Investor Brain

Saturday, December 09, 2006

The New Penny Options

REMEMBER THE HUBBUB OVER the decimalization of stock prices back in 2000? Well, get ready for a little déjà vu, because it’s coming to the options market early next year.

Options are currently priced in increments of a nickel, which means that a one-tick change in price changes the overall cost of a single contract by $5. (Each contract gives the right to buy or sell 100 shares of underlying stock.) Cutting the increment to a penny means that a one-tick change alters the price by $1.

More aggressive exchanges that help a trader get price improvement on a trade—that is, an increase in the selling price or a decrease in the buying price—are likely to find even greater flexibility in pricing when a contract is priced in the new, smaller increments. The net result should be a cost saving to investors, as well as an opportunity to turn a profit on smaller price moves.

The Securities and Exchange Commission has mandated that a pilot program in penny options pricing get under way Jan. 27, 2007, when 13 underlying stocks will have options offered in penny increments on various exchanges. One of those bourses is the NYSE Arca Options platform (formerly the Pacific Exchange and the Archipelago Exchange, or ArcaEx), which said in October that it would participate in the program.

Why didn’t options pricing shift to pennies when the stock market decimalized? The answer is bandwidth. In stocks, you have only one IBM, for example. But with options you have to contend with multiple strike prices and expiration dates, and also have to display the various puts and calls. A single stock can have hundreds of related options contracts.

The initial 13 tickers include QQQQ (Nasdaq-100 Tracking Stock), IWM (iShares Russell 2000 Index Fund), GE (General Electric), MSFT (Microsoft) and SUNW (Sun Microsystems). The pilot program could go on for a year or longer, depending on how quickly any technical issues can be resolved.

In a statement, the NYSE said the “proposed quote-mitigation plan will significantly reduce overall quote traffic in all of NYSE Arca’s options issues, not just those selected for the pilot program” and that the exchange proposes “to disseminate quotes only in ‘active’ options series.” Because of the smaller price increments, prices will change faster and more frequently, significantly affecting the amount of information the bourse can provide. Five other U.S. exchanges will also participate in the penny-pricing test.

Several online brokers have already begun to offer new ways for options traders to participate in penny options pricing. For instance, optionsXpress (http://www.optionsxpress.com) has introduced penny-increment pricing capabilities on certain options spreads. Options spreads are common strategies that help investors balance risk and reward, and involve buying and/or selling a combination of two or more different options at once.

“Tighter prices should bring more opportunity for more investors and more liquidity, as trades will require smaller market movements to be successful,” says David Kalt, chief executive officer of optionsXpress Holdings.

Interactive Brokers (http://www.interactivebrokers.com) is taking the penny pricing a step further and allowing customers to trade options with each other on most contracts, not just the 13 in the test. Only account-holders can place trades—but even noncustomers can see what’s available, since the exchanges require brokers to make the information publicly available.

IB rolled out its penny options-trading system in mid-October, and it’s seen a lot of volume and good liquidity, according to Steve Sanders, managing director. “I’m excited about this one,” he says. “This is one of those things that really changes the industry.”

ONLINE BROKER NEWS: Fidelity Investments (http://www.fidelity.com) has unveiled its new Trading Knowledge Center, featuring interactive video and charting as well as articles, interviews and video transcripts. Paul Graham, senior vice president of Fidelity’s brokerage-products group, says, “Launching as many products as we’ve done over the last couple of years, we wanted to consolidate them and facilitate interactive learning.”

The company’s primary goal in rolling out the center is to help customers learn to use the new tools, but also to educate them on trading strategies, and how to employ them with Fidelity’s offerings. Students can practice what they’ve learned at the end of each module before applying their new knowledge to their account.

The Trading Knowledge Center is accessible from Fidelity’s main page by clicking on Investment Products, then on Trading. On the left side of the Trading page is a table of contents; one of the arrows says “Learn about Trading.” After clicking on that, hit “Trading Knowledge Center” to launch the application.

“We want to give everyone a scalable, seminar-type environment to learn all these techniques and tools,” explains Steve Deroian, director of Fidelity’s Active Trader Group.

