With the end of the penny pilot looming, the options exchanges are staking out their positions.
Most exchanges are proposing an extension and expansion of the two-year old pilot. But they are divided on how many classes and series should trade in penny increments.
The pilot, which ends March 27, cover 63 options. Some trade in pennies; some trade in nickels. Those that trade in pennies–options whose premiums are under $3.00–account for about one-third of all industry volume.
Most exchanges want to increase the number of options covered by the program to around 300 or 350 options or to all options. If the current breakpoint of $3.00 was to remain in effect, those classes trading in pennies would then account for about 85 percent to 90 percent of industry volume.
The level of that breakpoint however is the subject of debate.
The Chicago Board Options Exchange, one of the two largest exchanges, wants to lower the breakpoint to $1.00. All options priced at $1.00 or less would trade in pennies. Those priced above $1.00 would trade in nickels. Under this proposal, the amount of volume trading in pennies would remain about one-third.
The International Securities Exchange, the other large player, also wants to see a $1.00 breakpoint under which options would trade in pennies. But the exchange would also like to see a second breakpoint at $3.00. Those options trading between $1.00 and $3.00 would trade in nickels. Those trading over $3.00 would trade in 10-cent increments.
The Boston Option Exchange and NYSE Euronext, which operates two exchanges, want the breakpoint to stay the same or rise.
Nasdaq, which also operates two exchanges, has not made its position public. Calls to the exchange were not returned.
“Our plan would preserve the benefits of penny trading for those lower-priced more retail-oriented contracts, but increase the displayed liquidity for options trading above $1.00,” an ISE spokesperson said. “It would help to create a more natural aggregation of liquidity in those names.”
What is troubling the ISE and the CBOE is the lack of liquidity at the inside in those options covered by the penny pilot. They say institutional investors trading large orders are harmed by the scarcity of size at the top of the book.
BOX, on the other hand, is not concerned about the lack of liquidity at the inside. Most of its order inflow comes in small chunks of, say, 25 contracts to 40 contracts, according to BOX vice chairman Will Easley.
BOX would like to see the pilot expanded to 300 options. It does not want to see the breakpoint reduced. In fact, it could countenance a rise in the breakpoint to $4.00 or $5.00, Easley said. BOX would like to see a maximum number of options trade in pennies, but not so many that the increase in message traffic would overwhelm systems.
“You could trade everything in pennies, but you would cause traffic to go up, perhaps disproportionately to the improved market quality you are trying to achieve for your customer.”
BOX’s market share in the penny names is twice that of its market share in non-penny names.
NYSE Amex Options and NYSE Arca Options, the two options exchanges owned by NYSE Euronext, have a single viewpoint. They want to expand the pilot to the top 350 names by volume and keep the $3.00 breakpoint. They would like to see a phased-in approach of adding 100 new options to the pilot every quarter.
All the exchanges must file for an extension (or otherwise) of the pilot with the Securities and Exchange Commission by March 27. Within those filings, they are likely to state their positions.
The SEC, sources say, is pleased with the outcome of the pilot and is amenable to expanding it. What is uncertain is the regulator’s position on breakpoints.
Elizabeth King, an associate director in the SEC’s division of trading and markets, speaking at this year’s Securitity Traders Association of Chicago conference, would only say:
“There is a difference of views among market participants about the relative weight that should be accorded the benefits of narrower spreads on the one hand and the potential costs associated with smaller size at the inside on the other.
“Though we have been looking, there is not any obvious line where the benefits of pennies cease or outweighed by the costs of less size at the inside or increased message traffic.”
