A customer who wishes to buy or sell an option on a major exchange-traded fund such as SPY or on a large, single-name stock such as General Electric or Home Depot typically has no problem transacting efficiently. However, when seeking a trade in a less liquid option class, the experience can be more challenging.
Options liquidity has increasingly become concentrated in the largest indices and single-name stocks. Among options trades reported to OCC in the first quarter of 2015, 43% executed in the top 10 names and 63% executed in the top 50 names. This is up from 36% and 58%, respectively, five years ago, according to OCC and Tabb Group estimates.
Execution constraints in less liquid names have led to the emergence of certain mechanisms intended to help customers seek the liquidity they need. However, such mechanisms can actually detract from the efficiency of transparent spreads because they enable orders to execute off to the side of displayed markets. While these mechanisms are still operating within the ecosystem of the U.S. options market, they are segregated from the customary requirements and allocation methodologies present in the displayed markets. The result is that customers may find it more difficult to get a true picture of the liquidity available based on what is on the publicly displayed markets.
One trading mechanism that has grown in popularity is the price improvement auction. Participants enter matched orders to which responders can improve prices, possibly receiving an execution without contributing to the displayed market.
“One potential concern is that, unlike a market maker who is providing open-market liquidity, a non-market maker participant may receive a favorable allocation without necessarily contributing to the displayed market,” said James Hyde, Senior Director at NYSE Options, which operates the NYSE Amex Options and NYSE Arca Options exchanges. “If a disparity between quoting behavior in the displayed market and response behavior in the auction mechanisms develops, displayed liquidity may decrease to the detriment of the market.”
As trades have moved into arenas where there are fewer incentives to continue contributing transparent quotes, the degradation of the quote-driven market is possible.
“One of the growing issues in today’s options market structure landscape is that market makers are not incentivized to aggressively quote,” said Jason Lichten, director of equities and listed derivatives trading strategies at Wolverine Execution Services. “A market participant can sit on the sidelines and interact with order flow at their discretion with little to no obligation to be on the quote before an auction begins.
"Auctions are potentially giving market participants the ability to interact only when they feel it is beneficial,” Lichten told Markets Media. “This takes away from the amount of on-screen liquidity and potentially widens the spread with less market makers aggressively participating. Why take on more risk when they don't have to?”
Without more displayed liquidity in mid-sized and smaller names, participants must go beyond the conventional methods of sourcing liquidity to achieve executions.
“Just because liquidity isn’t displayed, that doesn't mean it's not out there. You need to use more techniques, intelligently and with finesse, to find the liquidity,” said Peter Maragos, chief executive officer at Dash Financial. “If you're just looking at it from what's quoted on the screen, it's not good enough anymore to just clear the screens in those names.”
Market participants and market operators generally agree that options liquidity in mid-sized and smaller names is an especially complex issue, with no quick fix.
“Everyone is looking at this (liquidity issue),” said Paul Jiganti, until recently managing director of market structure, capital markets, and retail client advocacy at TD Ameritrade. “There are participants on all sides of the market trying to address this. They're likely to come up with some answers, but it's going to be a slow process. Just as it was slow making spreads widen, it's probably going to be a little slow making them tighter again.”
“Some of the exchanges are trying to make their rules a little more conducive to encouraging trading in the less liquid names by creating economic reasons to do so,” Jiganti said.
NYSE Options is working to bolster on-screen liquidity by enhancing functionality that protects its market makers with more sophisticated risk controls which enhance incentives to quote efficiently.
“We do this by developing sophisticated, well-thought-out risk controls that provide protection to all market participants,” said Steve Crutchfield, Head of Options Markets, ETPs, and Bonds at NYSE. “We recently added new price protection controls, which, when fully implemented, will apply prior to the market open, along with new price validation checks for all Market Maker Quotes. Next we’re working on expanding our participants’ abilities to cancel their open orders quickly should they experience a system problem, and plan on rolling out even more pre-trade pricing controls at the same time."
“Enhanced risk controls offer market makers the ability to add size and tighten quotes with confidence," Crutchfield continued. "This, in turn, strengthens liquidity in smaller names, providing a more robust displayed market for investors. Across the board, we are working to enable market makers to continue improving displayed liquidity. We are pursuing a variety of projects that could help improve the incentives for displaying tight quotes in the market across all symbols. Our goal is to set the standard for improving the quality of the displayed market and supporting customers by driving better quote behavior across all names.”
Featured image by Adimas/Dollar Photo Club