Published in Barron’s, December 4, 2006

Saturday, November 25, 2006

What Free Trading Costs

STOCKS OF RIVAL ONLINE BROKERS WENT INTO a tailspin recently, after Bank of America announced that it would offer commission-free trading through Banc of America Investment Services to customers with more than $25,000 in bank deposits. The shares have rebounded, but their dramatic reaction suggests that this might be an offer many electronic investors and traders would jump at. But are free trades a free lunch?

Now available in 18 states, including New York, New Jersey and Florida, the offer from Bank of America (ticker: BAC) is open to banking customers with combined balances of $25,000 or more in their checking, savings, CD and FDIC-insured IRA accounts. Those who qualify are entitled to 30 free equity trades a month—but still pay the usual fees for mutual funds, options and other transactions. BofA will roll the offer out in phases nationwide by the end of the first quarter of 2007.

BofA (http://www.bankofamerica.com) is definitely the biggest but certainly not the only recent price-cutter. A new brokerage service, Zecco (http://www.zecco.com), opened its virtual doors on Oct. 9, trumpeting no-tier zero-commission trades. (The tiny broker cheekily took credit for prompting Bank of America’s offer.) And SogoInvest (www.sogoinvest.com) entered the market in July, touting $3 trades. The rough industrywide average right now is about $10 a trade, with lots of variation, based on volume, frequency, creditworthiness and account size. Other brokers say they don’t plan to cut commissions.

Cheap trades, although attention-getting, aren’t new—remember FreeTrade and Brokerage America? What gets lost in the hullabaloo about free trades is that there are many components to the costs of investing; commissions are just one piece.

When we compile Barron’s rankings of online brokers every March, we certainly factor in stock commissions as part of our “Cost” ranking. But we also evaluate options, mutual-fund and bond-trading commissions and look at rates paid for cash kept in accounts, as well as what customers have to pay to buy shares on margin.

Drilling down into the Zecco offer, for instance, we find that customers receive 1% interest—on any cash balance—on the low side. And BofA pays just 0.35% on balances under $10,000, and about 1.5% on amounts between $25,000 and $50,000. Even Interactive Brokers (www.interactivebrokers.com), which has kept trading costs low for its customers for years, pays upward of 4% on cash balances at present. (The exact formula depends on how much cash is held in an account.)

The bank, of course, hopes to win over new customers and persuade existing ones to put more in their accounts. In a statement, Liam McGee, president, Bank of America Global Consumer & Small Business Banking, says: “Customers appreciate the simplicity and convenience of using a single, trusted financial institution for all their banking and investment needs, and are motivated by the preferred pricing and other rewards it can bring.” A BofA spokesman says it’s much too early to assess customer response, but “there seems to be a great deal of appetite.”

Free trading can be useful for certain investors. If you’ve got a small brokerage account and trade in small blocks, say 100 or 200 shares at a time, you might come out ahead by paying no commission, even if you give up some execution quality. On the other hand, free commissions may not be a huge priority to investors and traders putting up wads of money. Says Muriel Siebert, president of online brokerage Siebertnet.com: “I don’t think the cheap brokers are the best overall value if you’re trading in large quantities.”

She emphasizes that people with large accounts have to look at the entire suite of a broker’s offerings, including the quality of customer service and what they’re paying on cash. “A few service niceties, low margin rates, decent returns on cash and whether they sweep your cash to a money market every day—that’s what will change an investor’s return,” Siebert states. Features like sophisticated trading tools and the system’s operability may also be important to these clients.

Steve Sanders, managing director, business development at Interactive Brokers, says, “No brokerage is in business for charity. They have to make their money somewhere.” For instance, you’ll find Google-generated ads all over Zecco.com. Sanders says, “That wouldn’t be the worst thing in the world to deal with if you’re only doing a few trades per year.”

This is not to suggest that the inexpensive brokers mentioned here are doing this—but dealers can find ways to pad their revenues by not offering the best execution, says Sanders. “A cheap broker might be slower with routing, and might route orders to get payment for order flow,” he says. In other words, the broker can get paid to send the order to a particular market maker or exchange, even if it doesn’t necessarily offer the best prices.

Sanders also points out that brokers make a lot of money on the cash in your account and can charge you much higher margin fees to make up for not charging commissions. He concludes, “I think [free trades] are more applicable to the novice sector of the brokerage space.”

