Originally published on January 10, 2022
By Paul Golden
- Block trades allow institutions with high equity exposure to effectively eliminate risk
- Nearly 75,000 E-mini S&P 500 options block contracts were traded daily in the fourth quarter at CME Group as traders watch fiscal and monetary policy decisions
If the markets climb a wall of worry, the events at the origin of the phenomenon are not lacking. Federal Reserve policy could change, with the market expecting three rate hikes in 2022, variants of COVID-19 continue to emerge and the US 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 launched E-mini S&P 500 Options (ES) lock in trading to facilitate access to a market where the underlying E-mini S&P 500 futures provide approximately 10 times the liquidity traded on S&P 500 ETFs.
Block trades are privately negotiated futures or options trades – or combined trades – that can be executed between two eligible counterparties. They are subject to a minimum transaction size and time reporting requirements which vary by product, type of transaction and time of execution.
It should also be noted that the privately negotiated trade does not need to be exposed to the market before submitting it to the exchange. This means there is no risk of breakage on the trade once both parties agree on a fair and reasonable price for their trade, it is simply reported to CME for clearing within the reporting window of 5 minutes.
Over 4 million ES option contracts were traded per block from 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 expirations that span five years with thousands of strike prices available to meet hedging needs (unlike the futures contract where there is an E-mini futures contract S&P 500, but with different expirations).
There is considerable scope for market participants who are eligible for block trading, from liquidity providers and intermediaries to asset managers and banks.
“Blocks offer great accuracy for institutional participants, and we’re pleased to see that broad adoption of these products continues to grow since their launch in June,” said Tim McCourt, Global Head of Equity Indices and Products. of the CME Group’s alternative investments. “Trading E-mini S&P 500 option blocks allows firms to lay off risk at a specific strike price and expiration date with one large trade, which is its fundamental value proposition.”
Negotiate quickly, with one price
Robert Knopp is co-head of the S&P options trading team at proprietary trading firm Optiver, which has a long history of block trading across a number of asset classes.
Knopp describes option block trading as an excellent execution mechanism that allows market participants to make larger trades.
“We want everyone to be able to trade options through whatever mechanism suits their needs,” he said. “For large orders, bulk trades are a way to complete the trade at one price, quickly and with minimal hassle, supplementing the available on-screen liquidity that has traditionally supported smaller size executions.”
Although S&P 500 options block trading at CME was previously available, prior to June 2021 block trading functionality was limited to one standard-sized S&P 500 options contract with a multiplier of $250. The transition from option block trading via standard size contracts to E-mini S&P 500 options ($50 multiplier), completed on September 17, 2021, whereby the E-mini product is now the exclusive source of liquidity of the block of S&P 500 options at CME.
“It all came down to delivering the right sized offering to meet client and market demand, providing block trading capability to complement electronic execution,” explained Brian Burke, Senior Director of CME Group equity products. “This product offering brings everything together in one place and gives companies the flexibility to execute on screen or through private negotiations with counterparties, all in one highly liquid contract.”
Knopp described some of the factors that created a favorable environment for this type of trading. These include unprecedented stimulus from governments and central banks and stocks near all-time highs while volatility remains at elevated levels.
“Inflation has largely been attributed to supply chain disruption as a result of the pandemic,” he says. “But we haven’t really seen the numbers fade.”
Central banks are backtracking with the Fed’s planned asset purchases cut in half. However, if COVID infection rates were to rise sharply again, they may have limited room to intervene in the market as they are caught between rising inflation and the effects of an easing or fiscal stimulus.
“We are seeing strong reactions to the headlines,” adds Knopp. “Risk is changing rapidly and investors are constantly trying to interpret what these headlines and events mean for the market, which has resulted in large movements in implied volatility despite indices at elevated levels.”
Watch economic events
Options block trading tends to be particularly attractive around key economic events like a Fed meeting or non-farm payrolls data. At such times, investors with a core allocation to equities will want to ensure that they have protection against sudden market moves.
“There are various factors that support the use of option block trading,” adds Knopp. “During times of heightened volatility, block trades are effective in executing large trades at one price.”
“Operational efficiency and margins are another strength of CME’s E-mini S&P 500 option block offering,” Burke adds. “Clients have the ability to create delta hedging options strategies with E-mini futures contracts in a single block. This provides a streamlined and capital efficient solution for hedging directional risk where traders can benefit from offsets margin between E-mini S&P 500 options and futures.”
Policy shifts, elections, and market shifts could present several moments of heightened volatility for market participants in 2022. Especially for institutional traders, new methods of risk management will be welcome.
Editor’s note: The summary bullet points for this article were chosen by the Seeking Alpha editors.