Equity and commodity ETF options: Trading strategies are building a deep market

Deborah Fuhr Hi, I’m Deborah Fuhr, welcome to ETF TV. We’ve seen 194 billion of net inflows into equity ETFs this year and 71 billion going into commodity ETFs, primarily into gold.

Dan Barnes And I’m Dan Barnes. Discussing the increasing depth of market in both equity and commodity ETF options today, we have Gabriel Manceau, Equity Derivatives trader Morgan Stanley, and Matthew Riley, Buy-side Equity & Index Sales at Eurex. Guys, welcome to the show.

Gabriel Manceau Thank you for having us.

Matthew Riley Thank you very much, very nice to be here.

Dan Barnes How would you characterize the depth of markets in the equity and commodity ETF options space today?

Matthew Riley It’s something that’s really improved over the last 18 months, I think, particularly for the gold options in March and everything that happened then. It was clearly a test of how the market has developed and the fact that it was robust and people were able to get trades done through that period is all you really need to know about a functioning market.

Deborah Fuhr What were the drivers of those changes?

Matthew Riley Partly, it’s obviously the support of our members and the market makers who have stood up there, and I think as the market develops, attracts more eyeballs and people get more comfortable with the fact that this is a market they can trade, both in and out. Obviously, anyone who knows anything about the history of commodities, getting in and getting out is often not the same thing. Obviously, what we’re trying to achieve here at the exchange is to make sure they are both equally painless.

Gabriel Manceau When you start your business, it’s a hard thing to do. Basically you have a blank sheet and you want to go there somewhere. And for this trader there’s pretty much two ways to do it. First there’s the safe way, which is you start small, trading small, you start bringing in interest and slowly you grow the business. Unfortunately, European derivatives markets don’t work like that. Interest comes sporadically and in big size. So basically when you start your business, you have to be big on day one. So the best way to do it, there’s only one way, is basically to do proxy trading and to try tapping liquidity in other venues, so typically across assets or within the containers of the ETF. And that’s not easy either. And it is dependant and very specific on the ETF, but that’s the big challenge of ETF open trading.

Deborah Fuhr Could you give some examples of what proxy trading means in reality?

Gabriel Manceau The commodities ETF is a very good example, because let’s say you start trading in options on a gold ETF, listing on Eurex. You’re going to sell gold, so basically you need first to trade your delta. So the delta is basically the underlying of the options. That’s the first trial, if you control your delta, you can’t do option trading. By doing this, you can either sell the ETF itself, but it’s difficult because the ETF may not be as liquid as you would expect, but gold, we know, is a very liquid market on other venues. So you could easily sell another ETF somewhere on another continent, or sell the physical gold itself on the COMEX futures market or on the ETC markets. That’s when you bring liquidity from a different pool to the pool that you’re actually trying to.

Dan Barnes Have there been any regulatory changes which have affected who’s investing and how they’re investing?

Matthew Riley Absolutely, yes. And as usage regulations has changed, funds who may previously have had access liquidity in other markets, if that market, particularly, obviously, the US FTX companies, they are no longer usage-eligible. And so thhere has been a move towards either cash-settled options that reference a particular instrument or to the ETF market, in particular, the ETC market. And that has definitely been a driver of client interest.

Deborah Fuhr And how do you see investors using options in their asset allocation models?

Gabriel Manceau So there’s various ways to use options, but there is one obvious one, which is actually quite new for everybody in Europe, and it is flat rates. So if you take the example of Treasury yields in the US, everybody was used to geting a good income of two or three %. Nowadays it’s below one % if you go for short maturity. So how are you going to get your yield? Options is the way and the way to get yield-by options was very successful in equities trading for the last eight years, where clients saw pension insurances start to have some yield enhancement program, based on options for the last eight years. This was not done yet on Treasury bonds and you could keep that with option trading. So to give a quick example; if you buy a one-year treasury US, you won’t get more than one % yield. But what you can do is you can sell a call depending which side you want, one year for more than one %. In high volatility, around 10-15%, do the all on yields for one year. So the yield is actually non negotiable vs the yield of the underlying asset. So I think there could be a lot of growth in that direction.

Matthew Riley And that’s particularly something for the commodities complex, because they are unlike an equity, these are non-yielding assets by their nature, and if you’re holding them as gold and often as an inflation hedge, as a diversifier in case of crisis, to be able to make that non-yielding asset yield .is obviously very attractive.

Dan Barnes How do you expect the options to be used going into 2021?

Gabriel Manceau I think confidence is growing, so while we already see how successful ETF options on equities and ETF options on precious metals, namely gold and silver, will continue and that confidence is not given. You have some level of confidence. You have the trading confidence, so someone like myself. ‘Can I trust my trading when I market this product?’ Then you have the trading management confidence. ‘Oh, is this guy capable or can we run the business at a bigger scale?’ And the last level of confidence is compliance people for a bank vs intervention vs regulatory and limits. ‘Do we respect our limit or not?’ And that confidence is slow to build, and obviously we can increase size, we can increase the speed of trading and we can increase advertising to clients. So I’m expecting 2021 to continue to build on that slope. And then on top, I expect fixed income ETF to grow next year, mainly because of these non-yielding assets.

Deborah Fuhr Do you expect we’ll see a growing type of client using ETFs and using them in different ways?

Gabriel Manceau Yes, there are more and more clients. The pricing of these derivatives are going to be more and more efficient. I mean, if you take the example of gold option trading, in ETF the pricing is already very competitive, clearly in line with other venues.

Matthew Riley This year for the first time we’ve seen trades happening interbank. Up until now, it’s really been a bank to clients transaction with the bank then seeking a proxy hedge as Gabriel was alluding to earlier. And this year we’ve seen the first few people actually transferring the risk within the same asset. And that for us is a significant development.

Dan Barnes Matthew, Gabriel, thank you very much.

Both Thank you.

Dan Barnes I’d like to thank Gabriel, Matthew, and Deborah for their insights today, and of course you for watching. To catch up on our other shows or to subscribe to our newsletter, go to ETFTV.NET or TRADERTV.NET.

Published on December 10, 2020