A system to exercise automatically deep in-the-money credit options on quarterly expiry dates is being considered in the markets as dealers look for a way to stamp out the potential for mistakes on the now frenzied quarterly exercise dates. The idea is a function of the booming market: at last Tuesday's expiry in London, traders estimated the number of options exercised jumped by around 20% from June.
"This is a view shared by many dealers," said Hector Garcia, credit options trader at The Royal Bank of Scotland in London, adding automatic exercising has been discussed informally in the market, but there is nothing formal yet. Other market officials agreed formal discussions will be necessary if the market continues to grow exponentially, but were unable to say when they might be held.
The dealer community needs to agree to employ standard fixings for option underlying, as provided by a third-party broker such as Creditex or Markit Group, said one trading official. It also needs to agree on the timing of the price close, he added. Any option deep in-the-money at close on the basis of these fixings would be automatically exercised. "Dealers need to get together and discuss this," said Costas Katsileros, credit options trader at ABN AMRO in London. Officials at Creditex and Markit did not comment by press time.
One trader noted with huge volumes of options now being closed on the one day, an automatic exercise system would eliminate potential for these in-the-money options to be overlooked. "It would make sure these trades aren't forgotten when the focus is on options on-the-cusp," he said, adding, "If they are forgotten it would cost us a lot of money," he said. No firms were believed to have incurred losses on Tuesday.
Last week, dealers faced extra chaos due to a large number of options on the Crossover iTraxx with sticky strikes. This forced dealers to wait until the last moment before closing trades. "Crossover was at 274-276 basis points and there were a lot of options with strikes at 275 bps," said on a trader at a U.K. house, adding, "This created a lot of confusion around 4pm."
Dealers also had to cope with the roll of the CDS indices on the same day, which coincides with options expiry twice a year. "It was a crazy day," said one trader at a European firm. Garcia said a handful of firms, including RBS, are making headway into selling monthly options with expiry dates any month of the year, thereby alleviating quarterly expiries. "There is increasing liquidity in this area," he said.
