Few subjects in the options world are drier than transparency. However, recent events have suddenly thrust this obscure topic into the spotlight. This renewed interest can be traced back to the explosion of dividend trades in the option markets. Dividend trades are short-term trades involving large numbers of contracts where little capital is at risk and no liquidity is added to the marketplace. The record volume pouring into these trades has re-ignited an old debate about volume in the options industry.
For decades, the industry mantra has been "a contract is a contract." While there were arguments about how to deal with certain types of trading volume such as boxes, crosses and dividend plays, the answer was always the same. If it traded, then it counted, period.
Questions about where a particular contract came from, what it was intended for and what impact it had on the industry were irrelevant. For the exchanges, volume and market share became even more important with the onset of multiple listing in 1999. Intense competition ensued between the exchanges.
Events
Exchanges even paid brokers to route orders to their trading floor. In such a cutthroat environment, transparency was hardly the highest priority.
Multiple listing was a watershed event for the industry. Demutualization in 2005 is a close second. On March 9, 2005, the ISE became the first options exchange to go public. Hoping to follow suit, the remaining membership-based, non-profit exchanges reorganized into for-profit companies. This restructuring activity, along with the exploding market capitalizations of the Chicago Board of Trade and the Chicago Mercantile Exchange, caught the eye of the investment community.
However, analysts and traders don't care about semantic notions like transparency. They only care about fundamental numbers; hence the uproar over the dividend trades. With the PCX and PHLX trading millions of extra contracts every month, the delicate balance within the industry has been overturned. Competing exchanges saw their market shares plummet, something that public and for-profit companies can ill afford, no matter how dubious dividend trade volume may be. "Trying to explain why this isn't real volume' to an analyst who doesn't particularly understand the options business is a very difficult conversation," explains Michael Bickford, senior vice president for options at the AMEX.
The flurry of dividend trades has finally prompted the exchanges to react. They are beginning to segregate the industry's volume. The PHLX and the ISE were the first exchanges with segregated volume reports. The ISE's February 2005 report carried the following disclaimer to explain its decision. "The exclusion of dividend trades from total industry volume data presents a more relevant measure of the relative trends in our business."
False Impressions
Transparency advocates have long demanded changes to the way that options are routed, executed and counted. By lumping every single contract together into one volume number, they argue, the industry is giving customers a false impression of activity in the marketplace. However, once one begins parsing volume numbers, the question inevitably becomes, where does it end?' Do legitimate trades have to risk capital and add liquidity to the marketplace? Should trades that provide a disincentive to liquidity be counted separately? Is one trading strategy more legitimate than another? What criteria should be used to judge? The list of possible segmentations is truly endless. "When you try to slice this stuff down, it becomes difficult, if not impossible, to do," says Bickford. "At the end of the day, it really depends on what you think volume is."
The ramification of segregating dividend trade volume is that it makes other types of volume much more difficult to defend. For example, why should boxes and other trades that profit from interest rate differentials be counted, while dividend trades are not? After all, both strategies inflate volume and add no liquidity to the marketplace.
A Contradiction?
Some attribute this seeming contradiction to the enormous scale of the dividend trades. While interest rate trades are still a relatively small phenomenon, dividend trades have become so prominent that they can no longer be ignored. "We felt that we had to explain what was going on with these dividend trades because they are so large when compared to regular trading volume," says David Krell, CEO of the ISE. "If something is so abnormal that it distorts regular trading activity, and is only used by a couple of market makers, then our customers should be made aware of it."
The issue of segregating options volume raises far more questions than it answers. Some feel that the true problem lies not with what is included in the numbers, but with what is excluded.
While dividend trades may be causing the current furor, they are merely symptoms of a deeper problem. For an industry in which competition is predicated on market share, the options business is surprisingly tight-lipped about what actually goes into its volume reports. After years of ignoring questionable volume, the industry is now suffering the consequences of its inaction. After all, if something used to be OK for a few thousand contracts a month, why is it suddenly wrong for a few million? That question will become more important as continued fee cuts make dividend trades, interest rate trades and other similar strategies more attractive. Now that certain volume has been labeled misleading, perhaps it is time to take another look at the other numbers being released.
Do the most common volume numbers, including open interest and average daily volume, really provide an accurate reflection of option activity? Sadly, the answer is, No.' There is far too much misleading volume in those numbers to make them useful. For example, if a customer sees that 10,000 contracts traded on a particular strike on a certain day, what does that really mean? It could be legitimate customer volume, indicating that the strike is very active and liquid. It could also be a dividend or interest rate trade, giving the false impression of liquidity where none actually exists. It could also be a mid-market facilitation trade for an important brokerage client that was executed at a price the average customer could never receive. It could also be a combination of all three types of volume. The truth is that no one knows for sure, and that is a problem.
If the industry wants to continue to grow its customer base, then it needs to provide them with the tools to decipher trading volume.
Instead of providing one volume number, customers should be given an accurate breakdown of activity in a given option. Such a breakdown would require a serious debate on how to count and disseminate various types of contracts to the public. To accomplish this, technological upgrades would have to occur within the current system of volume reporting. In the past, the industry has been loath to take these steps. In the future, it may have no other choice.
The views in this column are those of the author and do not necessarily reflect the opinion of Traders Magazine.
