Options volume is expected to rise in 2017, according to a new report from the TABB Group. Always difficult to predict volatility – which is most often driven by surprise – could increase this year, as factors such as interest rate hikes and regulatory tailwinds are expected to bolster options trading volume along with increased user demand from professional investors.
Options volume expected to hit 4.12 billion in 2017
Options trading volume should hit 4.12 billion in 2017, up from 4.06 billion in 2016 but lower than 4.14 billion in 2015. TABB anticipates rising volatility, the most important factor in modeling option volume, to contribute only marginally to overall 2017 volume increases.
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However, if sustained volatility occurs, with the CBOE VIX index exceeding 20 for elongated periods rather than exhibiting quick mean reversion which has been its pattern, options volume will benefit.
If volatility increases by 5% relative to TABB’s base model, 2017 options volume could move to 4.23 billion contracts, while a 10% increase in average VIX levels might result in volume to jumping to 4.53 billion contracts.
Calling market volatility a “wild card,” TABB’s Andy Nybo looked to a number of factors that could lead to a rough ride for stocks.
Looking back at the past 10 years we can see a definitive pattern of falling volatility, with both the Chicago Board Options Exchange Volatility Index (CBOE VIX) seeing lower levels and the number of times it exceeds its 10-year average of 20.7 on the decline. In 2016 the VIX closed above its average only 40 times as compared to 2009 when the index closed above the average on all but six days. And the frequency is actually up substantially from 2013 when the VIX closed over 20.7 on just one day
Politics could drive volatility
Looking at a geopolitical environment in “flux,” Nybo notes the surge in populist candidates around the world “promises to create more legislative and regulatory uncertainty.”
Elections coming up March 15 in the Netherlands should be watched along with higher-profile measures of votes in France and Germany potentially setting up significant volatility.
“Massive shifts in public sentiment could add fire to calls for the dissolution of the European Union, piling on top of the Brexit vote that surprised the world last year,” Nybo observed in the report, noting a global issue. “US domestic political uncertainty promises to increase as well, with an increasingly fractious political environment ultimately raising concern within US markets.”
In anticipation of a shifting economic environment, portfolios increasingly using hedging techniques is expected to contribute to increased options volume. TABB sees increased usage by registered investment advisors (RIAs) in building noncorrelated portfolios in particular as driving the trend:
Active portfolio management will increase as stock picking comes back in vogue. The use of options will increase accordingly, especially as event-driven strategies begin to use more derivatives as part of strategies. Rising support from brokers as capital rules are relaxed will provide more access to capital for strategies, ultimately contributing to growth. Retail demand will also begin to increase, as retail traders emulate many of the strategies employed by institutions. Demand from new volatility trading accounts will begin to increase as overall market volatility increases.
Driving the portfolio readjustments is likely to be interest rates to a large degree, with investors hedging their fixed income exposure.
“Rising rates traditionally have hampered economic growth but since 2008 global financial markets have acted in few traditional ways,” Nybo wrote. “Markets have experienced low rates for so long that any shift in interest rates will have far-reaching consequences, especially in derivatives markets.”
Regulatory and financial reforms could also impact options volume:
Tax reform is certainly on the table as is, perhaps, the reversal of numerous regulatory initiatives layered on in the aftermath of 2008. Attention on rolling back provisions of the Dodd-Frank Wall Street Reform and Consumer Protection Act (Dodd-Frank) was an early focus of comments by Steve Mnuchin, the recently confirmed Treasury Secretary. Munchin’s comments around the complexity of Dodd-Frank, and the restrictions it places on lending, signal a less intrusive approach on regulating the industry. He also stated that this would be the biggest regulatory priority for the new administration.
Tabb is looking for idiosyncratic stock correlations to be reduced which could drive options volume to various degrees as well.
The decline in correlations should provide tail winds to volumes, as investor interest in positioning in companies which will benefit or suffer from the shift in economic policies attract investor interest. Shifting capital flows will create disparate opportunities, which ultimately reduces correlation and provides more demand for positioning through options. And these opportunities reduce correlation among sectors, which ultimately creates arbitrage opportunities—a factor that will support option volumes.
What TABB research poignantly points out is how a new market environment is upon us, which could benefit the active manager:
If there is anything we learned from events in the past few months it is that US financial markets have entered a new cycle, with a break down in correlations and rising interest rates providing the foundation for what potentially could be a stock pickers paradise. Add to that a sustained period of volatility and we could see options volume return to a much stronger growth profile, with trading reaching levels not seen since 2011.