Stock option market makers disappear

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Of all the ways to make money on Wall Street, few are currently more difficult than making options markets. Implied volatility is historically low, so profit margins are almost non-existent in most trades. Foreign exchange rules exacerbate the difficulties. Dealers must post bids and offers in byzantine market structures that technology has degraded into super-fast computer shooting galleries.

Intense operating pressures have forced some dealerships to sell or close their businesses. Others are considering a second career. It has simply become too expensive to perpetually tune trading systems to operate at the speed of light. Without fast machines, dealers miss out on lucrative retail orders. They end up with orders no one else wants, or with the “toxic flow” of institutional investors who have informational advantages over just about everyone.

These forces have percolated since electronic systems emerged in 2000 to challenge traditional trading pits at outcry. At the beginning of May, they have a crescendo.

Interactive brokers

(ticker: IBKR) has agreed to sell Timber Hill, the first options trading firm to use computers to price put and call options, to Two Sigma Securities, part of a 46 billions of dollars. Terms were not disclosed.

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The deal, likely to close in September, was unexpected. Few people anticipated that a successful quantitative hedge fund would be interested in options market making. After all, Timber Hill’s profits have plummeted in recent years, and Thomas Peterffy, the billionaire founder of Interactive Brokers, criticized the exchange rules for putting dealers at a disadvantage to predatory small investors with faster computers.

The trade against Peterffy rarely proved profitable. But Simon Yates, who runs Two Sigma Securities, the hedge fund’s brokerage unit, is optimistic. The Cambridge-educated mathematician previously managed global equity derivatives at



Swiss credit


Two Sigma Securities should buy orders from retail brokerage firms, such as

TD Ameritrade

(AMTD and

E*Trade Financial

(ETFC), which Timber Hill avoided, while taking advantage of what is presumably a sophisticated computer system. “We have substantial infrastructure to run back-testing and simulations, which we would like to bring to the business, through liquidity microstructure, volatility forecasting and modeling of more complex products like VIX,” Yates said. . Barons.

His firm trades in more than 7,000 US stocks and exchange-traded funds. Every day, its trading volume exceeds 300 million shares. If the company’s technological and quantitative prowess allows it to better price stocks and options, Two Sigma could have an edge over its competitors. While Yates declined to reveal details about its approach, the company should, at a minimum, destabilize what’s left of the dealership community.

SMALL AND MEDIUM ENTERPRISES are struggling to find the millions of dollars needed each year to keep their technology competitive. If implied volatility remains low, continuing to depress earnings, more dealerships will struggle to stay in business. Since 2013, the community of Chicago Board Options Exchange stock options dealers has grown from around 70 to 40. Consider this a proxy for the industry.

Even if Two Sigma only rivals the dominant firms – Citadel Securities, the giant hedge fund’s market-making division, and Susquehanna Investment Group – its entry into the market will sharply accelerate the technology arms race. Unless volatility increases, the options market is poised to be dominated by a powerful oligarchy that will likely discourage competition. In many ways, major dealers are creating what Warren Buffett calls broad-moat companies.

What this means for investors will be revealed in due course.

STEVEN SEARS is the author of The indomitable investor: why some succeed in the stock market when everyone else fails.

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