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.

Posted by on 12/09 at 02:19 PM

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