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June 4, 2007

Dollar Strikes Out

Time to Call for an End to the Moratorium on Dollar Strikes

By Christopher Nagy

A little more than seven years ago, virtually every computer in existence was a ticking time bomb, and the world raced to diffuse the predicted doomsday scenario. When Jan. 1, 2000 arrived, electricity still powered our appliances, planes still flew over our heads, the securities markets still opened and closed normally, as did our banks.

Just as those Y2K worst-case scenarios ran rampant, so too are pessimistic views flying high with the recent introduction of penny quoting to the options markets. But contrary to the gloom and doom, and in what some would call one of the best recent examples of firm, exchange and regulatory harmonization, not only did the penny pilot program go off without a hitch, but it launched on time and according to SEC Chairman Christopher Cox's wishes.

Back in 2000, options-industry consortiums were scurrying about attempting to cope with the massive amount of quote traffic flowing through the pipes of the options markets. "Multiple listing," the then-recent introduction of quoting options on more than one exchange, was hitting the airwaves and peaking message traffic at a staggering 24,000 quotes per second.

Today, looking back on that scenario, one almost chuckles, knowing now that message traffic regularly exceeds 250,000 quotes per second, with plans to expand to 500,000 per second. Quote traffic has been and continues to be at the center of nearly every single option-related implementation. One of the mandates handed down by the SEC in conjunction with the penny pilot implementation was that each exchange develop a method to mitigate the number of quotes disseminated on the pilot securities, to help avert disaster. The exchanges obliged, and each of the six options exchanges created methodologies to stem quote traffic. It is this primal fear, the fear of too many quotes overloading the infrastructure, that serves to inhibit the real growth potential for equity options.

Held Hostage

In an industry where capital formation of new products and offerings is becoming scarce, the same cannot be said for the options markets, which have witnessed tremendous growth over the past decade. Much of this growth is directly attributable to the very nature of the product itself, as derivatives can be morphed and molded into many different trading instruments, and today rely less and less on product creation based upon the underlying equity.

But that's not for lack of trying to increase product in the underlying equity. Take Google, for example. You can trade strike prices with options ranging from $430 in $10 increments to a strike price of $750-a lot of choices indeed. But what if Google happens to be smack-dab in the middle of one of those $10 increments? You can either pay up for an in-the-money contract or gamble on the chance that the next out-of-money contract may trade at or near the money prior to expiration, but you're out of luck for a strike near the trading price.

There are hundreds of different scenarios for each security. But why can't an investor get a strike price closer to the trading price? Thanks to government regulation, the issuance of strike prices is mandated, so even if an exchange wanted to issue $1 strike prices, it's prohibited by regulation from doing so.