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Options Trading Heads for Record as Institutions Lift Usage

Increasing use of options by asset managers may help boost U.S. equity derivatives volume about 8 percent to 4.2 billion contracts this year for a ninth straight annual record, according to research firm Tabb Group LLC.

Fund managers learning to trade options are the “engine of growth” as they use more contracts to guard against stock fluctuations, speculate on share moves or bet on higher or lower volatility, according to the report from Andy Nybo, head of derivatives at New York-based Tabb. The report is based on interviews with 51 options traders at U.S. hedge funds, asset managers and proprietary trading firms handling about 700,000 contracts a day and managing $2.7 trillion in assets.

“Demand for U.S. options continues to increase, with greater adoption across nearly all investor segments driving the industry’s steady growth,” Nybo wrote. “Buy-side traders are expanding activities, using more complex strategies and exploring the opportunities available through trading volatility, short-term options and other new products being introduced by options exchanges that are fiercely battling for order flow.”

Fund managers such as hedge funds will account for 42 percent of this year’s trades, up from 41 percent in 2010 and 25 percent in 2006, Nybo said. Individual investors will make up 12 percent, down from 14 percent last year and 30 percent in 2006, he said. Market makers account for the rest.

U.S. volume for contracts on stocks, indexes and exchange-traded funds rose 8 percent last year to 3.9 billion contracts, according to Chicago-based OCC, which clears and settles all equity options trades on the nation’s nine derivatives markets.

Japan’s Earthquake

Volume jumped 25 percent to 3.28 billion in 2008 as investors sought protection as the financial crisis drove the Chicago Board Options Exchange Volatility Index to a record high. The VIX, as the gauge is known, measures the cost of options on the Standard & Poor’s 500 Index. It has decreased to 18.39, down 37 percent from this year’s peak following Japan’s record earthquake in March.

“Volumes are continuing to see a slow and steady grind upward, and volatility is muted despite Japanese earthquakes and the collapse of economies throughout Europe,” Nybo said. “The U.S. options market has absorbed these market dislocations, with just a few spikes in volatility to remind investors that an untoward event has happened.”

More Tiered

Options-market activity has become concentrated in a smaller number of companies. The top 100 issues comprised 69 percent of volume last year, up from 63 percent in 2007 when many options began to be quoted in one-cent increments, the report found. This ensures there’s more liquidity, or ease of trading, in more active options contracts and less liquidity in other issues.

Asset managers will trade 89 percent of their options volume this year by calling brokers, down from 91 percent in 2009, while hedge funds are likely to do the same for 32 percent, compared with 54 percent two years ago, Tabb said. The main reason asset managers cited for calling their brokers instead of handling the orders themselves is convenience. Hedge funds say capital is the key reason they’d call their brokers, Tabb said.

Hedge funds are increasing their use of algorithms, or trading strategies that break up larger orders into smaller pieces, to 30 percent this year from 9 percent in 2009, the study reported. The funds tend to use algorithms for short-term strategies in options that are more liquid, Tabb Group said.

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