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March 23, 2005

Seduced by Index Options A Chance for Stock Trading Pros to Bail Out the Exchanges?

By Mark Longo

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  • Seduced by Index Options A Chance for Stock Trading Pros to Bail Out the Exchanges?
  • Page 2

The world of index options trading may never be the same. The ability to trade index options is becoming much easier at a time when options exchanges are facing unprecedented change. This has led to a huge reduction in equity options margins following earlier margin compression as a result of decimal pricing. But index options' margins stayed stable largely because there was no competition. It was that

simple. For example, today if you want to trade options on the popular S&P 500 (SPX) and S&P 100 (OEX) indexes, you have to go to the Chicago Board Options Exchange. Indeed, the exclusive nature of SPX and OEX options has been a lifesaver for the CBOE. In some cases, exclusive license agreements have made them the property of one exchange.

Now, however, the various options exchanges, in a battle for survival, are looking to equity traders to bail them out by buying index options. On January 5, the International Securities Exchange announced plans to list options on the popular "spiders," or SPDRs ETF. The announcement led to drama worthy of a TV soap opera.

The next day, McGraw-Hill Cos., owners of the lucrative S&P franchise, obtained a restraining order against the ISE. In response, the ISE entered into a licensing agreement with McGraw-Hill - which had sought 10 cents for each contract traded - to list the SPDR options. However, unlike the CBOE's license to trade the SPX and OEX, the ISE's deal wasn't exclusive.

Four other exchanges soon jumped onto the index bandwagon. So, with all five competitors aiming to take a bite out of S&P's pie, the CBOE was in a tight corner. It choose to cannibalize its crown jewel rather that let competitors eat its lunch. On the morning of January 10, the new SPDR options launched simultaneously on all six U.S. options exchanges. It was an impressive debut for a new product, trading a total of 240,886 options contracts on six U.S. options exchanges, according to the Options Clearing Corp. The OCC noted that 71,971 contracts were traded on the all-electronic Boston Options Exchange.

What explains the popularity of the SPDR options? At one-tenth the size of the full index, SPDRs are an easier instrument to trade than the more complex and expensive S&P future. The smaller size of the underlying instrument allows SPDR options to trade with only a dollar between strikes. That corresponds to ten-dollar strike intervals in the full index. This gives traders an array of hedging opportunities that weren't available before. The relative simplicity and flexibility of the new product has piqued the interest of many equity traders.

"We are definitely excited about it," says Kevin Connellan, director of equity trading at Northern Trust. "We normally stay away from S&P options because they are too cumbersome and complex for most of our clients. However, options on the ETF are much more simple and straightforward."