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Penny-Wise but Pound-Foolish?

February 15, 2007

Dear Fellow Options Trader,

From the movie "The Sting":

Doyle Lonnegan: "I put it all on Lucky Dan; half a million dollars to win."
Kid Twist: "Win? He said place! 'Place it on Lucky D…' That horse is gonna run second!"
(There is a pause, and Lonnegan runs to the betting booth, horrified.)
Lonnegan: "There's been a mistake! I want my money back!"


Dear Fellow Options Trader,

Just a couple of weeks ago (Jan. 26), the options industry -- pushed kicking and screaming by the Securities and Exchange Commission -- threw a switch and began pricing a handful of option chains in penny increments. That might not seem like a huge step to you, but believe me when I say that history will show that this was one of the largest generators of interest and liquidity ever to hit the derivatives trading industry!

The Penny Trading Pilot Program has only been rolled out in a small number of option classes (you can click here to refer back to last week's discussion on penny increments), but the impact will be anything but limited.

… LIKE A BAD PENNY

First and foremost, the liquidity providers (also known as market-makers -- although, depending on who you ask, they've attracted a host of negative monikers such as bloodsuckers, scum and "Ali Baba and the Forty Thieves") have tried to explain that the pricing of options in pennies will bog down the current quoting systems.

Nobody has wanted to listen to that argument against penny pricing, but I'm here to tell you that denial isn't just a river in Egypt -- it's what the SEC is in if it believes that penny pricing will not significantly delay the market's ability to deliver live quotes.

As an example, if you have a T1 connection to the Internet, then you have a 1.4 megabyte connection -- and most consumers would qualify that as high-speed Internet. However, describing a T1 connection as "high-speed" to a massive-bandwidth user like me is similar to taking a Schwinn 10-speed to Bike Week in Daytona! (It's a motorcycle rally, for the unfamiliar.)

To get the data I need, in its most virginal state, I need a gigabyte connection to the Internet. As you probably know, a gigabyte is 1,000 (in some cases 1,024) megabytes, so comparing my bandwidth needs to the average consumer's is simply not possible. In case you're shopping around for this type of connection, depending where you are in the United States, it will run you about $20,000 per month!

Now this isn't a tutorial for bandwidth, but I want to give you an overview of how much data capacity is necessary to provide all this extra information to see why the liquidity providers are screaming like the proverbial stuck pigs.

* A DSL connection with download rates of, say, 192KB and upload rates of 24KB will run you $25-$35 per month.

* A T1 connection with download rates of 192KB, but upload rates of 192KB, will run $300 per month.

* An OC3 connection with download rates of 19MB and 19MB in uploads will run about $7,000 per month.

Now here's where the rubber hits the road when it comes to you, the consumer/investor seeing trading data.

If you had a gigabyte of data that you need to "see" or download, the DSL user will need 1.4 hours. (What, were you in a hurry?!) The T1 user will need roughly the same, and the OC3 user will need 51 seconds. With my computers and Internet connection speed, I am seeing it in the same second that I access it!

So now let's say the SEC's mandated penny pricing effort increases the quote traffic coming off the U.S. options exchanges by just three times the volume of quotes that presently blast through the Options Price Reporting Authority. This means that instead of speeds of 60,000-80,000 quotes streaming per second, we will see 180,000-240,000 quotes per second.

This is like pushing icing through a cake-decorating tool. The larger the opening of the tool, the faster the frosting comes through. Conversely, the smaller the opening, the longer it will take for the frosting to reach its destination.

Bottom line, I think you should thank the good Lord that this is a pilot program and not an industry-wide practice yet, as your ability to see the bid and offer prices -- not to mention the last traded price of an option -- would be impacted so dramatically that you'd feel they purposely stacked the odds against you. (Hence those not-so-nice nicknames mentioned above!)

The good news is, that they haven't stacked the odds against you -- but it will take time to make sure you don't make trades based on quotes that arrive several seconds late. In horse racing, they used to call that "past posting," and fans of Robert Redford will recall how this form of cheating was effectively used in the 1973 movie "The Sting."

Knowing the outcome of a race before its run usually means you can't lose. The same is true with trading, only on a much larger scale!


Jon "Doctor J" Najarian
Editor
ChangeWave Options Trader