Back in June 1985, Richard Ketchum brushed aside criticism of the Securities and Exchange Commission's budding policy for trading options based on Nasdaq stocks.
"Fairness," said Ketchum, the then SEC director of market regulation, "is in the eyes of the beholder. I guess the NASD's view is that what they ended up with wasn't fair."
Certainly, the National Association of Securities Dealers had no doubt about the fairness of the SEC's policy, having lashed out earlier at the agency for allowing U.S. listed exchanges to begin trading options on Nasdaq stocks.
The exchanges were the Chicago Board Options Exchange (CBOE), the New York Stock Exchange, the American Stock Exchange, the Pacific Exchange (PCX), and the Philadelphia Stock Exchange (PHLX).
The NASD was upset because the listed exchanges had full regulatory approval, while Nasdaq's petition to join them trading options on the the Nasdaq 100 index was still pending. The listed exchanges were also approved for trading options on six of the most active Nasdaq issues.
Moreover, the NASD was hot under the collar because the other exchanges had the SEC's blessing to become, in effect, direct competitors.
The NYSE, Nasdaq's arch rival, sent blood-pressure levels soaring even higher among some Nasdaq officials when the Big Board cleared the way for trading in options.
To that end, the Big Board, which vehemently opposed "side-by-side trading," created a physical wall separating the options and stock trading-floor operations. Traders nicknamed it the Rappaport Wall, after Sheldon Rappaport, the SEC regulator involved in the pilot program. (In the late 1970s, the SEC expressed support, but since then never actually permitted side-by-side trading.)
The Big Board's options efforts worried the NASD's high command. If the SEC's approval remained, the NASD told the agency it would press for permission allowing Nasdaq to trade listed options and their underlying stocks. A somewhat bemused SEC called the petititon "highly unusual."
Pilot Program
Except for a brief fling soon afterwards, the foray by the NASD into trading options, based only on Nasdaq-listed companies, simply fizzled out.
"It never got off the ground," said Bernard Madoff, principal at the off-exchange retail-trading giant Bernard L. Madoff Investment Securities, whose firm participated in the pilot program.
"Part of the problem," added Madoff, who back then was director of trading at the New York-based firm, "was that the technology provided to market makers was not adequate for them to trade options efficiently."
The inadequate technology stymied Nasdaq market makers trading contracts on a companion futures product on the Nasdaq 100 index at the CBOE, as a hedge on contracts in the Nasdaq 100 index itself.
The Big Board, too, eventually exited the business, in part because of fears it would diminish the capital available for its core stock trading, and in part because stock and options trading were mixing like oil and water.
"The guys trading equities were sort of like nice boys from Eaton and Harvard, and the options boys were brawlers, like big rough boys from the docks," recalled Chris Keith, a former Big Board official who was the exchange's chief information officer during the pilot program.
Today, with consummation of a marriage that would have seemed unlikely just a few years ago, the NASD and the AMEX are locked in a sizzling new relationship. That relationship could once again bring into sharp focus the trading of stocks and options within a single marketplace, albeit the NASD's market of markets.
Later this year, the PHLX is likely to join the merger, making the market of markets a formidable stock-options trading competitor.
In fact, the U.S. options marketplace will likely be controlled by two players: the NASD and the entity formed by the CBOE, if it finally completes its acquisition of the options business of the PCX. At the moment, the CBOE is the leading U.S. options exchange with the AMEX ranking second.
But the question is, does a daring marriage of stocks and options trading make sense, especially the stock trading on an electronic dealer market with the options trading on the AMEX and its former East Coast rival, the PHLX?
"I think the NASD is hoping it will be able to pitch Big Board-listed companies such as IBM and say, Hey, we're already trading your options on the AMEX, we've dealer and auction-trading capabilities, so why don't you come trade your stock on Nasdaq?,'" said Patrick Healy, a former Nasdaq official, and now president of The Issuer Network, a Chevy Chase, Md.-based consultant to publicly-listed companies.
