, allowing traders to then set parameters within which the exchange can execute trades on their behalf.

He says such a radical redesign of the market model will best meet the needs of traders practicing complex trades. “In fixed income you have upwards of 20 active expiries in each month with close to a million ways that different contracts can interact with each other,” he says. “This can theoretically happen in stock options but it’s reality in fixed income because 80% of the trades are strategy-based.”

The goal is to embolden market-makers to make narrow, binding spreads on the screen the way floor traders do in the pits. “On EOS, market makers are afraid to make binding offers because they’re afraid of getting run over,” he says. “Our system gives users the ability to automatically hedge positions they generate as market-makers, and there’s a one-cancels-the-other (OCO) function that pulls your auto-quotes from the market when a pre-configured threshold for delta or volume is reached.”

The system also requires exchanges to recognize a host of order types that mimic how business is done on the floor. “One example is hidden orders, which font-ends do all the time,” he says. “They are set to generate orders if a certain price or certain delta gets hit, something analogous to a market-if-touched or an iceberg, but more subtle. With our system, you can make a hidden delta pin into a bona fide, binding order type that the exchanges will recognize.”

The system also offers a series of detailed RFQ functions, such as the so-called Large Volume Order (LVO). “Big institutional traders stay away from electronic platforms because they cannot finesse their orders,” he says. “They want to be able to test the market on a certain strategy without showing their hand and in the pit they walk in and just ask what you can do on a spread of 150 March calls against 100 April puts or something. They don’t even ask what you have to buy or sell, but just what you could do on this strategy.”

An LVO lets a qualified participant quote a spread or a complex position at a certain price not specifying the amount or the direction, just that there is interest in doing something at a certain level. Then other participants can post to that price and when a certain threshold is hit on one side or the other, usually well above 10,000 contracts, the order goes hot. “The market at large knows that someone has a big order and that it’s qualified,” he says. “But everyone is hitting the price with binding orders and if the others don’t get hit they still don’t know what it was because it can be oversubscribed.”

The ISE recognizes similar orders, but says creating an RFQ that morphs into a live order crosses the line from an exchange’s functionality to a broker’s. “The beauty of it being in the broker’s domain is that every broker can have a different product,” says Gregory Maynard, ISE's system and product strategy officer. “A broker can have something he thinks is the greatest thing in the world, but if an exchange tries to do the same thing, all brokers have to work the same way, and then the brokers do not have the flexibility to do what they want to do.” Indeed, Kalt credits the simplicity of ISE’s approach with enabling optionsXpresss to create its own pre-trade RFQ system (see “Fishing for quotes,” above). “If they tried something more complex they might have come up with a better system five years from now,” he says. “They may still do that, but in the meantime we have a functioning strategy market now.”

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