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December 6, 2006

Cancel Fees Aggravate Options Traders

By Nina Mehta

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  • Cancel Fees Aggravate Options Traders

Order cancellation fees at options exchanges are a thorn in the side of some active customers-and as the industry moves toward trading in decimal increments next year, those same fees could limit growth in the booming options market, observers believe. "Don't get us caught in your net," Jerrell Watts told the International Securities Exchange at a Futures Industry Association conference on the options industry in September. Watts, a managing director at Merrill Lynch, is responsible for the firm's global order flow and risk aggregation strategy for equity options.

Watts was referring to the ISE's use of cancel fees to limit trading behavior by active, or so-called professional, customers, many of whom are traders employing arbitrage strategies and combination trades. Cancel fees are imposed by exchanges to prevent public customers from acting like market makers without taking on the obligations of market makers. These public customers have various advantages when trading and aren't charged exchange transaction fees.

The ISE and Chicago Board Options Exchange, the two largest options exchanges, charge $1.25 and $1 per cancellation, respectively, when a customer's monthly order cancellations (over a certain minimum) exceed its executed orders.

Watts said broker-dealers wind up butting heads with exchanges over this issue. High cancel fees can make it difficult for brokers' active customers to execute various options strategies.

Costly Strategies

If an account wants to put on a pairs trade or do a correlation trade between two names, Watts said, the account must currently post two separate limit orders. When one side gets filled, that customer may want to change the aggressiveness of the other leg to ensure it gets filled as well. Cancel fees can make that process costlier-and some say that's unfair.

Watts added that accounts with delta-adjusted limit orders and those trying to replicate over-the-counter variance swaps also face hurdles because of cancel fees.

Merrill Lynch spends a lot of time managing cancellation fees for customers, according to Watts. The broker tracks the number of orders and cancellations on various exchanges. That ratio can affect Merrill's routing decisions, subject to best-execution requirements.

In a penny world that encourages algorithmic trading, cancel fees could also limit the efficiency and use of electronic trading tools. If the issue involving cancel fees is not addressed, "we'll be starving ourselves of certain types of order flow," Watts said. The adoption of direct market access in the options industry, which is likely to increase once pennies arrive, could also be slowed by the presence of cancel fees.

Options exchanges that rely on their market makers to quote deep markets, understandably do not want to see them get picked off by customer orders. In some cases, those orders come from professional traders, whose orders get priority and jump to the front of the line.

At the largest options exchanges, cancel fees are a work in progress. In recent months, as active customers found ways to adjust their ratio of executed trades to cancel orders-such as by "shredding" a single 100-lot trade into 100 one-lot trades-some exchanges reacted. For instance, in May the ISE instituted a rule that counts all executed orders in the same series on the same side at the same price within a 30-second period as a single order.