But there is a more compelling reason why the NASD wants to control the order flow in options trading. The business is growing at an exponential rate, among both retail and institutional investors.
San Francisco-based discounter Charles Schwab & Co., for instance, reported handling 1.85 million stock-option trades last year, a 54 percent increase over 1997, when it handled 1.2 million trades. Today, more than 110 million options contracts are traded annually in the U.S., representing over 11 billion shares. By contrast, only one million contracts were traded in the early 1970s when options were becoming a more standardized investment instrument.
Spurred by the strong growth in options trading, the NASD is said to be preparing a multi-million-dollar advertising campaign that will entice retail investors to more actively use stock options as a hedging and investment tool.
"If the NASD did not acquire the AMEX for its options business, then it is unbelievably screwed up," said Gene Finn, a retired NASD chief economist.
Proponents
Nowadays, one of the greatest proponents for the trading of stocks and options within a single market is Richard Ketchum, the former SEC director of market regulation, and now president and chief operating officer of the NASD.
In an interview with Traders Magazine, Ketchum said the NASD's goal over the coming years is to become a global marketplace. To achieve that goal, he said a marketplace must integrate stock trading and derivatives expertise, or else run the risk of losing a competitive edge. "We view the options business as very important," he said. "Certainly, we are going to make investors aware of our exciting initiative."
The AMEX's options business, some experts say, is probably the only good reason the NASD acquired the exchange, which is headquartered at 86 Trinity Place in downtown Manhattan.
Indeed, some have labeled the AMEX's options business the crown jewel of an otherwise lame exchange. (Others stress, of course, that the new partner gives auction-market trading capabilities to the combative NASD, and more spiced-up marketing heft).
Reflecting the growth in U.S. options business, the average daily options volume in September 1998 on the Amex was 380,000 contracts, maintaining the exchange's ranking as the second-largest options exchange in the U.S.
In 1997, option trading generated about half of the Amex's gross receipts of $200 million. (Options contracts on Intel, a Nasdaq-listed company, which are the most actively traded options in the U.S., accounted for almost 37,000 average daily contracts at the AMEX in September.)
If the PHLX joins the NASD's market of markets, it would put the CBOE and the NASD's combined entities in a neck-and-neck race, each holding a roughly 40 percent market share. The competition would become even more intense if the CBOE absorbs, as expected, the options business of the PCX.
"The U.S. would then have two options exchanges," an AMEX spokesman noted gleefully.
Meanwhile, one of the immediate aims of the NASD as it fully absorbs the AMEX, and later perhaps the PHLX, is the electronic integration of options and stock trading
But can the NASD successfully manage a business that is still on the periphery of its core stock-trading capabilities? Most likely yes.
More than ever before, the NASD has the technological muscle to seamlessly integrate its Nasdaq and options marketplaces, experts say. "They can pull it off this time," said one market veteran. "Failure would be unthinkable."
Nasdaq market-marking firms do, of course, trade options based on Nasdaq-listed companies. However, since the Nasdaq market itself does not list options contracts, the risk managers at Nasdaq trading firms will sometimes hedge, buying and selling, for example, puts and calls on other markets but not on an NASD-controlled entity excepting its merger with the AMEX. (Options contracts on the Nasdaq 100 index are quite popular on the CBOE.)
For his part, Ketchum said the NASD wants to build an electronic link on the Nasdaq workstation, giving market makers easier access to the AMEX options floor. "The main thing is a fast, efficient and low-cost electronic system allowing market makers to send their [options] orders down to the floor of the AMEX so they can hedge and lay off risk," he said.
The NASD has budgeted $110 million to upgrade AMEX technology. But the labor intensive, open-outcry trading on options at the AMEX and the PHLX will likely remain, despite the rush to automation at derivative exchanges elsewhere, especially in Europe. (Currently, market orders for under 20 contracts are eligible for automatic execution at the AMEX.)
The terms of the provisional agreement with the PHLX envision trading remaining domiciled in Philadelphia for up to five years. Later, it is expected that the PHLX's trading-floor operations will be consolidated at the AMEX.
