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December 19, 2007

2007 Review: Pennies Roil Options Marts

The Year in Trading

By Peter Chapman

The biggest story of 2007 in the options market was the switch to penny pricing. Under a "pilot" program encouraged by the Securities and Exchange Commission, the nation's six options exchanges agreed to quote a limited number of options classes in either 1- or 5-cent increments, depending on their prices.

The pilot began in January with 13 names and was renewed and expanded in September with 22 more names. Next March, another 28 names will be added.

The 35 classes now trading in pennies account for about one-third of the industry's total traded volume. The 63 that are expected to be trading in pennies next March will represent about half of overall volume.

The impact on the market has been significant. Spreads in penny classes declined. Size at the inside dried up. Volume outpaced that of the overall market. Market makers dropped options. And exchanges introduced new pricing models.

This summer the SEC proclaimed itself pleased with the results of the pilot and indicated it was eager to see it expanded. The regulator's goal was to see spreads decline along with, it hopes, the industry practice of paying for order flow.

Not everyone is happy with the program. Options executives point out that the drop in size at the inside is bad news for institutional investors, a group driving much of the surge in options trading of the past few years.

The largest debate around pennies, though, centers on the future of options exchanges. Since they first came into being about 30 years ago, options exchanges have been supported by dealers risking their capital to quote bids and offers. In return, the dealers were guaranteed wide spreads and sizable chunks of incoming orders.

With pennies, three exchanges--two existing and one on the way--have challenged the traditional order with different pricing models. NYSE Arca and the Boston Options Exchange (BOX), the two newest exchanges, now pay anyone who quotes on their books for providing liquidity. Firms that are specialists elsewhere are welcome to quote on these systems, but their incentive is a cash payment, rather than a piece of the incoming order.

At the same time Arca and BOX charge traders for hitting bids and lifting offers, a practice the other exchanges largely abandoned several years ago. Nasdaq, which has said it would start up its own exchange this month, also plans to use the maker-taker model pioneered by Arca.

So far, the maker-taker model has been successful. NYSE Arca, for instance, reported its market share in the 35 penny classes stood at 17 percent at the end of October. That's up from 12 percent in April. Ed Boyle, in charge of options at NYSE Arca, attributes the exchange's success partly to its "uniquely attractive market structure." The remaining exchanges--the Chicago Board Options Exchange, International Securities Exchange, American Stock Exchange and Philadelphia Stock Exchange--are now faced with the possibility that they too may have to embrace the maker-taker model.

One exchange has already made its decision. As Traders Magazine was going to press, the Philadelphia agreed to be bought by Nasdaq. "The only way you add value in this area and an ability to grow is to have multiple market models under one holding company," Philadelphia chief executive Sandy Frucher told analysts at a briefing. "Which is what Nasdaq is wisely doing."

Nasdaq executives maintain they will operate two options exchanges--Philly's specialist-based pro-rata model and Nasdaq's maker-taker model. "The only way to grow our share and the only way for Nasdaq to grow its share is to have these two market models," Frucher said.