Investor Brain

Wednesday, August 22, 2007

No, No, A Thousand Times No

The rumor mill is abuzz, once again, with the possibility of E*Trade merging with TD Ameritrade.  I have one plea, based on the needs of online investors and traders:  Please Don’t Do It. 

Yes, TD Ameritrade has some noisy hedge funds trying to force them into a merger.  It would be a disaster from a customer point of view – which is the point of view of my “Electronic Investor” column.  Both firms have huge customer bases, as they are currently #2 and #3 in terms of number of accounts.  (Schwab is #1.)

They serve very different needs, though, and I believe a merger, though it might make certain hedge fund managers happy, would make millions of customers miserable. 

And one columnist. 

Saturday, August 18, 2007

An Improvement on Penny Pricing

WE ASKED OUR READERS TWO WEEKS AGO what they thought of the Securities and Exchange Commission’s test of penny pricing for options, and whether the new format had affected their trading habits. Maybe it was the summer doldrums or the arrival of bigger problems elsewhere in their portfolios, but the response by Barron’s readers was uncharacteristically underwhelming.

All we can figure is that penny pricing isn’t having a huge effect.

What did emerge from our related discussions with market participants, however, was an alternative to penny pricing that might be more far-reaching and useful to the options market.

The SEC introduced penny pricing of options at the start of this year in a pilot program involving 13 underlying stocks. Most options are still priced in increments of a nickel, which means that a one-tick change in price translates to a $5 change in the cost of a single contract. (Each contract gives the holder the right to buy or sell 100 shares of underlying stock).

Reducing the increment to a penny would make a one-tick change alter the price by $1. The SEC’s hope is that smaller increments will make options less expensive for retail investors and allow everyone to turn a profit on smaller price moves.

The SEC’s current plan is to expand the test by an additional 22 stocks on Sept. 22, then add 28 more next March.

Going in, the fear among market makers was that the additional data required for smaller increments would overwhelm quote providers and cause serious slowdowns. That fear has not been borne out, because the providers have come up with technological fixes that reduce the volume of information traffic.

BUT ANOTHER early concern has proven prescient. Recent studies show that the number of contracts available to trade at a particular price is significantly lower than it was before the test.

Peter Bottini, an executive vice president and head of trading at the brokerage optionsXpress, compared volume in the 13 tested options over the last three months of 2006 (when prices were quoted in nickels) with the three months ended in June (when prices were quoted in pennies). Six of the 13 underlying stocks had significant drops in contract-trading volume; five were relatively unchanged; and the two most active issues, iShares Russell 2000 Index (ticker: IWM) and PowerShares QQQ (QQQQ), both popular exchange-traded funds, enjoyed increases.

Bottini, who was a market maker at the Chicago Board Options Exchange for nine years before joining optionsXpress (http://www.optionsxpress.com), believes that the markets need an entity that is obliged to provide liquidity—like a market maker, who has an incentive to take the spread. When that potential reward is substantially reduced by the penny spreads, liquidity providers go away.

Bottini believes penny pricing is causing the market to fragment. Customers use trading tools and screeners to find opportunities; if they decide to place a trade for 20 contracts and can get only five, they are frustrated. Bottini has seen the quote size, which is the number of contracts available at a particular price, drop 75% to 80% for many of the stocks in the test.

To be sure, others see it differently. At a recent Sandler O’Neill investor conference, Interactive Brokers President Thomas Peterffy said the firm’s trading volume in penny-priced issues has risen 99%, which more than compensates for a 32% drop in profit per contract. Steve Sanders, an executive vice president, says Interactive (http://www.interactivebrokers.com) very much favors extending the program.

Neville Golvala, president of ChoiceTrade (http://www.choicetrade.com), reports that his firm has seen an uptick in volume in the QQQQs, but not much else. ChoiceTrade, he says, would “cautiously support” expansion of the pilot to another 50 names by March, “if liquidity at the top of the book is not compromised.”

However, both Golvala and Bottini say that their customers would prefer to see more dollar strikes, which would make additional at-the-money options available, rather than further expansion of the penny-pricing test.

