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Elaine Wah

Modern Markets, Modern Metrics - A Blog By IEX

In this blog by IEX's Elaine Wah, the newest public exchange looks to refute public claims that the metrics it uses are designed to inflate its own volume numbers and mislead people.

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August 14, 2007

Dark Orders in Options Under Fire

By Peter Chapman

The number of options in the penny pilot program was just expanded, but one options exchange and a contender are chomping at the bit to trade more in penny increments. Their approach has angered two of the industry's bigger players.

The Securities and Exchange Commission-urged penny pilot, which was just extended and expanded for another 20 months (see related story, p. 24), permits quoting in penny increments in 13 options.

The Chicago Board Options Exchange and Nasdaq, which hopes to launch options trading later this year, are proposing to enable penny trading in many more classes. By allowing controversial "dark," or hidden, order types, they believe they can provide broker-dealers with large-scale penny trading with or without the SEC's go-ahead.

The concept doesn't sit well with a rival exchange and one of the largest hedge funds. The International Securities Exchange and Citadel Investment Group have blasted both proposals as violations of industry rules, and have said the proposals would undermine the structure of the options marketplace.

Both Nasdaq and the CBOE plan to let their customers post orders on their books in penny ticks, even if the option is officially quoted in nickels or dimes. The exchanges will disseminate those quotes to the public at the nearest legal increment. Most of the approximately 2,000 options are quoted and traded in nickel and dime increments, depending on their premiums.

Under the proposal, if the public quote is $1.00 to $1.05, for example, a trader could post a bid for $1.02. The exchange would round the quote to $1.00 for dissemination to the Options Price Reporting Authority.

An incoming contra-side sell order would then trade at $1.02, not $1.00. In effect, it would have received price improvement over the published quote. That's why the CBOE and Nasdaq are promoting their initiatives under the banner of "price improvement."

The process is similar to the price-improvement auctions run by the Boston Options Exchange, CBOE and other exchanges within their markets. The proposals would, effectively, transform the main market along the lines of these "mini" auctions.

The ISE and Citadel protested via comment letters to the SEC. "Nasdaq's proposed price-improving orders will violate the firm quote rule," the ISE stated. "No one will know the actual prices communicated to the exchange, which are the prices [at which] the transactions can take place."

The ISE had the same message regarding the CBOE plan. It "proposes to make a mockery of the firm quote rule," the ISE wrote.

Citadel struck the same note. It told the SEC that Nasdaq's price-improving orders as well as other non-displayed orders will "result in a Nasdaq Options Market limit order book that consists of hidden trading interest of unknown depth and size. It will be impossible for market participants to know the true price or size of the best trading interest on the NOM at any given time."

As for the CBOE, Citadel said, it "would like to create a hidden market for options. This hidden market would make a mockery of transparency and order display rules." In its defense, Nasdaq maintains it is doing nothing that isn't done already in the mini auctions. In fact, it is improving on them, according to Nasdaq officials.

"It moves that process up front and makes it a lot faster," said Adam Nunes, the Nasdaq official in charge of the exchange's options program. Nunes said the Nasdaq process is fairer because it doesn't "freeze" an order for three seconds.

"We think it is an enhancement over the way the market works today," Nunes added. "We are confident it will be approved."