CBOE Holdings Inc. plans to launch an electronic options contract based on the Standard & Poor’s 500 Index that analysts say may overtake volume in the 28-year-old flagship gauge traded on the Chicago Board Options Exchange.
CBOE’s C2 Options Exchange was approved on Sept. 2 to begin S&P 500 derivatives that settle based on the end-of-day prices of index stocks, rather than levels at the start of the expiration day. S&P 500 options trade in live auctions at the CBOE in Chicago, the largest of nine U.S. equity derivatives venues by volume. The new contract, designated SPXpm because settlement is based on prices at 4 p.m. New York time, will change hands on C2, an electronic exchange.
The S&P 500 products will appeal to different users, with electronic traders adopting SPXpm while those who need to “negotiate large, complex orders” continuing to buy and sell in the CBOE pit, William Brodsky, chairman and chief executive officer of CBOE Holdings, said in a Sept. 2 statement. The Securities and Exchange Commission cleared the product over objections from International Securities Exchange, which said it will spur late-day volatility and investor confusion.
“Over time you’d expect the electronic trading of the SPXpm option to rival that of S&P trading in the pit,” Richard Repetto, an analyst at New York-based Sandler O’Neill & Partners LP, said in a phone interview. He said the company’s index volume may increase 30 percent next year because of the new product. “That’s a pretty good growth rate,” he said.
Trading in futures on the S&P 500 increased after a smaller electronic version was introduced on the Chicago Mercantile Exchange’s Globex platform in 1997, Repetto said. Volume in the equity futures products rose 36 percent in 2000, 64 percent the next year and 105 percent in 2002 as more investors used the benchmark index. WTI crude oil futures had a faster shift after electronic trading began in 2006, surging 81 percent that year and 60 percent the next, data from Sandler O’Neill show.
CBOE and C2 had 26.2 and 1.3 percent of total U.S. options volume last month, respectively, and CBOE accounted for more than 95 percent of the industry’s index volume, according to data compiled by Chicago-based OCC, which clears and settles all options trades. CBOE’s exclusive license to trade options on the S&P 500 ends in 2018.
CBOE Holdings isn’t likely to allow the C2 contract to cannibalize its S&P 500 options volume until the new product builds liquidity, Diego Perfumo, an analyst at Equity Research Desk LLC, said in a phone interview. The Greenwich, Connecticut-based company advises hedge funds and institutions about exchanges. The transition to electronic trading can happen gradually and with greater exchange control than elsewhere because there are two related products, he said.
Trading in S&P 500 options is conducted by humans in a pit on one end of CBOE’s Chicago trading floor. The SPX pit, expanded to include more rows for market makers and clerks in 2008, holds more than 200 traders. Most buying and selling takes place manually through open outcry, with traders using hand-held computers, their voices and hand signals to communicate.
Most options products on the CBOE can be bought and sold in the exchange’s hybrid system, both electronically and in open outcry, or only through automated processes. The trading floor is less populated now than five years ago, with some pits empty.
“Typically markets convert to electronic trading without a substitute contract,” Perfumo said. “CBOE is very smart in how they created this non-fungible contract,” he added, meaning the contracts aren’t interchangeable and positions opened in one market can’t be offset by those in the other. “They have until 2018 to shift, so they won’t hurt their existing liquidity. By the time their exclusivity expires, it’ll be mostly electronic and will most likely stay with the CBOE.”
SPXpm is likely to improve CBOE Holdings’ revenue and profit. CBOE got $44 million in transaction fees from its index products including options on the S&P 500 in the second quarter, more than half its total options fees of $81.7 million. The rest came from products based on stocks and exchange-traded funds. Trading fees from options and futures accounted for 72 percent of the company’s operating revenue in the second quarter.
“C2 has a tremendous opportunity to capture over-the-counter business in S&P 500 options,” said Thomas Foertsch, president of Exchange Capital Resources, a Chicago-based company that advises trading firms on operational and market structure issues. Foertsch worked at the CBOE from 1983 until 2009 and ran day-to-day operations for SPX on the trading floor starting in 1989. Over-the-counter transactions take place away from exchanges and aren’t cleared by the OCC.
Off-exchange trading in S&P 500 options developed after the contract moved to morning settlement in the early 1990s, Foertsch said. Brokers and investors began trading “essentially lookalike a.m. products with p.m. settlement,” he said. About 95 percent of over-the-counter options based on the S&P 500 use afternoon settlement, according to C2 data. CBOE’s SPX product accounted for almost 60 percent of index options volume earlier this year, ISE said.
The ISE, the first electronic U.S. options exchange, wrote three letters to the SEC this year urging it to reject C2’s request to trade S&P 500 options with p.m. settlement. It said the industry began shifting away from afternoon settlement in the late 1980s because of disruptive volatility near the close of trading on expiration days for S&P 500 stocks listed on the New York Stock Exchange. New York-based ISE is owned by derivatives exchange Eurex, whose parent company is Deutsche Boerse AG in Frankfurt.
