The result is an environment in which market makers need to be more aggressive in terms of both price and size, seeking to capture a narrower spread while at the same time increasing the size of the position they are willing to assume. And since the events of August 2011, both bid/ask spreads and size available to trade have moved against the best interests of all but the most nimble market makers.
A look at volatility over the past few decades is indicative of the challenge market makers faced in 2012. Volatility over the past year has been essentially range-bound when compared to 2011 and 2010, with only 13 points separating the high and low in the CBOE VIX index in 2012. This compares to the 33-point and 30-point ranges in 2011 and 2010, respectively (see chart, below).
The Highs and Lows of the VIX Index: 1990 to 2012
Source: CBOE, TABB Group
It is clear that the options market has seen significant structural shifts in the past decade. Volume has increased more than five-fold. There are now 11 different exchanges, compared to just 5 in 2002. And the SEC’s Penny Pilot has forced the industry to transform through greater adoption of technology in order to become more efficient.
[For details on options trading volumes, check out TABB Group's Options LiquidityMatrix.]
It is these structural shifts that placed initial pressure on options market making business models by reinforcing the need for technology to manage the complexity of the evolving marketplace. Technological superiority has become a critical component of an options market maker’s business model as the combination of technology requirements, rising expenses and lower profit opportunities have created a playing field where scale is the key to success.
The importance of technology in options markets cannot be underestimated and has become a key driver of business models within the market making industry. The need for analytical models to facilitate market making has always been a computationally intensive endeavor, but the structural shifts occurring over the past decade have only intensified demand for technology.
Technical sophistication is the delineating factor that is driving the success of firms both large and small, and it is by far the biggest business challenge facing options market makers today. Having the necessary level of resources to build out infrastructure to support technology requirements is a key component of success. A market making firm may have talented staff and an unsurpassed trading model, but if it lacks the resources to make continued investments in technology, it ultimately will fail.
For more on the options market making landscape, including the current and future business environment, the uncertain regulatory framework, the critical role of technology and the most promising growth opportunities, look for TABB Group's latest research report, "US Options Market Making 2013: Scale, Scope and Survival."