Equity Options Business Faces Hard Times
May 04, 2002 03:43 PM ET Email this article Printer friendly version
By Doris Frankel
CHICAGO (Reuters) - A passion for risk, a partner with deep pockets and the entrepreneurial spirit were once enough in the equity options business for a small independent trader to make quite a decent living.
But those heady days may be over for options traders, who thrive on high volatility from stormy stock markets.
Volatility has waned over the past year as the stock market has remained depressed. Along with that, the prices of options -- which give investors the right to buy or sell stocks at specified prices within a limited time period -- have come down.
Increased competition from the multiple listings of options on different exchanges, the growth of electronic trade and the high costs of floor trading have driven a growing number of options specialist firms to band together or merge with bigger, more capitalized houses to stay afloat.
While consolidation has been underway for two years, it is still very much on the front burner. The issue is expected to be one of the main issues at the two-day annual Options Industry Conference in Palm Springs, California, starting Friday, May 3.
"This consolidation is driven by economies of scale," Alex Jacobson, vice president of business development at the all-electronic International Securities Exchange said, adding it was now limited by the small number of remaining firms.
LARGE GOBBLE THE SMALL
Huge financial institutions like Goldman Sachs Group Inc. GS.N , Toronto-Dominion Bank TD.TO TD.N and Knight Trading Group Inc. NITE.0 , the top dealer of Nasdaq stocks, have snapped up a number of options trading firms.
The trend has expanded the trading arms of these firms, which had previously provided orders to brokers, but now offer full service in the options business.
"At one time, some of these firms wore one hat," said Jack Kennedy, executive director of the DPM Association of Chicago, which represents 75 percent of the designated primary market makers on the Chicago Board Options Exchange. "They predominantly were either a bank, an order flow provider or a liquidity provider. Now they may be wearing all three hats."
In March, Goldman Sachs acquired the options firm TFM Investment Group, boosting the trading operations it already acquired in its earlier acquisitions of Spear, Leeds and Kellogg and electronic market maker Hull Group.
Toronto-Dominion Bank made a strong push last year when it bought two U.S. options businesses, Stafford Trading Inc. and LETCO, in a deal worth about $430 million.
These firms have a major presence on the U.S. options exchanges and make markets in high-profile technology companies like Cisco Systems Inc. CSCO.O , International Business Machines Corp. IBM.N and Dell Computer Corp. DELL.O .
Fueled by these deals, buyout speculation surrounds options specialist firm Botta Capital Management LLC, which recently sold to larger firms parts of its business on the CBOE, the Pacific Exchange and the Philadelphia Stock Exchange.
"There are people who have talked to us about all sorts of business combinations," Botta Vice President John Power said when asked to comment on talk that the firm was up for sale.
Privately held Susquehanna International Group LLP has agreed to buy 67 "books," or stock options classes, from Botta on the CBOE, pending approval by the exchange, Power said.
MULTIPLE LISTING OF OPTIONS
The landscape of the options business changed in 1999 when U.S. exchanges abandoned the informal practice of listing certain options exclusively on one exchange. That shift opened the doors for the multiple listing of options among all the exchanges and increased competition.
But the change also led to the practice of payment for order flow, whereby some specialist firms in stock and options markets pay retail brokerages to send order flow to them.
"The rapid expansion of multiple listing of equity options meant lower costs for the customer, but more competitive options pricing among specialists and market makers," the DPM Association's Kennedy said.
Since it was launched two years ago, the all-electronic ISE has captured a significant slice of equity options volume as other exchanges lost share. The ISE has grabbed 17.8 percent of the market so far this year. CBOE's market share has declined to 31.3 percent this year from 35.2 percent in 2001 and 41.5 percent in 2000, according to the Options Clearing Corp., which clears all trades for the five U.S. options exchanges.
LOWER VOLATILITY AND MARGINS HIT TRADERS
Volatility, a key component of options pricing, has languished in recent months.
The CBOE's Market Volatility Index .VIX , a yardstick of investor fear, has been trading in a narrow range since last November, said Michael Schwartz, chief options strategist at CIBC Oppenheimer.
"The VIX has been languishing most of the time at the 20 to 23 number, implying that the public is not fearful and therefore not buying options," Schwartz said.
"Since early November, the VIX has been between the levels of 20 to 30 and has treaded below 22 in the past two months. If it moves in the upper part of its range, that would reflect higher investor fear," said Joe Sunderman, trading manager at Schaeffer's Investment Research.
The reduced volatility is not good for traders. Not only do they have to assume more risk to reap the same profits they enjoyed during the stock market's boom years of the 1990s, but they also face a new profit squeeze.
Traders are coping with shrinking profit margins, rising overhead costs and the need to spend more capital in technology to keep and attract order flow. Revenues are hurting because of narrower spreads -- the difference between what a buyer and seller are asking for an option.
"We take more risk now to make the same dollar," said Monte Henige, president of O'Connor Specialists LLC, a Chicago-based options specialist firm. "We have to trade in a larger size and put on bigger positions for the same profit. This larger size means more risk for us, the liquidity provider."
O'Connor Specialists LLC was formed two years ago when a group of independent options specialists and their clearing firm, O'Connor & Co., teamed up to boost their order flow to the CBOE, the world's largest options exchange.
"Our revenues have decreased because the spreads have tightened," Henige said. "Our costs have increased because of the big money we have had to put in technology and the money that we have had to pay for order flow. So we have had pressure both on our top line and our expenses. That has prompted many firms to find strategic partners or band together." |
