Have credit options taken off and are they set to be the Next Big Thing in the credit derivatives market? The answer rather depends on who you talk to.
For Daniel Berman, head of European credit product management at JPMorgan, the answer is definitely yes. JPMorgan has now traded more than €20 billion in option notional this year in Europe, which is between five and 10 times 2004's level, depending on the sector.
"We are seeing an increasing account base, and a broader range of investors interested in learning about product dynamics and options strategies," he says. "Options on government bonds or equities are relatively standard products in those markets, and what we see now is really just the same product range becoming liquid in credit."
Exponential
He adds that users that were once doing one or two deals a week are now doing 15 or 20. The volumes are much greater than the few hundred million a week that was seen last year, and growth is described, predictably, as exponential.
The explosion in the credit options market has happened over the last six to nine months, says Berman, but the real catalyst, in this as in so many areas of credit derivatives, was the launch of the unified iTraxx credit indices in June of last year.
"iTraxx really made a massive difference," he says. "Until you have that degree of liquidity in the underlying, it is difficult to express a view through the options market on the level of implied volatility efficiently." He estimates that 75% of all trading is based on the iTraxx indices, and 25% on single names.
Not everyone is convinced that the market is booming, however. One London-based dealer says. "During the credit bust-up in May, there was no real liquidity in the option market. Dealers in New York were saying: 'Is this a real market or not?'"
By appointment only
A senior dealer at a major CDS dealer in New York agrees. "We don't see the sort of volume that would merit a great deal of attention. The market has had numerous false starts and these days it is sort of by appointment only," he says.
It was JPMorgan that tried to push the market hard last year, says the dealer but he notes that the number of banks making markets in the option sector hasn't increased in six months.
According to Matt Woodhams, global product manager for analytics at GFI in London, there are active markets in the indices. "There's not an awful lot of liquidity in options on single names, but there is some liquidity on the indices. There is definitely interest here," he says.
Not only are there puts, calls and straddles on the indices, GFI brokes cancellable CDS positions that confer the right to cancel the position at a defined time for a defined price. Given the remarkable growth of the index market in 15 months, it is not surprising that if the option market is developing it will be based here.
Another London broker agrees that the single-name market is pretty moribund. "You might see the occasional price on GMAC, for example, but it's usually short lived and one-way," he says.
Options on indices have increased dramatically, however, despite going into a temporary slump as the roll of Series 3 into Series 4 approached. Options on the Crossover Index have proved particularly popular, and in the credit meltdown of this spring, June straddles on the Crossover were trading at an implied volatility of 81%.
December straddles on the Europe Index in mid-September were at 51%, while December straddles on the HiVol were 53%.
Berman is adamant that the market is coming along by leaps and bounds. He explains that the current tight and range-bound level of spreads gives hedge funds and proprietary desks the incentive to use options to maximize income. Long views, for example, can be supplemented by selling puts or straddles.
Or, if a trader thinks that the market will widen, he can buy out of the money puts on the iTtraxx Europe at 45 (the index is currently around 35). If the index fails to widen, his loss is limited to the premium of the option and this is less than it might be from a conventional short position.
Berman thinks there is no doubt that option volume will have grown significantly by this time next year. "This environment is perfect for options," he says. "Accounts normally have to get internal approvals to trade which can take a little time, but the number of clients we trade with is growing steadily."