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September 30, 2004

Out of the Dark Ages: Access to More Prices and Big Reduction in Trade-Throughs

By Mark Longo

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  • Out of the Dark Ages: Access to More Prices and Big Reduction in Trade-Throughs
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Are the dark ages of U.S. options trading finally over? It sure seems that way thanks to a system that has modernized the industry. The technology has accomplished what many thought was impossible it has built a new electronic link connecting the major options exchanges.

"Linkage allows specialists to access all prices on behalf of customers," Edward

Provost, executive vice president of the Chicago Board Options Exchange, told Traders Magazine. "This assures that customers receive the best possible execution at all times."

Before this linkage, as it is called, options traders had to navigate a hostile landscape of warring exchanges to find the best prices. With six major exchanges, the resulting markets could be very confusing. Traders routinely entered orders on one exchange only to find the same option trading at a better price on a competing exchange. For example, let's say that you bought 100 Intel October 20 calls for 1.30 on the PHLX, only to find that the ISE was offering them for 1.25. The nickel price difference translates into $500 that has vanished into the ether.

Prior to the introduction of multiple listing in 1999, the options markets were actually relatively orderly. A gentlemen's agreement between the exchanges limited most equity options to a single exchange. If you wanted to trade IBM options, your trade was executed on the CBOE. If you wanted to trade Intel, your order was executed on the Amex.

However, when the gentleman's agreement was broken by the Securities and Exchange Commission, the options market, practically overnight, degenerated into a fragmented and brutal business. Exchanges battled ruthlessly for volume. Competing market makers fought tooth and nail for pennies. While this intense competition benefited the customers by tightening markets, it also made trading options an exceedingly complicated process.

Trade-throughs became a regular occurrence. Demands for price-adjustments flooded the marketplace. Market makers soon became desperate to find a way to satisfy their customers without going broke. As a former market maker myself, I experienced this frustration on numerous occasions. Honoring competing markets may have sounded good in theory, but it was difficult to implement in practice.

In order to honor a competing market, a market maker had to stop what he was doing, pick up a phone, call a broker on a competing exchange, place an order for the options in question and then wait to see if his order was executed. Depending on how busy his broker was, and how far his broker was from the competing pit, it could take five or ten minutes to receive a confirmation.

As any trader knows, that is an eternity when you are waiting for a fill. During that time, the market could move against you, or the customer could cancel the order, leaving you with options that you never wanted in the first place.

The rivalry between the exchanges also made it difficult to satisfy customer orders. Trading crowds often refused to honor orders from competing broker dealers. That's even if they were sent on behalf of customers. On the few occasions when an order was honored and the customer was satisfied, the market maker was rewarded for his trouble with a hefty brokerage bill.