Some unnerving trends have been developing in the option trading industry. While daily volume has continued to increase by double digits over the past decade, where transactions are conducted both faster and cheaper, there are signs the business in danger of collapsing.

OK, this may be an overstatement. A more accurate assessment might be that beneath a seemingly robust top line, there are indicators the market may be less healthy than it seems. My diagnosis – the structure has become too top heavy and the underlying infrastructure too fragmented leaving it in danger of, if not collapse, at least reversing the past decade of growth and participation by the individual retail investors.

By top heavy I mean the vast majority, some 85%, of daily option volume is traded in just the top 10 issues, with 7 of those being exchange traded funds (ETF). This is part of the larger trend towards indexing/passive investing and the domination of high frequency or algo based trading.

Full Oceans, Empty Ponds

Once you go beyond index ETFs such as SPY, or QQQ, the option volume leaders are increasingly popular volatility related products such as VIX futures and the VXX ETF or SPDR Gold (GLD), as well as just a handful of actual individual stocks such as Apple (AAPL) and a few banks such a like Bank of America (BAC). These, or any particular stock in the news due to earnings or merger chatter, have daily volume in excess of 10,000 contracts and open interest beyond 50,000 at any given time.

What this means is there is a general lack of liquidity in the vast majority of stock options. This is illustrated by wide/bid ask spreads which makes it nearly prohibitive for a retail trader, especially for those with shorter time frames.

For example if 30 day call option is being quoted at $2.00 bid/ask $2.80 that means assuming you could execute at the midpoint, you are giving away a 15% on both entry and exit. Or a whopping 30% of the contract’s value to open and close a trade. This is too large a hurdle to overcome and prevents traders from making speculative trades on the notion they’d be willing to scratch or even take a small loss if they want to quickly change their mind.

The lack of liquidity becomes self-fulling. The biggest most active pools continue to gain liquidity while the rest go dry.

Splintering the Pie too Thin

Another culprit is the expansion of weekly expiration dates and $1 wide strike prices and trading in penny increments. All of this offers flexibility traders love but it also spreads trades too thinly across the platform. Again, the result is only a few names and strikes providing a truly liquid market

For the most part we’ve seen volume shift forward to the weekly options, which is fine for speculators or professionals. But it leaves a hole in the later dated options which prudent investors may want to use for longer term portfolio management. Again, without a healthy long term investment pool to provide a broad foundation I’m afraid the near term speculative component could collapse.

We see evidence that is happening by the fact that brokerage firms such as Schwab (SCHW), Ameritrade (AMTD) and Fidelity have all recently undergone a price war, slashing commissions on stock and option trades to $4.95 and less in some cases.

The real reason isn’t so much to generate commission income, which hasn’t been a very profitable business for awhile, but to gather assets which can be placed in their own ancillary investment products. All roads lead back to indexing and ETFs.

Disappearing Market Makers

I started in the business as a market maker on the floor of the Chicago Board of Options Exchange and it was a very competitive business. If you wanted to win an order or facilitate a transaction you had to offer the best price. But as penny increments and electronic trading came there was little for humans to improve upon.

The market making business became taken over by big firms run by machines, which will only trade when pre-programed conditions are met. Volume became the name of the game. Again, this leads to a cycle of lopsided liquidity where it only makes sense to trade in a handful of names.

Just the other day Interactive Brokers (IBKR) announced it discontinued options market making activities globally, which are conducted through its Timber Hill companies. This was one of the largest option making firms in the world and even they don’t find it a worthwhile venture anymore!

Thomas Peterffy, Chairman and CEO, said, “Having initiated the first automated option market making operation in the mid ’80s, which grew into the largest such business on a global scale over the next 25 years, it’s been painful for me to see it deteriorating in the last few years. But we do not have a choice in this matter. Today retail order-flow is purchased by large order internalizers. they would represent a conflict we do not wish to have. On the other hand, providing liquidity to sophisticated, professional synthesizers of short-term fundamental, technical and big data is not a profitable activity.”

Translation; the Fidelities and Schwab’s of the world are matching orders among their own customers rather than bringing them out to the open market place. And they keeping those ever widening spreads between the bid/ask. Which is why they can afford to reduce commissions.

The removal of Timber Hill, and other non-conflicted third party market makers will only lead to less liquidity among the vast number of individual stock options.

This creates a dangerous situation in which if the market ever does undergo a correction there will be a cascade of everyone needing to use ETF options and those owners of individual issues will get flushed out in wash.