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August 6, 2009

Final Stretch for Options Penny Pilot

By Peter Chapman

Decisions. Decisions. The Securities and Exchange Commission has twice put off deciding whether to expand or shrink the pilot covering trading in penny increments. The pilot was originally slated to end March 27. The SEC chose not to decide on an expansion and permitted it to run until July 3. The regulator did the same last month, sanctioning an expansion to Oct. 31.

The pilot is now more than two years old, and the industry is divided over whether the current number of options trading in pennies should be increased. Many participants are eager to take the pilot to the next level.

NYSE Arca is one of them. The exchange is now driving the agenda with its June proposal to expand penny trading at its exchange by another 300 classes. That would bring the total number of options classes trading at NYSE Arca in pennies to 363. The plan is unchanged from a previous NYSE Arca proposal to require penny trading in all options that cost less than $3. Those costing $3 or more would trade in nickel increments.

If all exchanges adopted this plan, trading in pennies would account for between 85 and 90 percent of all volume. Today, trading in pennies accounts for about half of all volume.

NYSE Arca's proposal has both supporters and detractors. The Chicago Board Options Exchange and the International Securities Exchange are in the opposing camp. They would prefer to reduce the number of options trading in pennies.

The two recently submitted proposals of their own calling for an expansion of penny trading, but recommended a $1 break point. Only those options trading for less than $1 would trade in pennies. Under the CBOE's plan, all other options would trade in nickel increments. Under the ISE's proposal, options trading from $1 to $3 would trade in nickels. Options trading for more than $3 would trade in dimes.

The two exchanges' proposals would reduce the number of classes trading in pennies, leaving about one-third of volume subject to penny trading. The exchanges want to curb trading in pennies because the pilot has resulted in less size at the top of the book, which has driven block trading to the over-the-counter market.

The CBOE points out that most volume occurs in the classes trading for less than $1 anyway. Both exchanges note that retail customers, presumably the SEC's target, tend to trade the cheaper options.

"The case for trading options over the counter has gotten stronger," Boris Ilyevsky, managing director of the ISE's options exchange, told Traders Magazine. "Two years ago, the spread was at least a nickel wide and there was more liquidity on the screen. Spreads were wide enough that a market maker was more willing to take the risk."

The Securities Industry and Financial Markets Association and at least one big options broker also want to see a rollback of the pilot by reducing the break point to $1. "Executing larger client orders in pilot options has been more difficult due to decreased liquidity at the inside market," executives from UBS told the SEC in a letter. "To compensate for the loss of liquidity, UBS more frequently facilitates the other side of larger options orders."

NYSE Arca does have its supporters. Large retail brokerage TD Ameritrade recommended the SEC keep the $3 break point in a letter to the regulator. TD Ameritrade noted that while most volume occurs in options that trade under $1, most trades occur at or below $3.



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