“Learn how to see. Realize that everything connects to everything else.”
Leonardo da Vinci
With US equities regularly “melting up” to new all time highs on low volume in 2024, it might be a good time to share Alphacution’s view of market mechanics: The chart below – and many similar versions of it – is intended to tell a story of success over the 50-year lifespan of the US equity option market since its inception in 1973. Naturally, this view of that success story is typically promoted by those who are compensated per transaction, like exchanges and clearing utilities…
The inherent drawback, however, of this perspective is that it tells us very little about what’s truly going on in US equity markets other than consecutive annual all-time highs in transaction volume…
In order to understand the key players – market makers – at the center of the US equity derivatives market, we need to understand their core trading strategies. And, in order to understand their core trading strategies, we need to understand the products – and key securities within product classes – that attract the most order flow…
To accomplish this, Alphacution observes the landscape a bit differently than the low-dimension version above. First, as you will eventually understand in greater detail, we add equity index futures and futures options to the picture – thereby applying a wider lens to the US equity derivatives market. The chart, below, represents this view with equity index futures and futures options traded at CME Group added as of 2012 when available historical data begins…
Here, for example, we are essentially adding nearly 1.7 billion contracts to the total scope of the “opportunity set” for 2023 thereby elevating total US equity derivatives units to 12.8 billion…
Next, we need to understand liquidity concentration…
Alphacution took CBOE Exchange‘s analysis of the top 50 option products for 2023 – mixed in equity index futures and futures options (on S&P 500, NASDAQ 100, and Russell 2000) – and re-ranked that roster based on each product’s 5-year total volume, 2019-2023. This methodology mutes some of the recent intense impacts of the 0dte boom and artificial intelligence revolution of 2023 (and beyond) while preserving the overall constituency of concentration that has occurred over the past 5 years; and that which has intensified since mid-2022 with the launch of daily expiries in SPX index options, among others…
The chart below is one result of Alphacution’s concentration ranking effort. It shows that over the past 5 years, only 10 products – out of total listings averaging more than 5,000 – represented nearly 50% of total contract volume. All told, the top 50 products represented nearly 70% of total contract volume…
Problem is, this view is too flat. It doesn’t adequately convey how interdependent products cause liquidity concentration. We need more dimensionality to illustrate how this puzzle fits together – and fuels itself…
So, with that need in mind, we arrive at a quintessentially Alphacution “money shot”: A visually-quantitative, higher-dimension diagram depicting how the concentration in US equity derivative products is primarily intertwined with the products that are derived from – and constituents of – the S&P 500 Index…
In the following Top 10 US equity derivative products diagram, we see how the dominance of the SPDR S&P 500 ETF Trust (SPY) serves as a magnet to capture fleeting price inefficiencies between and among similar products, like S&P 500 futures, SPX index options, and S&P 500 futures options – as well as the most heavily weighted constituents, like Apple (AAPL) or Tesla (TSLA), among others…
Variations on these arbitrage opportunities – between and among different segments of the diagram below – are what drive the core trading strategies of the most savvy and powerful players in the global capital markets ecosystem: Tier I option market makers…
Funny, that.
Even this slick diagram doesn’t fully capture the nature of concentration in these few products: For example, based on daily data collected from our friends at ORATS (Option Research and Technology Services) during March 2024, SPY ETF options averaged 34 expiries to trade per day and 270 available strikes to trade per day. In parallel, SPX index options averaged 54 expiries to trade per day and 538 available strikes to trade per day…
And yet, 46.1% of SPY volume during March 2024 occurred not only on the day of expiry (0dte) but also at strikes within +/- 1% of the underlying price (which is Alphacution’s current range for “at-the-money” – or, ATM). For SPX index options during March 2024, Alphacution estimates that 47.0% of volume occurred 0dte and ATM…
Meantime, note that TSLA’s 0dte / ATM level for March 2024 was only 8.6% largely because it doesn’t have daily expiries of weekly options – at least not yet…
The charts below attempt to visualize this critical additional level of concentration for SPY and SPX…
Now, here’s a quick back-of-the-envelope analysis to drive the point for grins and giggles:
If we applied the “0dte / ATM” figures for SPY, SPX, and TSLA from March 2024 to the remaining applicable securities in the top 10 roster (namely, QQQ, IWM, and APPL) and then overlaid that on 2023 volume – then Alphacution estimates that as much as ~1.9 billion contracts (~40%) of the top 10 US equity derivative product volume for 2023 could have been attributable to 0dte / ATM trading…
This means that without attributing additional 0dte / ATM volume from the remaining Top 50 products, the 0dte / ATM levels in March 2024 for 6 products could have translated to ~20% of the entire US equity derivative market for 2023…
Let that sink in for a minute…
And then consider that concentration has increased in 2024 with Nvidia Corporation (NVDA) topping the S&P 500 Index…
Until next time…
