If markets are climbing a wall of worry, there is no shortage of events driving the phenomenon. Federal Reserve policy could be changing with the market expecting three rate hikes in 2022, COVID-19 variants continue to emerge, and the U.S. midterm elections are less than a year away.
As in any time of uncertainty, market participants are looking for new tools to manage risk in equity markets.
For institutional traders, the risks posed by rising inflation or a Fed rate hike can be significant and immediate. In June 2021, CME Group introduced E-mini S&P 500 (ES) options block trading to facilitate access to a market where the underlying E-mini S&P 500 futures provides around 10 times the liquidity traded across S&P 500 ETFs.
Block trades are privately negotiated futures or option trades -- or combination transactions -- that are permitted to be executed between two eligible counterparties. They are subject to minimum transaction size and time reporting requirements which vary according to the product, the type of transaction and the time of execution.
It should also be noted that the privately negotiated trade does not need to be exposed to the market before submitting the trade to the exchange. This means there is no breakup risk on the transaction once the two parties agree to a fair and reasonable price for their transaction, it is simply reported to CME for clearing within the 5-minute reporting window.
Over 4 million ES option contracts were traded via block in the fourth quarter through mid-December 2021 with an average daily volume of just under 75,000 contracts. There are 43 E-mini S&P 500 option expiries that span five years with thousands of strike prices available to suit hedging needs, (unlike the futures contract where there is one E-mini S&P 500 future, albeit with different expiries).
There is considerable scope for use by market participants who are eligible to engage in block trading, from liquidity providers and intermediaries, to asset managers and banks.
“Blocks offer a great deal of precision for institutional participants, and we’re pleased to see the wide adoption of these products continue to grow since launching in June,” says Tim McCourt, CME Group Global Head of Equity Index and Alternative Investment Products. “E-mini S&P 500 options block trading allows firms to lay off risk at a specific strike price and expiry date with a single large transaction, which is its core value proposition.”
Trading Quickly, with One Price
Robert Knopp is co-head of the S&P options trading team at the proprietary trading firm Optiver, which has a lengthy track record of block trading across a number of asset classes.
Knopp describes options block trading as an excellent execution mechanism for market participants to conduct larger-sized transactions.
“We want everyone to be able to trade options through any mechanism that meets their needs,” he says. “For large orders, block trades are a means of conducting the transaction at one price, quickly and with minimal hassle, complementing the liquidity available on-screen which has traditionally supported smaller sized executions.”
Although block trading of S&P 500 options at CME was previously available, prior to June 2021, block trading functionality was limited to standard-sized S&P 500 options contract with a $250 multiplier. The transition from option block trading via standard size contracts to E-mini S&P 500 options ($50 multiplier), concluded on September 17, 2021, whereby the E-mini product is now the exclusive source for S&P 500 option block liquidity at CME.
“It all came down to achieving the right-size offering to meet client and market demand, by providing block trading capability to complement electronic execution,” explained Brian Burke, CME Group Senior Director of Equity Products. “This product offering brings everything together in one place and allows firms the flexibility to execute on-screen or through private negotiation with counterparties, all in a single, highly liquid contract.”
Knopp outlined some of the factors that have created a favorable environment for this type of trading. Those include unprecedented stimulus from governments and central banks and stocks near all-time highs while volatility remains at elevated levels.
“Inflation has been attributed largely to supply chain disruption as a result of the pandemic,” he says. “But we haven’t really seen the numbers trail off.”
Central banks are reversing course with planned asset purchases by the Fed cut in half. However, if COVID infection rates were to rise sharply again they could have limited scope to intervene in the market due to being caught between rising inflation and the effects of more easing or fiscal stimulus.
“We are seeing some sharp reactions to headlines,” adds Knopp. “Risk moves fast, and investors are constantly trying to interpret what these headlines and events mean for the market, which has resulted in significant movements in implied volatility despite indices being at high levels.”
Watching Economic Events
Options blocks trading tends to be particularly appealing around key economic events like a Fed meeting or non-farm payroll data. At these times, investors with a core allocation to equities will want to make sure they have protection in place in case of a sharp market movements.
“There are various factors that support the use of options block trading,” adds Knopp. “During periods of heightened volatility, block trades are effective for executing large transactions at one price.”
“Operational and margin efficiencies are another strength of the E-mini S&P 500 options blocks offering at CME,” adds Burke. “Customers have the ability to delta hedge options strategies with E-mini futures all in one block trade. This offers a streamlined capital efficient solution for hedging directional risk where traders can benefit from margin offsets between E-mini S&P 500 options and futures.”
Changes in policy, elections and market shifts could present several moments of heightened volatility for market participants in 2022. Particularly for institutional traders, new methods to manage risk will be welcome.
OpenMarkets is an online magazine and blog focused on global markets and economic trends. It combines feature articles, news briefs and videos with contributions from leaders in business, finance, economics and politics in an interactive forum designed to foster conversation around the issues and ideas shaping our industry.
All examples are hypothetical interpretations of situations and are used for explanation purposes only. The views expressed in OpenMarkets articles reflect solely those of their respective authors and not necessarily those of CME Group or its affiliated institutions. OpenMarkets and the information herein should not be considered investment advice or the results of actual market experience.
Neither futures trading nor swaps trading are suitable for all investors, and each involves the risk of loss. Swaps trading should only be undertaken by investors who are Eligible Contract Participants (ECPs) within the meaning of Section 1a(18) of the Commodity Exchange Act. Futures and swaps each are leveraged investments and, because only a percentage of a contract’s value is required to trade, it is possible to lose more than the amount of money deposited for either a futures or swaps position. Therefore, traders should only use funds that they can afford to lose without affecting their lifestyles and only a portion of those funds should be devoted to any one trade because traders cannot expect to profit on every trade.
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