HFTs face options trading challenges

While the country’s stock exchanges may have become extremely quick, high-volume markets as a result of high-frequency trading, the U.S. options exchanges have seen minimal change. In options trading, hft traders remain, at best ancillary players, five years into the penny tick/maker-taker revolution.

Just 20% of the industry’s equity volume is controlled by the four maker-taker exchanges, which are those that fast-moving, high-volume firms find most appealing. This is barely an improvement from five years ago. The previous year, two of them even took action to accommodate better market makers, who they had previously treated in the same manner as all other traders. In an effort to draw in additional liquidity, Nasdaq Options Market and BATS Options started providing bulk-quoting technology to conventional dealers. HFTs are the primary source of liquidity for stocks.

Barriers in the market structure have been widely blamed for the lack of HFTs in the options trading market. These include regulations that uphold market-maker privileges, prevent professional traders from participating, and hinder exchanges from moving as quickly as they otherwise might. Despite the market being dealer-focused, some high-frequency traders assert that the product itself is the largest issue. More risk, more price points, and potential liquidity issues plague the instrument.

Peter van Kleef, CEO of Lakeview Arbitrage, stated at a recent industry conference that “the only strategy you can execute in high-frequency trading is market creating.” 

“Because spreads become wider when you pass the in-the-money strike. Thus, you can’t just keep raising the offer and making the bid. You’ll be consumed by the spread.”

Although HFT tactics are numerous, market making, arbitrage, and momentum may be the most well-liked—at least in the case of equities. High-frequency trading (HFT) market creation typically focuses on liquid instruments with high volume and narrow spreads. In terms of options, this entails contracts with strike prices that are in close proximity to the price of the underlying stock. High-frequency traders are uncommon among options market makers, though Getco, a proprietary trading firm, has just entered the market.

While trading extremely liquid options contracts may be similar to trading highly liquid stocks, other high-frequency trading strategies present greater challenges, particularly for the small hedge funds that predominate in the industry. 

 

 

 

At a recent industry conference, BlueCrest Capital Management’s Mark Holt, head of systematic implementation, said: “When you trade options, you’re trading volatility.” High-frequency traders face much greater risk as a result.

According to Holt, the British hedge fund BlueCrest invests a lot in futures and a lot less in options. It’s hardly unexpected that the majority of high-frequency trading in derivatives that are listed on exchanges is in futures. Over 25% of worldwide futures volume, according to research from the Aite Group from 2010, is carried out by HFTs. Considering that the business is far ahead of the options exchanges in terms of electronic trading, the research house anticipates that number to increase to 40% by 2015.

Holt emphasized that the majority of high-frequency traders are small and undercapitalized at this year’s High-Frequency Trading World conference, which was hosted in New York. This causes the companies to reconsider investing in options rather than equities. According to Holt, your total risk is much less predictable than trading based solely on price. “The market is much more intricate. You’re not simply making the most of that one price, are you?

Holt makes the point that the additional factor of implied volatility, or how much the underlying asset is anticipated to fluctuate, makes forecasting the price of an option much more difficult. Trading decisions can be based on more than just the passage of time and sales data.

Options pricing models are helpful for traditional market makers and proprietary traders in this situation. Although Black-Scholes is a well-liked alternative for estimating an option’s future price, there are other options, and many traders create their own models.

However, the statistical analysis required to price an option has yet to be a part of an HFT’s toolkit. These shops have primarily concentrated on three things: speed, speed, and even more speed. Being first means being the fastest. It might be effective in straightforward markets like futures and equities but isn’t very helpful when trading options.

Yuri Balasanov, head of research and trading at AQ Strategies, told guests at HFT World that cutting latency was the name of the game in the early going—first in milliseconds, then in microseconds. Investment in complex strategies wasn’t really encouraged.

Balasanov said that the majority of HFT operators were tech experts. The business was focused on being the first, even if the companies employed just a token statistician.

He feels such times are over. Due to the fact that trading now occurs in microseconds or millionths of a second, there needs to be more room for further reducing latency. Because of this, businesses are turning to more advanced tactics. The executive from Chicago remarked that some groups had even merged with traditional statistical arbitrage firms.

Balasanov, a professor of financial mathematics at the University of Chicago, also acknowledges the issues with managing risk in options. He asserts that high-frequency traders who enter the options market need to develop better risk management plans. He advised conference attendees that they needed to be able to estimate the volatility structure’s risk. The risk associated with how puts move in relation to calls must be quantified. For high-frequency trading, existing paradigms need to be revised.

It might not be enough to control volatility. The tick regime is yet another obstacle. The increment structure of options works against high-frequency trading (HFT) tactics because it often entails making tiny profits on hundreds or thousands of trades each day. The striking prices of options are established at large intervals, in contrast to the pricing of futures contracts, which is tightly correlated to the value of the underlying assets.

A stock can have 100 price points that are all within one dollar, but an option on that stock is only allowed to have one strike. Also, the expense of continuously crossing the spread will eat into any gains because a typical options strategy includes regularly changing a hedge.

If volatility trading is the definition of options trading, then a delta hedge is required, according to van Kleef. “You must transact using the underlying. And if you do it for each tick, the cost becomes prohibitive”.

In order to trade volatility, also known as volatility arbitrage, one often takes a position in options and offsets it with a countervailing position in stocks. If the realized volatility of the stock is higher than the implied volatility of the market, the trader will make money using this so-called delta-neutral technique.

According to van Kleef, the issue with options is that you can only take one position—either long or short—and you cannot alter it like you can with futures. You can immediately go long or short in the futures market because there is no spread. In contrast, you keep going through the spread in the most liquid contracts while using an options contract. Any potential margin is destroyed.

Even though there are difficulties for high-frequency traders in the options market, at least two of the professionals are confident that viable trading methods can be developed. Van Kleef points out that even while conventional volatility arbitrage would not be successful, a trader can benefit from the fact that the underlying is traded in hundreds of different contracts. The contracts in question are not always “ideally priced,” he claimed. So, over time, a trader can exchange one contract for another.

He explained that even if you might maintain your initial position for several months, you can still trade frequently because so many linked instruments are available.

Mr. Balasanov also made some statements about the future. He said that many high-frequency shops are seeking the next thing as the race to achieve zero latency draws to a close. Options trading will probably come next, he predicted, with a very high probability.