Wall Street slump highlights liquidity crunch in U.S. options market

By Saqib Iqbal Ahmed

NEW YORK (Reuters) - The sharp slump in U.S. stocks on opening on Monday threw U.S. options markets out of gear as a dearth of liquidity made it extremely difficult for traders to make trades.

The Dow Jones Industrial Average lost more than a 1,000 points in the first few minutes of trading, after a more-than 8.0 percent drop in Chinese shares and a selloff in crude oil and other commodities.

Prices for the CBOE Volatility Index <.VIX>, the market’s favored barometer of volatility, did not update for the first half hour of the trading, a result of market volatility that also led to erratic quotes in S&P 500 <.SPX> options, Suzanne Cosgrove, a spokeswoman for the CBOE said.

Traders who wanted to buy and sell SPX options were held back because a lack of liquidity caused problems in their pricing. Many were at zero or had bid/ask spreads so wide that they were unusable for trading. As a result, SPX options barely traded.

"Basically, the computer market makers that sit behind it all were flashing 'I don’t want to trade' signs," said Jim Strugger, a derivatives strategist at MKM Partners.

The lack of liquidity was not restricted to SPX options, but was broad based, with even normally very liquid sector Exchange Traded Funds (ETFs) hardly trading in the first hour or so, strategists said.

"It was extremely difficult to put any trades on in options," said Steven Spencer, partner at proprietary trading firm SMB Capital in New York. "There were no offers in a lot of options that we were short, so we couldn’t cover anything."

However, the market righted itself by 10:30 a.m., Spencer said.

When the volatility index did start updating, it quickly shot up to up 25 points to 53.29, the highest since Jan 2009.

While options volume was robust later in the day, with trading volume of about 31.5 million contracts, nearly 75 percent higher than what is normal, the lack of liquidity in the first hour is likely to raise eyebrows.

"There is no doubt that people are going to look back instantaneously and start evaluating liquidity just as they did after May 2010," said Jim Strugger, a derivatives strategist at MKM Partners.

(Reporting by Saqib Iqbal Ahmed)

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