As part of the AMEX's earlier agreement to acquire the PHLX, the PHLX temporarily relocated traders writing contracts on Dell Computers to New York from Philadelphia. That allowed the AMEX to upgrade the PHLX technology platform.
The Risks
To be sure, the trading of options contracts is sometimes fraught with more peril than the trading of the underlying stocks, especially given the volatile markets of recent months.
"The volatility over the past few months has driven some people from the business," said Steven Lesser, an options trader on the AMEX floor. Another options trader, who is based in Chicago and declined to be named, said rumors are swirling with accounts of several traders who were financially ruined by recent market swings.
"If the market moves daily on 500 and 600-point swings in the Dow Jones Industrial Average, an options trader can get his head handed to him because he is going through so many different strike prices," explained the trader, referring to the prices at which the underlying shares in a contract can be bought or sold for.
If, for example, an investor buys a put with a strike price of $50, paying a $3 premium, the investor would presumably profit on any drop in the stock price below $47 (excluding commissions and other charges).
The options trader on the exchange floor who is short the put, could just as easily lose on each stock dip, because he would be obliged to buy the shares at a loss. Options trading, in effect, is a zero-sum game.
Traders, however, offset risk with complex strategies and make money on changes in the price of premiums, rather than in exercising options in puts or in calls (which are the opposite of puts and give the holders the right but not the obligation to buy shares at a fixed price up to a fixed date).
Some traders thrive on volatility. A straddle, essentially a bet on volatility, is a good illustration. A trader buys two matching options, a call and a put, which cancel each other out. One profitable outcome allows the trader to let one option expire while exercising the other option when the underlying stock price has moved far enough.
Side by Side
Some experts think the SEC should allow market makers and listed floor professionals to trade options based on Nasdaq and listed issues alongside trading on these stocks, in so-called side-by-side trading. Thus, market makers on Nasdaq could essentially take a position on a stock, and at the same time turn around and buy a defensive put call.
Critics charge that such a move would create a compliance nightmare, because, for example, closer access to a Nasdaq desk's equity order-handling business could unfairly influence the same desk's options strategies.
"To my mind that's ridiculous," Madoff said. "Anything is open to abuse if it is not monitored properly. With the surveillance capabilities and the technology available today, there is no reason why those concerns can't be alleviated to allow side-by-side trading."
Howard Lasher, a stock trader on the floor of the AMEX, said he thinks side-by-side trading is in the cards. "It won't occur from the get-go, but it is something that the AMEX member firms want," he said.
But the NASD has no plans to introduce the trading of options and equities side by side. Ketchum said that market makers over the years never expressed much enthusiasm for it. Besides, he stressed, the SEC still prohibits the practice.
Madoff, nevertheless, insisted that strong options products trading alongside equity products would strengthen Nasdaq's core business, in part because more investors are interested in efficient hedging capabilities. Another trader on Nasdaq echoed Madoff.
"Why not? I think it makes sense to do side-by-side trading," said Andy Garrett, head of Nasdaq trading at Sterne, Agee & Leach in Atlanta. "It could have potential benefits."
Others think that the NASD could get its fingers burned by too aggressively marketing and integrating its newly-acquired options business. "In my view, companies don't like derivative products," said The Issuers Network's Healy. "If a guy is going to make money on my stock, then I want him to buy my stock. I don't want him to invest in the company's price movement."
For his part, the NASD's Ketchum said that studies contradict that argument. "[Options trading] actually increases stock volume rather than decreases it, because it allows investors to adjust their risk profile more completely than if all they were able to do was buy or sell stocks," he said.
Whatever the full truth, some traders on the floor of the AMEX say they are excited by the marriage to the NASD.
"Nasdaq is going to bring some terrific expertise to the exchange in the very near future," said AMEX floor options trader, Steven Lesser. "That will give us access to the other side of our transactions and an easier view of the financial intermediaries upstairs."
