Earlier this week I wrote about the role of Market Makers in maintaining an orderly and liquid options market. As I explained, the human kind of market makers are becoming a dying breed, as firms like Susquehanna exit the market making business. The consequences of this shift for options trading are becoming increasingly apparent.

As I wrote back in March, this has become something of a vicious cycle, as a decline in option volume in all but the most active names leads to further thinning of liquidity.

In the article I pointed out “some unnerving trends have been developing in the option trading industry” which included the lack of volume and liquidity is many of the individual listed equity options, the widening of bid/ask spreads and the decision by several large market making firms to exit the business.

I cited as the culprit 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. This has caused an unhealthy fracturing or splintering within the options

A Wall Street Journal article at the time entitled Traders are Fleeing the Options Market, not only confirmed my thoughts with some hard data, but also provides some additional explanations and most worrisome discusses the risks poised by this breakdown in the option industry

From the article:

Falling volumes and spiraling costs are pushing trading firms out of U.S. options, raising concerns about fragility in a market that investors rely on to protect portfolios.

Trading has dwindled in most areas of the market, and investors and traders are grappling with increasing fragmentation.

Liquidity, the crucial ability to do trades without significantly moving prices, has deteriorated, according to interviews with market participants and data reviewed by The Wall Street Journal. Options on key indexes, exchange-traded funds and high-volume stocks dominate trading. Meanwhile, there is less activity in the rest of the listed U.S. options world.

The stresses prompted at least six prominent options market makers to exit from the business since 2012. Market makers are firms willing to both buy and sell using automated programs.

Thomas Peterffy, a pioneer of electronic options trading at Interactive Brokers Group (IBKR), would pull the plug on options market making. KCG Holdings announced its exit from retail options market making last year, while UBS AG and Credit Suisse Group AG have also left automated options market making. J.P. Morgan Chase & Co. and Bank of America Corp. made similar decisions in 2014, according to people familiar with the matter.

“Most market makers congregate in the highly traded products,” Mr. Peterffy said in an interview. “It’s difficult for a market maker to maintain hundreds of thousands of bids and offers all the time.”

It is hard to pinpoint what triggered the trader exodus, but industry experts say as firms leave, liquidity gets further drained, which spurs more market makers to retrench. The dangerous feedback loop could sap appetite for options, key derivative securities that investors use to manage risk in their portfolios.

Data from the Options Clearing Corporation shows a continued bifurcation of volume and liquidity.  Through July index and ETF options trading volume rose from April by 28% and 4%, respectively.  Meanwhile, total equity options volume shrank by 10% from the prior year.

While volume isn’t an exact equivalent to liquidity, it is easier for the options market to absorb trades when an individual asset trades more.

Ultra-active options include those on the SPDR S&P 500 Trust ETF, the PowerShares QQQ ETF, Apple (AAPL)  and Facebook (FB)  On the flip side, on an average day in September there was zero options activity on about 1,400 individual equities, ETFs or indexes, data from analytics firm Hanweck Associates show.

Ironically, the options industry’s willingness to give users more choices is adding to the overall liquidity problem. Investors can trade options for more hours now, and exchanges have boosted the number of products, introducing wider ranges in both expirations and strikes, the prices at which options can be exercised. But this makes it more challenging for market makers who need to continuously provide quotes across an ever-increasing range.

Again I would love to see more human involvement in making a market, and one way to do that might be to actually reduce the number of options, both in strikes and time frames. Unfortunately, I know it’s much easier to add choice than reduce it, especially once it’s been introduced. In the meantime, options trading is left to suffer.

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