Boom in Bespoke ETFs Drives Growth of Niche ‘A-La-Carte' Options

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(Bloomberg) -- When Matt Kaufman needs to include options in Calamos Investments' defined-outcome ETFs, he turns to a type of bespoke equity derivative that lets him — rather than an exchange — set the terms of the contract.
These Flexible Exchange Options — also known as 'Flex' — have existed since Cboe Global Markets Inc. introduced them in 1993 but only gained traction in recent years. The number of outstanding contracts has more than tripled since 2022, while the average daily volume has climbed 44% over the past year, according to data from Cboe.
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Their popularity is largely tied to the blistering growth in the defined-outcome exchange-traded funds. These ETFs aim to deliver highly specific goals — whether that's hedging against losses or enhancing income — using options. Assets in such products have swelled more than 60% over the past year to $215 billion, according to Asym 500, with nearly $90 billion of that managed by buffer funds that can reduce downside risk by giving up some potential upside.
Flex contracts are crucial for building these products, thanks to their ability to let users pick custom strike prices and expiration dates, according to Kaufman, the head of ETFs at $44 billion asset manager Calamos.
'I cannot reliably or effectively use listed equity options to build a defined outcome strategy,' Kaufman said. 'If you went to the listed equity options marketplace, you might not be able to find the exact strike prices that you need.'
While such a-la-carte features are common in over-the-counter derivatives, Flex options retain the benefits of being listed on exchanges and cleared by the Options Clearing Corp. That adds transparency and reduces counterparty credit risk — a key advantage for US ETFs regulated under the Investment Company Act of 1940, which tightly limits credit exposure.
'Using Flex options, we can now create something that's exchange traded,' Kaufman said. 'That gives you liquidity. You can buy in and out whenever you want, and you can know exactly what your outcome is before you buy.'
One particularly popular feature of Flex options is the ability to leave the strike price blank, meaning it automatically executes at the end of the day based on the closing price of the underlying security — for example as a hedge against a 10% drop in the S&P 500 Index.
Dealers can offer more competitive pricing on such contracts because they don't need to worry about hedging their position dynamically through the day, according to Chad Blank, RBC Capital Markets' global co-head of flow trading.
Beyond ETFs
There are other uses beyond just ETFs, including so-called synthetic stock borrow and reverse conversion trades, which account for roughly half of Flex option trading, said Henry Schwartz, vice president of derivatives market intelligence at Cboe.
Normally, US-listed single-stock and ETF options are 'American-style,' meaning the holder can exercise them any time they like. That can cause complications for investors trying to maintain a hedge for a specific period of time.
Flex options, on the other hand, can be 'European-style,' where the contracts can be exercised only at the expiration date. That eliminates the possibility of early exercise and ensures positions remain in place until closed or expired.
Hedge funds 'prefer the European style options, because then there's just no chance of an early assignment and no chance their trade gets morphed into something else,' Schwartz said.
Short sellers betting against a stock often turn to Flex contracts to build a synthetic short position by buying a put and selling a call at the same strike price. That allows them to avoid going through a stock loan desk, with the cost of borrow instead embedded in the option premiums.
Here are some examples of Flex options with bespoke strikes and expiration dates that traded Friday:
This is particularly valuable when a stock is hard to borrow — if there is high demand from short sellers and limited supply — which can lead to unstable or prohibitively high costs. According to Schwartz, Circle Internet Group Inc., Wolfspeed Inc. and Paramount Skydance Corp. are among the companies with sizable outstanding Flex options. They're all hard to borrow names.
Flex options are also increasingly used in reverse conversion trades that give an alternative method of financing a stock position while locking that in for a specific time horizon.
Risk arbitragers often use this multi-leg package — long stock, long put, short call — to structure bets on complex deals and tender offers because they need the trade to stick through the deadline of the offers. In recent years, that was seen in situations including AMC Entertainment Holdings Inc.'s conversion of preferred stock into common shares and Johnson & Johnson's split-off of its $40 billion stake in Kenvue Inc.
'That business is seemingly going to increase just because the desks that are using it, they love it, and there are more people figuring out that there's a more efficient way to locate stock,' Schwartz added.
The bespoke expiration dates lets a client isolate protection for specific events such as earnings, Blank noted. That mirrors the precision of major index and ETF options, which have expiry dates every day of the week.
Small But Growing
To be sure, Flex options are still a drop in the ocean compared with listed equity derivatives, representing just 2% of total volume on a typical day, according to Cboe data. They're not for the casual trader as they typically come with more brokerage and execution fees.
On the other side of the trading spectrum, some seasoned hedge funds might still prefer over-the-counter trades to keep their moves under the radar. And to brokers and other intermediaries, a lingering concern is that this product might eat into their profitable business of bilateral contracts.
But banks and clients are getting more adept at putting these trades on, according to Alex Kosoglyadov, managing director for equity derivatives at Nomura Holdings Inc.
'It is getting easier to book Flex options trades,' Kosoglyadov said. 'There is definitely more awareness of the product.'
Meanwhile, at RBC, the Flex options business of Blank's desk has increased 'in orders of magnitude' over the past couple of years as demand from ETF providers has risen, he said.
'Growth has exploded,' Blank said.
--With assistance from Carly Wanna and Christian Dass.
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