Evaporating Liquidity and the Fight for Nano-Pennies

Options volume continues to set records year after year. But that doesn't necessarily mean liquidity has improved. In fact, it's apparently the opposite:

"Regulations are having a negative effect on the liquidity of U.S. equity and index options. As banks and traditional market makers deleverage and decrease capital commitment to facilitate trades, it is becoming more and more challenging for the buy side to find the other side. According to Andy Nybo of the Tabb Group in his January 2015 report, 'US Options Trading 2014/2015: The Buy-side's Insatiable Thirst for Liquidity,' 42% of the buy-side traders he surveyed said that the lack of liquidity impacted their trading in 2014."

Surveys like that sometimes overstate the actual impact. It's easy to say "X" has impacted your trading, but it's more important to see if it's causing you to react with your feet. Well, in this case, traders are indeed changing their behavior:

"Again, according to Nybo, 'Asset Managers executed 31% of their total volume through electronic tools, up from 15% in 2013.' Hedge fund share of volume traded electronically in 2013 / 2014 stayed constant at 62-63%.

In response to growing frustration over the appearance that liquidity faded when they sought to sweep the market, traders increasingly picked their spots-making others act on their liquidity rather than aggressively trying to chase the market. Additionally, passive algorithms are good at extracting liquidity in illiquid options. In 2014, 43% of orders were passive, a 49% increase from the 29% of orders that were passive in 2013."

I have to say, it's an unbelievably different world from the one I left in 2001 (the floor trading part). We always said that when we're all gone, liquidity will dry up. And hey, we're pretty much all gone (independent market makers), and look what happened!

Of course, the structure of the business bears close to zero resemblance. There were four physical exchanges and one online exchange when I left. We had machines auto-updating quotes and small orders could execute on markets automatically, but by and large, there was a human making a decision on everything bigger than a 20 lot. Now there are 12 exchanges and remote market makers running algos that generally duck size as best they can. Or better said, try to slow down size. At least, that's the picture painted above. In order to put on any size, you apparently need a better algo that "works" the order patiently enough to not scare the size away on the other side.

None of this particularly impacts smaller traders. The world still loves our orders. We're impacted in the sense that when you pop an order on the machine, it's going into that same netherworld of algos, it's just that they're competing to take the other side of it -- preferably in a spot where they can instantly lock in a nano-penny off us.

It does impact overall volatility a bit. Lower liquidity ultimately translates into higher volatility. That's really on the margins, though -- it's not going to become notable unless there's a flash crash … and I'm sure they've had plenty of time to make sure that won't happen again (I'm kidding).

Disclaimer: Mr. Warner's opinions expressed above do not necessarily represent the views of Schaeffer's Investment Research.