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June 1, 2011

Problems With Limit Up, Limit Down

By Peter Chapman

Options industry executives predict problems for their marketplace if the Securities and Exchange Commission approves a new rule intended to curb volatility in the stock market. The so-called "limit up/limit down" rule could cause options spreads to widen and result in bad fills for investors, some say.

"I foresee a lot of problems," Jerry O'Connell, chief compliance officer at Susquehanna International Group, one of the options industry's largest market makers, said at this year's Options Industry Conference. "You will see a flood of orders coming into options that may be predicated on prices people are misreading in the stock market. There may be retail customers involved. We will be left with a bunch of orders possibly executed at bad prices."

The proposal was filed with the SEC by the stock exchanges and the Financial Industry Regulatory Authority in April. It is intended to replace the circuit-breaker rules put in place following last year's "flash crash." A limit up/limit down rule would place a constantly updating price band around a stock's rolling average price. For some stocks, the limit price is 5 percent away from the bid or offer. For others, it is 10 percent.

If a stock's quotes reach the band's prices, the market has 15 seconds to exhaust all liquidity at that price. If it does, then the band is reset and trading continues. If it doesn't, trading is halted. The purpose is to cap sharp price moves without halting trading, as happens under the circuit-breaker program.

It is that 15-second pause that irks O'Connell and other options executives. During that time, trading is effectively halted in the stock market, but orders may still enter the options market.

"We're still open in options," Paul Finnegan, co-CEO of NYSE Arca Options, said at OIC. "Are we merely transferring volatility from the equities side to the options side?" Spreads would widen during these periods, other exchange officals said.

James Boyle, a UBS executive and member of SIFMA's options committee, noted broker-dealers and exchanges would need to adjust. Brokers would have to decide whether to put customer orders through, he said. Market makers would have to decide whether to widen or narrow their spreads. Exchanges would have to decide whether to run their auctions.


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