This month's column is for all the spendthrifts out there. If you're like most equity traders, then your primary focus is on earnings calls, Federal Reserve announcements and other events that can significantly impact your portfolio. While every trading day is important, these are the events that can make or break your year. Unfortunately, when it comes to trading options on these specific events, your choices are limited. Most options are only available in denominations of months or years. That is a lot of extra volatility and interest premium to incur just to trade a single event. However, after decades of ignoring this problem, the options markets are coming to the rescue with a host of short-term products that may forever change the way you look at trading.
The CBOE was the first to launch a short-term product when it announced weekly SPX and OEX contracts. Its newfound interest in short-term traders was sparked by recent developments in the endless war between the options exchanges. In this increasingly brutal conflict, proprietary products have become the weapons of choice. Exchanges are constantly on the lookout for new ways to expand their monopoly products. The CBOE already owns a proprietary license on S&P options products. This license has given it control on the world's best-known index and allowed it to survive the steady erosion of its equity options market share. However, its primacy in the S&P market was challenged earlier this year. That's when the International Securities Exchange (ISE) applied to list options on the SPDR ETF (see March's Options Trader column for details). The result was a feeding frenzy on SPDR options that gave every exchange a chance to garner a piece of the lucrative S&P pie.
The CBOE Strikes Back
Now, in an effort to regain some of its lost volume, the CBOE is making a foray into the world of Weeklys. "The CBOE's Weeklys offer an innovative way for customers to efficiently take advantage of news-driven market moves and short term trading strategies," said CBOE Vice Chairman Edward T. Tilly. "Weeklys will build on the liquidity provided by CBOE's deep pool of experienced and well-capitalized index traders, and will add a whole new dimension to this already versatile option product," he added.
The Weeklys share many of the distinguishing characteristics of existing SPX and OEX contracts. Both Weekly contracts are cash-settled, with the Weekly SPX offering European-style options and the Weekly OEX offering American-style options. However, there are a few significant differences with the existing products. As their name implies, the Weeklys expire at the end of the trading week instead of every month or year. In order to reduce confusion with the original products, no Weeklys will be listed that expire on the third Friday of the month. In addition, each Weekly will be restricted to five strike prices. These will include two out-of-the-money strikes, one at-the-money strike and two in-the-money strikes. Unlike the existing products, no new series will be added between listing and expiration.
And Then There Were Two
The CBOE is not the only exchange that is attempting to capture the short-term options market. Another member of the Chicago triumvirate has joined the fray. And it is doing the CBOE one better. The Chicago Board of Trade recently announced an agreement to license their mini-DOW futures to the Sidney Futures Exchange (SFE). This agreement allows the SFE to launch a new 1-Day Mini-sized DOW option that settles to the CBOT's futures prices. It is an intriguing attempt by the CBOT to leverage the strength of its brand and to increase its presence in the critical Asian markets.
"The CBOT-SFE agreement is another important agreement by the CBOT in the Asia-Pacific region," said Bernard W. Dan, President and CEO of the CBOT. "By having the SFE one-day option contracts settling to existing CBOT mini-sized Dow futures contracts, we seek to expand the volume and liquidity for these contracts during Asian hours."
A New Phase
The launch of shorter-term options marks the beginning of an interesting new phase for the derivatives industry. While both the CBOT and the CBOE have ulterior motives for creating these products (expansion in Asia and recapturing the S&P options markets, respectively), these new instruments also allow the exchanges to target new customers that have been ignored in the past. Since these customers are only interested in single events, they do not need products that encompass an entire month or year's worth of premium. These new weekly and daily option products will be much cheaper than regular index products, allowing traders to employ new strategies and new degrees of leverage that were once financially prohibitive.
While these new short-term products offer a great deal of promise, they also pose a number of interesting questions. By reducing the time to expiration, the exchanges have dramatically altered the way these options perform in the marketplace. Short-term contracts are much more sensitive to minute swings in the underlying than their full-size counterparts. As a result, these new contracts, particularly the daily contracts, will perform much more like futures than options.
Promise or Peril?
How this will impact the marketplace is yet to be determined. Since these products primarily entail directional risk instead of volatility risk, they may prove popular with equity traders looking to offset or leverage underlying stock positions. On the other hand, their unique characteristics may also limit their utility. After all, expiration is a notoriously difficult time for options traders. With the fundamentals of the options changing at nearly exponential rates, many theoretical models end up breaking down during expiration. This can result in wildly inaccurate measurements of position risk. By pushing up the expiration date on these new products, the exchanges may only have succeeded in trading one set of problems for another.
At the end of the day, these new short-term products may hold more theoretical interest than practical value. Although they have piqued the curiosity of academics around the world, the true market for these products remains unknown. Are there enough traders interested in short-term events to merit the creation of a new class of options? If so, can these products succeed in luring new customers to the options markets or will they simply cannibalize existing index volume? The early tally is unclear. The CBOE's Weeklys launched on October 28th with little fanfare and even less volume. As of this writing, the CBOT/SFE products are still awaiting regulatory approval in Australia.
Prometheus Unbound?
However, if either of these products takes off, then we may finally have found the Prometheus of the options world. The options industry has spent three decades trying to sell its products to the retail investor.
Unfortunately, its efforts have met with little success. By taking options out of the hands of wealthy institutions and putting them into the hands of the average investor, these short-term products may finally succeed where so many others have failed. Let's just hope they meet with a better fate than their Greek predecessor.
Comments or questions about the column can be sent to Mark.Longo@sourcemedia.com
