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[Video] How does liquidity work for Buffered ETFs?

Buffered ETFs & Liquidity: A conversation with Bill O’Keefe, Cboe Global Markets


After launching Buffered ETFs on Halo’s platform, we realized there was some key ideas that needed more education and we sought to answer those, including:

  • What kind of options strategies are utilized in Buffered ETFs?
  • Are FLEX options different from regular SPX options?
  • What’s the liquidity in FLEX options and how is it measured?
  • Market makers role in these Buffered ETFs

In this video, we brought in Bill from Cboe Global Markets, the leading exchange which provides the listed options for Buffered ETF strategies, to learn how the liquidity of Buffered ETFs work.

Below is a transcript of the conversation between Bill O’Keefe from Cboe Global Markets and Halo Investing’s Joanna Kanakis.

Joanna: Our aim in this conversation is the give financial advisors interested in Buffered ETFs better context for these products. We know they are growing in adoption, but there are questions about it.

Obviously Halo is really excited about partnering with Allianz in distributing their products. We wanted to bring in you to talk about the underlying components of these strategies. So we wanted to bring you in to talk about FLEX options, that are held in the buffered ETF vehicle.

So lets dig a little deeper on that especially the liquidity component, most of our advisors know the S&P regular options are unbelievably liquid. One of the most liquid options markets in the world, right. How does liquidity in FLEX options differ from that and how would it be measured?

Bill: You know from working with FLEX trading for the last 9 years and prior to coming to CBOE, the liquidity, in my opinion, is the same. Obviously that's insane to say that because if you look at the marketplace, the SPX writes a million contracts a day, and maybe a FLEX would trade maybe the average volume is about 160,000 per day, not all SPX obviously. But it's the same market makers that are trading this and they’re using the same theoretical pricing models and metrics to come up with their strategies and theoretical pricing. So they’re just trading on a volatility curve, so for them it's indifferent, it’s just another trade to them. Just the fact that its not a listed option with a specific trade date, these guys are very fast at trading these and coming up with the price discovery around these.

For example, from 2018 to 2019 the average daily volume of FLEX was up 70%. That’s quite amazing and that’s about the time that these buffered protect strategies came into the marketplace in summer 2018. This is definitely on the radar for market makers and it's an area of growth for the CBOE and the industry as you know, you guys are involved with this as well. I think Allianz got in at the last year at the end of May and trading every month now and if its redemptions/creations this could be daily. So this is a new game in town for all participants.

Joanna: Just so I heard your right on the basics, sounds like its fair to assume that the FLEX options are held inside the ETF wrappers have the same liquidity as traditional S&P options from an underlying perspective?

Bill: Yes because the same market participants are trading them. The same market maker groups that are in the SPX pit they are committing the FLEX trades as well which fits into their book.

The good thing about FLEX is that with respect to the regular SPX, it is completely fungible. In other words, with respect to regular options Is that it can go into the same book.

So if you’re long FLEX trades in the SPX you can offset that with 100 short for the regular SPX. So it's not like it's this separate animal where they are traded differently.

From my experience, and I might be dating myself CBOE started FLEX trading in 1993 and basically just had individual stock names. Basically nobody wanted to do them, they were a nuisance and people didn’t know how to price them and it just evolved over time. The reason the Cboe did that in 1993 was to have an alternative to the over the counter market. It took for several years to take off, like most products. Now it's here and it’s used quite often and it trades everyday with ample liquidity

Joanna: When you’re buying a financial product right, as especially putting other people’s money to work you have to be cognizant of who’s taking the other side of that trade. Understanding the role of the market makers in these FLEX options, that are held inside these buffered ETF wrappers - that’s a critical point to understand.

Its the market maker's job to make a fair and transparent market and exchanges job that it happens.

Bill, I grew up on an options trading desk at the beginning of my career and you obviously work for the exchange and understand the options. Where do you see, and maybe to your previous point, there’s at least a four-legged option embedded in the ETF wrapper. Where do you see the value of these buffered ETF products - from your perspective as an options guru - how do you see the value of these Buffered ETF products, and what they can help folks achieve?

Bill: Just by the nature of their design, it takes a lot of the guessing out of it. For example, I look at it as an alternative to a fixed index annuity, or a fixed income product. But the fixed income product and capped annuity have caps that are relatively low due to the low interest rate environment. But the fact that these target outcome ETFs, buffer protect strategies have some level of risk, way down below, given they provide a buffer. And because they provide a buffer, you’re going to get a cap, a higher participation rate to the marketplace.

Now the same people that have no problem buying a long only mutual fund, they might look at this and say holy smokes, I could have no risk down 10%, but i get 17% of the upside - not bad!

It takes out that ‘oh my god’ the markets are down 18% - you’re down only 8% you’re not doing as bad as your next door neighbor. However, you have a good participation cap to play with so its pretty intriguing!

You’re not as shocked by big moves in the market because this thing is going to be there tomorrow and the next day.

Joanna: Yeah, I would love for our last question to talk a little bit about advisors assessing the liquidity of the ETF. Typically they are looking at the shares trading in the ETF. However, when you have the underlying component, they are in these options. The options are one of the most liquid markets in the world - help us think through the true liquidity of the ETFs? Is it fair to assume that it's the underlying options you should be looking at or is it the ETF - how do you look at it?

Bill: Well in this example, the nuts and bolts of these are an options strategy, and the liquidity in the options market for these things. Of course you have a lead market maker in these ETFs, usually part of options groups and as they’re buying a providing liquidity, you’re creating and redeeming shares, it doesn’t matter to them, and at the end of the day that’s going to determine the options rate. So the options trade at the end of the day happens as the net of buys and sells of the options shares. Those are done on a competitive basis. So its not like the lead market maker has to do everything or may participate, he/she not required to, so its a very competitive price market and it benefits the ETF holder.

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