If the goal of the SEC is to encourage options trading, dollar strikes would be more effective than penny pricing. Currently, most stocks have options listed in $2.50 increments—say, $7.50, $10, $12.50 and $15. If, for example, a stock is trading at $9.25, the lower $7.50 option is too far out of the money to attract much interest. However, there would likely be a great deal of interest in a $9 option, which paired with the existing $10 option presents two prices close to being in the money.

According to Bottini, the exchanges would like to expand dollar strikes, but the SEC is hesitant, citing a worry about a spike in quote traffic.

“The quote providers [a group that includes Bloomberg and Barron’s parent, Dow Jones] are going to scream if dollar strikes are mandated,” says an industry insider who asked not to be named. “They will whine that they don’t have enough capacity even now, and that dollar strikes will kill them.”

Nevertheless, dollar strikes seem to me to be a more useful trading tool than penny pricing.

Perhaps it’s time the linkages between exchanges were beefed up to handle the additional quote traffic so that investors can be better served.

The SEC is taking comments on its penny-pricing test, a route it seems to favor over dollar strikes. Still, it wouldn’t hurt to visit its Website (http://www.sec.gov) and tell them what you think.

ONLINE-BROKER NEWS: TradeKing (http://www.tradeking.com) just introduced The Options Playbook, by Brian Overby, TradeKing’s “Options Guy” and its director of education. The book features a breakdown of more than 30 of the most common options strategies. It also defines numerous terms, explains how volatility affects the options trader, delves into concepts like “rolling” and outlines margin requirements for various trades. I found it clear and often entertaining. You can pick it up on Amazon or at the TradeKing Website for $34.95.

Interactive Brokers recently expanded its global direct-access platform to include Australian stocks and Swedish stock options. This brings the total number of market centers offered under the IB Universal Account to 72, across 17 different countries.

Published in Barron’s, August 13, 2007.

Friday, August 17, 2007

Schwab Melts Down on Day NASDAQ Peaks

Bad time for a case of “human error,” Schwabbies. 

Yesterday (August 16), the NASDAQ announced that it had the biggest day ever in its history for total matched volume, with approximately 3.73 billion shares traded.  But around 9:45AM Pacific time, Schwab’s (http://www.schwab.com) online trading site, along with its phone lines, shut down due to what they said was “a human error that restricted trading capacity,” according to an Associated Press report. 

Other brokers I contacted yesterday, including thinkorswim, optionsXpress, ChoiceTrade, TradeStation, and E*Trade reported that they were experiencing no trading-surge-related problems. 

Having covered online brokers since 1992, I’ve seen plenty of meltdowns.  Most of them happened during the mid- to late-90s, when online brokers were setting up shop and trying to simultaneously cope with the surge of interest in trading.  Capacity planning was a huge issue, and one that I query every year when I put together my online broker surveys for Barron’s. I once likened Schwab’s ongoing efforts to spiff up their platform and avoid the constant crashes as trying to change a tire on a car that was barreling down the freeway at 100mph. 

The one and only time Schwab answered the my question, “What percentage of your accounts can be online simultaneously?” they said 15%.  I made a fairly big deal about it at the time, so they have since refused to answer question with anything specific.  This year, their answer was, “We are committed to ensuring the stability and security of our systems. Our capacity is at a level which can handle many times the maximum historical demand.”

To be fair, there are several other brokers who dance around this question, including Fidelity who says, “We do not track capacity in this way,” and E*Trade, which states, “Not publicly disclosed; E*TRADE employs open ended architecture with scalable capacity.” TD Ameritrade flat-out did not answer the question at all, even with evasive dancing. 

Most other brokers reported capacity between 95% and 250%. 

Saturday, August 04, 2007

For Once, a Favorable Exchange Rate

DIRECT-ACCESS ONLINE BROKER TradeStation Securities recently added foreign-exchange trading to its platform’s capabilities. It’s a nice complement to what already was a very powerful program for creating and testing strategies: The upgrade means customers can now develop and execute their own strategies for trading equities, options, futures and forex pairs on the TradeStation site, with access to up to 34 years of historical data.

In the past, some institutional investors would use TradeStation’s (http://www.tradestation.com) technical analysis to develop their own trading strategies and then back-test them using its historical data before executing their actual buy and sell orders elsewhere. But, with the release of version 8.3, they don’t have to leave: The capacity for anyone to trade—at what seem like decent prices—is built right into the software.

