A little more than seven years ago, virtually every computer in existence was a ticking time bomb, and the world raced to diffuse the predicted doomsday scenario. When Jan. 1, 2000 arrived, electricity still powered our appliances, planes still flew over our heads, the securities markets still opened and closed normally, as did our banks.
Just as those Y2K worst-case scenarios ran rampant, so too are pessimistic views flying high with the recent introduction of penny quoting to the options markets. But contrary to the gloom and doom, and in what some would call one of the best recent examples of firm, exchange and regulatory harmonization, not only did the penny pilot program go off without a hitch, but it launched on time and according to SEC Chairman Christopher Cox’s wishes.
Back in 2000, options-industry consortiums were scurrying about attempting to cope with the massive amount of quote traffic flowing through the pipes of the options markets. “Multiple listing,” the then-recent introduction of quoting options on more than one exchange, was hitting the airwaves and peaking message traffic at a staggering 24,000 quotes per second.
Today, looking back on that scenario, one almost chuckles, knowing now that message traffic regularly exceeds 250,000 quotes per second, with plans to expand to 500,000 per second. Quote traffic has been and continues to be at the center of nearly every single option-related implementation. One of the mandates handed down by the SEC in conjunction with the penny pilot implementation was that each exchange develop a method to mitigate the number of quotes disseminated on the pilot securities, to help avert disaster. The exchanges obliged, and each of the six options exchanges created methodologies to stem quote traffic. It is this primal fear, the fear of too many quotes overloading the infrastructure, that serves to inhibit the real growth potential for equity options.
Held Hostage
In an industry where capital formation of new products and offerings is becoming scarce, the same cannot be said for the options markets, which have witnessed tremendous growth over the past decade. Much of this growth is directly attributable to the very nature of the product itself, as derivatives can be morphed and molded into many different trading instruments, and today rely less and less on product creation based upon the underlying equity.
But that’s not for lack of trying to increase product in the underlying equity. Take Google, for example. You can trade strike prices with options ranging from $430 in $10 increments to a strike price of $750-a lot of choices indeed. But what if Google happens to be smack-dab in the middle of one of those $10 increments? You can either pay up for an in-the-money contract or gamble on the chance that the next out-of-money contract may trade at or near the money prior to expiration, but you’re out of luck for a strike near the trading price.
There are hundreds of different scenarios for each security. But why can’t an investor get a strike price closer to the trading price? Thanks to government regulation, the issuance of strike prices is mandated, so even if an exchange wanted to issue $1 strike prices, it’s prohibited by regulation from doing so.
In 2003, the SEC approved a pilot program for which the exchanges and general public had lobbied for years. The program allows the exchanges to list $1 strike prices on a very short list of options on certain underlying stocks, with trading prices below $20, at $1 strike-price intervals. This program has been wildly successful on the handful of securities in the program.
In fact, the exchanges themselves cite that of the 22 option classes originally selected, average daily volume increased more than 100 percent in 10 classes, and that in some of the pilot stocks, volume even tripled. So why has a pilot program that has been in existence since 2003 and demonstrated remarkable success not been allowed to thrive?
Enter quote traffic worries, and you have your answer. In their zeal to race to penny quoting, regulators are hampering the growth potential of options, exerting government choice over consumer demand. Dollar strikes would serve to lower the ultimate cost borne by investors, as strike prices at the money tend to be more liquid, trade with tighter spreads and offer less premium to the investor. In fact, one could easily argue that dollar strikes would be infinitely more beneficial to retail clients and the options markets than penny quoting.
At the money is generally where the action is. For buyers, at-the-money options provide a favorable balance between risk and reward. Why? Their values are more sensitive to underlying price and volatility movements. Similarly, sellers of at-the-money options are rewarded due to the highest levels of time decay. The lack of dollar strikes creates fewer opportunities for these strategies, a factor potentially many times more costly to clients when compared with the penny-generated savings on transactions costs.
We Want Our Cake
While it is almost certain that more securities will be added to the penny pilot over the course of the next few months, it is more certain that the dollar-strike pilot, once again up for renewal, will be approved as-is, without hope of expansion. And once again, the options industry and investors alike will be held hostage to decisions avoided because of the fear of catastrophe that permeates our markets. In the end, we are watching our pennies but losing our dollars. It is time to call for an end to the moratorium on dollar strikes, to allow our options exchanges to realize their full potential and to give consumers what they really want.
Christopher Nagy is a managing director at TD Ameritrade and oversees its order routing practices.
