Financial markets had an interesting start to the year with major indices down over 7% YTD after a stretch of positive returns recovering from the depths of the pandemic. Options volume remained strong with 39.5M average daily contracts traded YTD, even with 3 consecutive monthly ADV declines (including April MTD) since January. Options market quality continued to improve with an unprecedented amount of liquidity. These market conditions persisted even with high inflation readings, rising interest rates, the Russia-Ukraine conflict, and surges of Covid variants in various parts of the world.
Liquidity and volume could improve further after high-priced stocks Amazon (AMZN) and Alphabet (GOOG/GOOGL) announced 20-for-1 stock splits happening this summer. AMZN is scheduled to split in early June, and GOOG/GOOGL are scheduled to split in early July.
From a theoretical standpoint, one could argue that ceteris paribus the $ notional (options volume * contract multiplier * stock price) or $ market value (options volume * contract multiplier * options price) traded should be equal pre- and post-split -- market participants trade the exact $ amount that they prefer, and the preferences would not change after a split. If that were true, then we can back out the new implied ADV post-split based on the new post-split stock price. Using ADNV (avg daily notional value) leads to a nearly 7M increase in ADV. We believe this to be highly unlikely and serves as the high estimate in our range.
When AAPL split its stock 4-for-1 in August 2020, we saw AAPL ADNV drop 50% in the month immediately following the split, and in the ensuing months, it swung between being down 50% to being down as much as 75%. In a Down 50% ADNV scenario, AMZN would gain about 2.3M incremental ADV, and GOOG/GOOGL would gain about 1M incremental ADV for a total incremental gain of 3.3M ADV. In a Down 75% ADNV scenario, AMZN would gain 1M incremental ADV, and GOOG/GOOGL about 0.5M incremental ADV for our low estimate total incremental gain of 1.5M ADV.
Referencing the AAPL and TSLA splits, we saw options volume increase by roughly half of their stock split ratios. If that were to happen for AMZN and GOOG/GOOGL, a 10x increase would yield an incremental gain of 2.4M ADV in AMZN and nearly 1M in GOOG/GOOGL for a total of ~3.4M incremental ADV gain.
Combining all our estimates, we have an estimate of 1.5M incremental ADV up to an unlikely high estimate of 7M incremental ADV with other estimates coming in close to 3.5M. AMZN was ranked 21st, GOOGL 97th, and GOOG 153rd in options ADV for Q1. Applying our most conservative estimates, AMZN could potentially leap into the top 5 most active options, and GOOG/GOOGL into the top 40.
Why are the estimates less than the split ratio? Many investors use options to gain exposure to expensive, high-priced stocks like AMZN and GOOG/GOOGL. After a large stock split, the stock price becomes more accessible to investors, which can result in deleveraging. More investors can gain exposure to the stock by transacting in shares of the stock rather than using the overlying options. Leverage, defined as the notional amount of stock controlled by options positions divided by the market value of the options, declined by 30% and 32% for AAPL and TSLA, respectively, in the 4 months following their splits as compared to the 4 months preceding.
On the other hand, an option contract now representing 100 shares of a less expensive stock becomes more accessible for retail investors to trade, so one can expect some opposing force to the deleveraging.
In addition to these split announcements, TSLA announced that it is seeking another split, and SHOP is also seeking shareholder approval for a proposed 10-for-1 stock split at the end of June. With these additional potential splits, one can anticipate future market volume increases.
Even before these highly anticipated stock splits, liquidity was already robust. In Q1 2022, posted size measured in $ of market value and in contracts was at its highest level since at least 2019 when we started tracking the metric. Spreads measured in basis points ticked up slightly in February and March of this year due to high volatility caused by the Russia-Ukraine conflict, rising energy prices, and inflation readings. With larger posted size and wider spreads, it can be difficult to get an accurate picture of whether market quality improved, just as narrower spreads and less posted size are countervailing factors. Looking at the ratio of posted size to quoted spread gives us a more holistic view of market quality. This ratio was at multi-year highs in Q1 indicating that on net, posted size improved more than spreads widened. We can point to a few factors contributing to the improved liquidity conditions: 1) a higher proportion of front month options traded in Q1 compared to prior quarters, 2) a higher proportion of out-of-the-money options traded, and 3) Options ETF concentration was higher. These three types of options tend to have tighter spreads and larger posted size.
We saw SPY share of total options volume at multi-year lows since the 2nd half of 2020 and through 2021. With the negative catalysts of rising inflation and the Fed raising interest rates at the end of 2020, volatility rose, and ETF volume concentration rose with it. This continued into Q1 with the added negative catalyst of the Russia-Ukraine conflict. SPY concentration rose to a peak of 18.9% for the month of February 2022 and ETF concentration cleared 40% of options volume. For context, these shifts in concentration were modest compared to the beginnings of the pandemic in March 2020 when ETFs overtook single stocks in % of options volume. Some ETF concentration will likely shift back towards single stocks with the upcoming stock splits later in the year.
We have previously noted that Floor and Institutional-sized options volume declined during the pandemic and the pandemic-related Floor closures. These volumes approached pre-pandemic levels in Q1 2021 but remained a lower proportion of overall industry volume due to the rise of retail and associated electronic volumes. In 2021, Floor volume accounted for 6.3% of industry volume, and in Q1 2022 Floor volumes took another leg up and accounted for 7.2% of industry volume. NYSE Options, with the NYSE Amex and NYSE Arca Floors, accounted for nearly 40% share of Floor volume in Q1 and remained the top destination for Institutional volume.
The Options market proved remarkably resilient in Q1 even as volatility rose, major indices declined, hot inflation readings placed pressure on the Fed to raise interest rates faster, and war in Ukraine broke out. High profile stock splits by Amazon, Alphabet, and others should add more volume to the market in the coming months, and Floor volume servicing institutional order flow is currently on an uptrend.