There is, in other words, no such thing as a free trade.

Published in Barron’s, November 20, 2006

Saturday, November 04, 2006

New Options for Traders

ONLINE BROKERS AND TRADERS ARE EXPECTED to be the first to employ newly revised margin requirements that can allow investors to take on more leverage. The new rules, which reflect options’ widespread acceptance, can significantly reduce the amount of cash an investor has to keep on hand to play the markets—provided his broker is willing and able to monitor the risks and the trader can demonstrate his ability to cope with the potential hazards.

Buying on margin, which means borrowing from a broker to buy securities, is a time-honored practice that allows investors to own shares without paying full-freight on every purchase.

Although there are a number of variations, all margin accounts have two essential features.

One is called the initial margin requirement, or the amount of money an investor has to put up to buy a particular security. Currently, this is 50% of the purchase price. Many brokers impose their own added requirements to protect themselves in case a loan goes bad; for example, Fidelity Investments requires customers to have a minimum account equity of $5,000 when placing orders on margin.

Once you have a particular security in your account, the second piece comes into play. You must meet maintenance guidelines that require an investor to keep a certain amount of equity in the account. The exact level is set by the securities exchanges and brokers who handled the transaction. Again, using Fidelity as an example, it wants customers to have either 30% of the market value of the holding in question, or $3 per share, whichever is greater. Each broker has the right to define its own requirements based on a customer’s profile as well as the kinds of securities held.

Margin requirements have typically not taken into account the effect of having an options position that hedges a stock holding. But the new rules do. They can be thought of as portfolio margining—taking into account all of a trader’s positions including options that offset the risk in a particular stock—rather than margining for individual trades as the existing rules mandate. Some think the new system, still being fine-tuned by the Securities and Exchange Commission staff and the exchanges, will cause a revolution in options trading. The revisions to what’s known as Regulation T are expected to take effect no later than the first quarter of 2007.

Foreign bourses already use the portfolio approach, which helps them attract active traders seeking leverage.

David Kalt, CEO and president of broker optionsXpress, provides an example of just how significant the change can be. Suppose an investor bought 1,000 shares of Microsoft for $27 each, or $27,000 in all. Under current rules, optionsXpress would loan you half the money, so you’d have to have at least $13,500 cash in your account.

But in the new setup, if you simultaneously bought January 25 puts, which give you the right to sell the stock for $25 up until the time the contract expires, you would only be required to cover the difference between $27 and $25, or $2 for each of the 1,000 shares, which is thought to be a more accurate reflection of your overall portfolio’s risk. So the investor would have to put up about $1,000 instead of $13,500. The new requirements may also allow an option on an index to offset an individual stock holding.

The new system won’t change Reg T guidelines, but will instead open up this portfolio-margining alternative to certain investors, says Doug Engmann, chief executive officer of broker Fimat Preferred. These investors must be deemed qualified by the broker to trade uncovered calls and puts—an extremely risky form of trading. As a result, the investor will need to thoroughly understand how options are written. And because participants will be putting up less money to trade similar-sized positions, they are subjecting themselves to greater possible losses.

“The whole idea behind the program is that it is designed so that experienced options traders who understand the risk in options trading are the only ones eligible to use the extra leverage,” Engmann says.

Not every broker will want—or be able—to offer the revised margins. It will require the analytical skill and technological capability to assess a trader’s margin requirements in real time. “You have to have really good risk management,” says Engmann. His firm will require “an interview with the customer to give them this level of margining.” And accounts taking advantage of portfolio-margining rules will be monitored separately from those using the more typical standards.

Only brokers with sophisticated computer systems that can be adapted quickly to comply with the new rules will be able to offer portfolio margining in the near future. Executives from thinkorswim, Interactive Brokers, optionsXpress and Fimat Preferred say they plan to utilize the new rules as soon as they are clearly defined.

Some would prefer to monitor the market’s progress for a bit. Randy Frederick, director of derivatives and corporate market data for Schwab’s Cybertrader, isn’t sure his firm will offer the program right away, “but I can say that if it makes sense, we’ll be involved.”

Published in Barron’s, October 30, 2006