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October 1, 2012

FINRA Eyes Options Manipulation

By Peter Chapman

The Financial Industry Regulatory Authority is investigating allegations of manipulation in the options market.

Specifically, the regulator is targeting newly discovered types of "mini manipulation," or the trading of an option's underlying equity in order to profit from movements in the price of the option.

"This is an area of interest for us," Gene DeMaio, a senior vice president in FINRA's market regulation division, said at a recent industry event. "We're spending a lot of time on it."

Gene DeMaio

Traditionally, so-called mini manipulation occurs when a trader with a large position in an option trades a small amount of the underlying stock in order to drive the option into an in-the-money status. Often done in illiquid securities, this tactic produces a profit for the trader and is illegal.

FINRA has recently been tipped off by options market makers to potentially new permutations of this age-old strategy, DeMaio said last week at an options conference sponsored jointly by the Futures Industry Association and the Options Industry Council.

One example involves traders moving the price of the underlying in order to establish a position in the option at a better price. In this case, the trader has yet to establish his options position. That contrasts with the classic scenario where the trader already has an options position.

The other tactic FINRA is looking at involves moving the price of the underlying in order to affect the volatility of the option. This, DeMaio explained, is akin to "spoofing." That occurs when a trader rapidly quotes and then cancels his orders to draw in buyers or sellers in order to move the price of a security.

DeMaio acknowledged that instances of mini manipulation are very difficult to prove. Rather than manipulation, it just might be "good trading," he said. "Certainly we understand that in this environment where algos are acting and reacting very quickly, it just might be a legitimate algo strategy that looks like manipulation."

In response to dealer complaints, FINRA has re-worked some of its surveillance reports "to address these new varieties of the classic scenario and hopefully to capture more of the data," DeMaio told conference go-ers.

 

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