One of the key components in testing is an accurate strategy-performance report. That aspect of the program has been overhauled, with more information specific to foreign exchange, such as the computation of a rollover credit for currencies held overnight.

You can create a strategy that will enter a trade based on events, either in the foreign-exchange market or in other markets.

For example, the system allows you to execute a trade automatically when the price of the Nasdaq 100 tracking-stock QQQQ hits a predetermined level. Then you can define your exit point based on a specific profit target. The trades will occur whether you’re online or putting your exchange-challenged dollars to work in a pricey Paris boutique. Don’t worry: You also can set your account up so that you manually approve each trade before it’s executed.

Data is provided in real time at no additional charge, and the base currency for the display is set by the customer. For example, if your account is funded in dollars, the calculations are in dollars even if you’re trading other currencies. If you open an account in euros, it will be set up for euros. Your stop losses and profit targets are also defined in your base currency.

Extremely active traders have long favored the forex markets for, among other things, their liquidity and round-the-clock opportunities. TradeStation President Salomon Sredni says, “Forex is the most liquid market in the world, and one that appears to be growing for individual traders in the U.S. and abroad.”

Typically, forex brokers don’t charge an explicit commission, but they are effectively trading against their own customers. That’s because they’re displaying a much larger spread between the bid and ask prices than the actual market spread quoted by banks. The broker will absorb the smaller market spread but then base the customer’s order on the wider one. This levy can lop off as much $30 to $100 per trade.

TradeStation’s new platform takes a different approach. Its pricing plan offers tighter spreads, which appear to run $10 to $15 per 100,000 units for the most liquid currency pairs (the actual unit, or deal lot, size will vary with the currencies being traded). The firm also charges an up-front commission that ranges between $5 and $8.14 per 100,000-deal lot.

As a result, the customers get to trade forex pairs at lower cost, while automating their exit strategies.

Trades are executed through an independent foreign-exchange-services company, GAIN Capital Group (http://www.gaincapital.com), which acts as the counterparty for each transaction and as a liquidity provider to clients using its access to the interbank market.

You can also place orders manually, rather than relying on an automated strategy. This process can be streamlined by using hot keys, such as pressing F9 to enter a market buy or F10 to enter a market sell. The functionality is the same as for the stock, options and futures platforms, says product manager Aaron Walters. “It’s the same product across the board, no matter what asset class you’re trading.”

TradeStation’s software runs on Windows or Intel-based Macs with cross-platform systems such as BootCamp.

The platform costs $99.95 per month, plus real-time exchange fees that depend on the data you choose to access. (Forex data is free, however.) The platform fee is waived for traders who place orders for 10 or more round-turn lots or 100 round-turn mini-lots. Other fee waivers exist for active stock, options and futures traders as well.

The platform fee includes access to all of the TradeStation analytics and data feeds, plus access to OptionStation, which is an extremely powerful options-analysis program. TradeStation’s fees were much higher a year ago; even if your trading activity doesn’t get you the platform for free, the analytical power and data feeds are reasonably priced—a bargain if your trading is profitable.

PENNY PRICING of options update: The Securities and Exchange Commission announced in June that early results from its Penny Quoting Pilot program, which launched at the end of January, suggest that the new system will lower trading costs for retail trades. (See “The New Penny Options,” Barron’s Dec. 4, 2006.)

We expected that result for the limited number of options included in the pilot—but several online brokers have told us informally that they’re seeing drops in trading volume for those options’ underlying shares. The smaller spreads may mean market makers are avoiding those options.

Traditionally, options are priced in increments of a nickel, which means that a one-tick shift in price changes the overall cost of a single contract by $5. (Each contract gives the holder the right to buy or sell 100 shares of underlying stock.) Cutting the increment to a penny is intended to make a one-tick change alter the price by $1. The net result should be a cost savings to investors, as well as an opportunity to turn a profit on smaller price moves.

The pilot program was originally intended to last for a year or so. The SEC is now considering expanding the trial to include additional options while it decides whether to make penny pricing the standard.

So we thought we’d ask you, Barron’s readers, whether the availability of penny options has made a difference in your trading habits. Have you been trading penny-priced options over the last six months? Let us know about your experience via e-mail at electronicinvestor@yahoo.com
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Published in Barron’s, July 30, 2007.