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June 4, 2007

Dollar Strikes Out

By Christopher Nagy

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In 2003, the SEC approved a pilot program for which the exchanges and general public had lobbied for years. The program allows the exchanges to list $1 strike prices on a very short list of options on certain underlying stocks, with trading prices below $20, at $1 strike-price intervals. This program has been wildly successful on the handful of securities in the program.

In fact, the exchanges themselves cite that of the 22 option classes originally selected, average daily volume increased more than 100 percent in 10 classes, and that in some of the pilot stocks, volume even tripled. So why has a pilot program that has been in existence since 2003 and demonstrated remarkable success not been allowed to thrive?

Enter quote traffic worries, and you have your answer. In their zeal to race to penny quoting, regulators are hampering the growth potential of options, exerting government choice over consumer demand. Dollar strikes would serve to lower the ultimate cost borne by investors, as strike prices at the money tend to be more liquid, trade with tighter spreads and offer less premium to the investor. In fact, one could easily argue that dollar strikes would be infinitely more beneficial to retail clients and the options markets than penny quoting.

At the money is generally where the action is. For buyers, at-the-money options provide a favorable balance between risk and reward. Why? Their values are more sensitive to underlying price and volatility movements. Similarly, sellers of at-the-money options are rewarded due to the highest levels of time decay. The lack of dollar strikes creates fewer opportunities for these strategies, a factor potentially many times more costly to clients when compared with the penny-generated savings on transactions costs.

We Want Our Cake

While it is almost certain that more securities will be added to the penny pilot over the course of the next few months, it is more certain that the dollar-strike pilot, once again up for renewal, will be approved as-is, without hope of expansion. And once again, the options industry and investors alike will be held hostage to decisions avoided because of the fear of catastrophe that permeates our markets. In the end, we are watching our pennies but losing our dollars. It is time to call for an end to the moratorium on dollar strikes, to allow our options exchanges to realize their full potential and to give consumers what they really want.

Christopher Nagy is a managing director at TD Ameritrade and oversees its order routing practices.