C2 told the SEC the concerns were misplaced since NYSE and other exchanges have automated and improved the auctions that set stock prices at the end of the day, allowing more offsetting orders to enter the market to mitigate buy or sell imbalances.
While the commission approved the SPXpm contract because it provides additional choice for investors and may draw over-the-counter options trading onto C2, it said the potential effect of p.m. settlement is “unclear” since the improved closing auctions for stocks depend on attracting orders in a “very concentrated window of time” on expiration days. The SEC said it “remains concerned about the possible effect of volatility” once afternoon-settled index options are reintroduced.
Even as the SEC dismissed other evidence C2 offered to show that volatility wouldn’t be increased, it noted that the potential impact “would be more significant if both index options and index futures” offered afternoon settlement. The Chicago Mercantile Exchange moved its S&P 500 futures contracts to a.m. settlement in 1987 and the CBOE first allowed both types of contracts in the late 1980s before shifting to morning settlement starting in 1992, according to the SEC.
The SPXpm product will operate for a 14-month pilot. The exchange will submit confidential annual and interim reports to the SEC analyzing trading patterns in SPXpm and shares in the S&P 500 stocks. This will help regulators assess the effect of afternoon settlement on S&P 500 index options, the SEC said.
ISE also said C2’s new contract wasn’t materially different from the SPX, or options on the S&P 500, and was aimed at skirting rules and preserving trading on the CBOE floor while allowing the electronic market to provide a narrower spread, or difference between the best bid price at which traders are willing to buy contracts and the best offer price at which they’ll sell. Providing different contracts means that better prices on C2 won’t directly affect trading and prices on CBOE.
Alternatives for Investors
The SEC disagreed. SPXpm will offer electronic trading in a similar contract to the SPX and give investors more alternatives to hedge their broad market exposure, the agency said.
Foertsch expects SPXpm to draw volume from firms trading over the counter as well as those using the SPX contract as long as sufficient liquidity -- the availability of bids and offers at different prices -- develops on C2. Some investors and traders active in the smaller-size SPDR S&P 500 ETF Trust, which aims to track the index, may also choose the SPXpm once the electronic S&P 500 product is available, he said.
Options on the SPDR ETF, which can trade on any exchange, were the most popular contract in the first half of this year, accounting for 13 percent of the industry’s volume, according to OCC data. CBOE’s S&P 500 options were the next most active, with 3.8 percent, the data showed.
“The pie isn’t shrinking, it’s expanding,” Foertsch said. He said volume in the two S&P options products could reach 1.1 million contracts a day early next year, up from 762,000 on the CBOE this year through August. “This is a tremendous opportunity for the CBOE,” he said.
C2 hasn’t announced the transaction fees users must pay for SPXpm contracts or said when it will begin trading. Repetto said he expects the product to begin trading sometime after the September quarterly expiration.
In addition to attracting over-the-counter volume, “SPXpm will offer users ‘point-and-click’ convenience, and the large contract size -- with one SPXpm contract being 10 times larger than one SPY option contract -- will make SPXpm extremely cost-effective to trade,” Brodsky said. SPY is the ticker for the SPDR S&P 500 ETF. Exchanges charge fees per contract traded.
August was a record month for CBOE, which traded 144 million contracts, almost 8 million more than in October 2008, the month after Lehman Brothers Holdings Inc. filed for bankruptcy. S&P 500 options traded a record 1.3 million contracts daily, according to the CBOE. Alex Kramm, a New York-based analyst at UBS AG, said in a report dated Sept. 6 that SPXpm “represents the biggest upside potential” for C2.
The SPXpm may offer better bid and offer prices and would appeal to firms that want to buy or sell electronically, including high-frequency traders, Perfumo said. He expects initial volume on C2 to come from traders arbitraging price differences between the contracts. The SPDR ETF is likely to remain the primary product for more cost-sensitive institutions and retail customers because of its smaller size, he said.
“If you’re a portfolio manager tracking the S&P 500, you would need to hedge with the SPX or SPXpm,” Perfumo said. “If you’re a hedge fund hedging your equity portfolio, the SPY or options on the S&P 500 futures at the CME are substitutes.” Those traders don’t need an exact hedge for their market exposure and the substitutes “are acceptable all-electronic alternatives to the SPX,” he said.
Foertsch said the new electronic S&P 500 options will give hedge funds and other institutional customers a new way to trade the most popular U.S. index contract.
“From a strict customer standpoint, this is an enormous win,” said Foertsch, who spent more than 26 years on the CBOE floor. “They can now interact with liquidity electronically. It will lower their costs.”