Will the Futures Market Kill the Options Golden Goose?

by: Options Insider

The July Explosion

The options market has been growing at an amazing clip for the past seven years. While other financial markets have stagnated, new entrants continue to flood into the options pits and bins. This unending tide of retail and institutional customers has allowed the options industry to dramatically outpace other financial sectors in recent years.

The explosion in options volume has outlasted even the rosiest of predictions. We've certainly come a long way from the dark days of 2001 when antiquated technology, plunging seat prices, unchecked competition and a regulatory morass threatened the future of the industry. In the prolonged downturn after 9/11, few prognosticators would have dared to suggest a seven-year options bull market was on the horizon.  The very idea seemed ludicrous

Setting The Bar Too High?

Yet that is exactly what we have witnessed over the past seven years. This bull market has continued for so long that it has reshaped the definition of success in the options world. Many observers have now come to expect dramatic volume increases every month as a matter of course.

However, even in this environment of skewed expectations, the July volume numbers are enough to give jaded options veterans a moment of pause.

Shattering Old Records

July was the busiest month in the history of options trading. It also recorded the single busiest trading day in options history (read "The Perfect Options Storm" for more details). Total July options volume amounted to 366,270,867 contracts. That is nearly 38% higher than the July 2007 volume level. It is also 2.5% higher than the previous monthly volume record that was set back in January 2008.

Year-to-date options volume has already reached 2.1 billion contracts. That is a 38% increase over the same period last year. At this rate, the options market should easily reach the 3 billion contract mark before the end of the year.

Equity option volume records were also shattered last month. 337,942,932 equity option contracts changed hands in July. That is an astounding 40.5% increase over the July 2007 volume level. In addition, year-to-date equity options volume is already up 40.5% from the same period last year.

Bang For The Buck

If we put these volume numbers in dollar terms, their impact becomes even more apparent. By the end of July, the options market had traded nearly $1 trillion worth of options premium. When you extrapolate the value of the underlying that has changed hands using these contracts, that figure balloons to $3 trillion. That is an incredible figure for an industry that has long labored in the shadow of the equity market.

The Great Futures Malaise

While the options market was shattering volume records, the other hemisphere of the derivatives world was showing signs of fatigue. Volume on the world's largest derivatives exchange, the Chicago Mercantile Exchange (NASDAQ:CME), dropped precipitously in July. This was the second consecutive monthly volume decline for the CME.

Daily futures and options volume on the CME averaged 11.16 million contracts in July. That is a decrease of nearly 10% from June's average daily volume of 12.36 million contracts. It also marks a 1% decline from the July 2007 volume level.

The CME blamed this volume slump on the credit crunch. The liquidity crises in a variety of products have forced banks and funds to liquidate substantial portions of their fixed-income holdings. These liquidations have resulted in a dramatic decrease in fixed-income open interest levels. Interest rate contracts experienced a 31% OI decline in July from the same period last year.

The End Is Near?

But all is not lost in the futures world. Despite the fixed-income slump, other aspects of the CME's product line remain moderately healthy. Volume in currency futures increased 2% from July 2007, indicating that the slumping dollar is renewing retail and institutional interest in these products.

Yet, in the same month that the options industry posted 40% gains, even the strongest futures growth looks anemic by comparison. In an environment where dramatic year-over-year volume increases are expected, the recent downturns at the CME are troubling. Many equity and index options traders are concerned that these losses will eventually spread into their corner of the derivatives world.

So far, most of these fears appear to be unfounded. The problems at the CME are confined to a product sector with little parallel in the equity and index option world.  If anything, the turmoil in the credit market has been a substantial boon for the options market. It has raised awareness of the need for downside protection and sparked a resurgence in protective puts, collars and other defensive strategies. This hedging activity was a primary driver of the dramatic volume gains in July.

Much of the concern over the futures downturn can be traced back to the same old hand wringing that has plagued the options market for years. There appears to be a certain degree of pessimism built into this industry. No matter how dramatic the volume gains every month, there are always whispers that the end is near. We seem to be waiting for the other shoe to drop. After all, the options golden goose can't live forever...can it?.

Thankfully, as the incredible July numbers clearly show, that golden goose remains alive and well. At least, that is, for now...

Stock position: None.