Options Execs Fret Over Proposed Limit Up, Limit Down Rule

Good news for the stock market may be bad news for the options market.

Options industry executives predict problems for their marketplace if the Securities and Exchange Commission approves a new rule in its present form 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, according to some.

"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 an industry conference last week. "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 new rule was filed with the SEC by the stock exchanges and the Financial Industry Regulatory Authority in early April. It is intended to replace the circuit breaker rules put in place following the "flash crash" of May 2010. As written, it places 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, then trading is halted. The thrust of the proposal is to cap sharp price moves without halting trading, as is done under the current circuit breaker program.

It is that 15-second pause that irks O’Connell and other options executives. During that time, trading at new prices is effectively halted in the stock market but orders may still enter the options market. Options exchange executives initially pushed the SEC to accept a briefer pause state than 15 seconds, O’Connell noted at this year’s Options Industry Conference held last week in Savannah, Ga.

At least one options exchange executive expressed concern. "We’re still open in options," Paul Finnegan, a senior vice president at NYSE Euronext and co-CEO of NYSE Arca Options, said at OIC. "Are we merely transferring volatility from the equities side to the options side?" Other options exchange executives expect spreads to widen during these periods.

Ed Boyle, a managing director at market maker Getco and a former options exchange executive, noted the quandary of options players. "You’re open for business, but not really," he said at OIC. "It’s a tough one. Halts are easier to deal with."

Boyle’s brother James Boyle, a UBS executive and member of the options committee of the Securities Industry & Financial Markets Association, also wondered how the options industry would deal with the 15-second pause. "What happens to the options?" he asked at OIC. "Do they become the de facto equity?"

Boyle noted that broker-dealers and exchanges would have to figure out how to deal with the new rules. Brokers handling customer orders, for instance, would have to decide whether or not to put those orders through or stop them. A firm may choose not to accept market orders, he said. Market makers will have to decide whether to widen or narrow their quotes. Exchanges will have to decide whether or not to run their auctions during the 15-second window.

The SEC received the proposal from FINRA and the exchanges on April 5. It has yet to open a comment period.