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Penny Candy for Traders

February 07, 2007

Dear Fellow Options Trader,

Whether you've been trading options for a few days or a few years, you might have noticed that prices are quoted in 5- or 10-cent increments. But in certain securities (with more potentially to come), you could be able to get into a trade for $1.21 instead of $1.25, for example. "Saving" 4 cents might not sound like a big deal, but when you spread that out over 10 contracts, that's $40 that you've already profited before the trade starts moving!

How's that, Doc?

Because the Securities and Exchange Commission (SEC) kicked off a penny pilot program last week on the six U.S. options exchanges, which reduces the minimum price change to a penny on the options for a core group of underlying stocks.

Thirteen classes of securities are involved in the pilot -- the iShares Russell 2000 (IWM), the Nasdaq-100 Trust (QQQQ), the Semiconductor HOLDRs (SMH), General Electric (GE), Advanced Micro Devices (AMD), Microsoft (MSFT), Intel (INTC), Caterpillar (CAT), Whole Foods (WFMI), Texas Instruments (TXN), Glamis Gold (GLG), Flextronics (FLEX) and Sun Micro (SUNW).

With the exception of the Qs, increments of 1 cent must be made available for all options series trading below $3 (including long-term options, or LEAPS) and 5 cents for options $3 and higher. (All options series for the Qs will be quoted as penny spreads.) The minimum price increments for all options series not participating in the pilot program will remain the same.

Depending on the success of the pilot, it will expand to include other stocks, indexes and Exchange-Traded Funds. Who says you can't get anything for a penny anymore?

BID/ASK SPREADS -- PERHAPS THE ONLY THINGS
THAT HAVE GOTTEN CHEAPER THROUGHOUT THE YEARS

To truly grasp what this will mean to our ability to trade options, it's important to understand the history of option pricing and trading. Here's a Reader's Digest version:

When the Chicago Board Options Exchange began trading listed options back in 1973, the only options available for trading were calls, which give the buyer the right (but not the obligation) to buy shares at a prescribed price for a set period of time. Put trading, which gives the buyer the right to sell shares at the strike price during the life of the option contract, didn't become widespread until the 1980s.

In fact, when I arrived at the CBOE as a clerk in September 1981, traders who served as market-makers in put options were in a distinct minority, as most preferred to simply trade call options.

Market-makers are exactly what the term indicates -- firms and individuals who match buy and sell orders to ensure a two-sided market. Those appointed to serve in this role are responsible for establishing/maintaining liquidity in a security and its options, which may include adjusting the prices to encourage more buyers or sellers, attracting money flow and thus providing balance. In exchange for the risk that they take on, they are able to profit from the difference between the prices where they buy and sell their inventory.

Since options began being listed in the 1970s, calls were both priced and traded in eighths, which means the minimum trading increment was $12.50 per contract (1/8 of a dollar per share, multiplied by 100 shares). For instance, if IBM traded for $281 per share, the bid price might be $281 and the offer price could be $281 and 1/8 ($281.125).

Similarly, the call options at the $280 strike might have a bid price of $5.25 ($5 1/4) and an offer price of $5.375 ($5 3/8). Thus, if you were an options market-maker, your profit margin would be the difference between the bid and the offer, or 12.5 cents ($5.375 minus $5.25). Option market-makers can buy and sell hundreds or even thousands of options per day, which meant that their profit potential from trading 1,000 options might be $12,500 (1,000 options x 12.5 cents x 100 shares per contract = $12,500).

I'd love to say that option market-makers never had a losing trade, but I suspect you know there's no such thing as a free lunch. However, if they were nimble and disciplined, they could scratch (i.e., trade out of losing positions at the same price where they entered them) and lose just an eighth instead of making the full 12.5 cents per trade. Done 1,000 times per day, they might net half (6.25 cents) per trade, which would mean a profit of $6,250.

WILL IT CHANGE THE WAY WE TRADE?

Looking back at numbers like this, you can probably conclude correctly that I took very few vacations in the '80s, as every day away from the pits meant kissing off thousands of dollars in potential profits. But the evolution of technology and competition throughout the years has already narrowed the profit between the bid and the offer from an eighth to a 16th of a point. And applying the same 50% of trades scratched, market-makers ended up with half the profit potential. The trade-off was that option volumes were exploding, so we were trading two or three times as many options to make the same profit.

Then the SEC mandated that both stocks and options trade in decimals. So, stocks went from having a minimum spread of 1/16 (6.25 cents) to a penny. You can imagine what that did to the profitability of trading stocks for the stock specialists. As a metric, when I started trading in 1981, the NYSE stock volume was routinely 50 million shares traded per session, and today the NYSE volume tops 2 billion shares changing hands, and that's on a slow day!

Now, as you know, options are derivates of the underlying stock or index. For every move in the price of that underlying security, the option-pricing models will move call and put prices up or down. Since the minimum spread between option bids and offers was 5 cents up until now, the models would round the values to the price that fit best, either rounding up from 5 cents to 10 cents or rounding down.

Penny pricing changes all that, as these derivatives will be moving up and down far more frequently when the computers round to the penny rather than the nickel. This will no doubt make the options market more competitive and attract all kinds of money flows from professional and personal investors who might have identified themselves as buy-and-hold stock investors in the past. For us, it could mean better bargains as well as increased volume that could, in turn, mean more people we can sell our contracts to (and potentially earn bigger profits in the process)!

In any event, if someone offers you a penny for your thoughts, you might want to take it and buy some options with it!


Jon "Doctor J" Najarian
Editor
ChangeWave Options Trader