Penny for your quotes under pilot program

The U.S. options market is preparing for major changes that may be a mixed blessing for institutional investors turning more than ever to options as a means to mitigate risk or generate better returns.

On Jan. 26, the six U.S. options exchanges will embark on a pilot program to quote, in pennies, series of options on a dozen stocks and on the popular QQQ exchange-traded fund that tracks the Nasdaq 100 index. The plan, which Securities and Exchange Commission Chairman Christopher Cox advocated last June, will shrink the currently wider 5- and 10-cent quote increments.

Regulators hope that penny quoting ultimately will help reduce payment for order flow, or when a broker buys customers' orders from another broker to match them in-house, hopefully at a profit, instead of trying to get a better price for those orders.

Meyer "Sandy" Frucher, chairman of the Philadelphia Stock Exchange, expects "the penny pilot will answer a lot of the questions that people have speculated about for a long time. The answers will determine market structure and payment for order flow issues."

The PHLX is the third-largest U.S. options exchange, behind the Chicago Board Options Exchange and the International Securities Exchange. The other options exchanges are NYSE Arca, a unit of NYSE Group; the American Stock Exchange; and the Boston Options Exchange.

SEC Commissioner Annette Nazareth recently explained to an industry gathering the rationale for the move to pennies.

"Pricing inefficiencies caused by nickel- and dime-minimum increments correspond to a proliferation of payment for order flow practices and internalization arrangements. … The move to penny increments in equities greatly reduced spreads in those securities resulting in a commensurate decrease in payment for order flow," Ms. Nazareth said.

But many question whether bringing pennies to the options world would create for institutional investors the same problems that decimalization unleashed on the U.S. equity markets in 2001.

"The markets have already reached a critical phase in terms of liquidity and transparency," said Tim Strazzini, senior managing director at brokerage Pali Capital Inc., New York, which serves institutions. "The tightening of markets by allowing them to quote in penny increments will not make them more liquid, and it will make them less transparent. People will not be motivated to post real size."

For equities, decimalization prompted institutional investors to execute large orders away from exchanges in order to avoid market impact and information leakage. They also use slice-and-dice algorithms to hide their orders on open markets — all of which results in lower transparency.

"For the most liquid securities, it's a non-event. For the medium-liquidity securities, it's not necessary," said Mr. Strazzini, who served on the board of the Securities Industry Association's options committee and is a guest on CNBC's "Fast Money" program at the Nasdaq MarketSite.

Regulators will monitor the penny quoting pilot before deciding whether to extend it to all U.S. options series. Their decision could have a major impact on a red-hot market that has soared in the past five years, setting a record volume of 2 billion contracts traded in 2006.

Although there are no data available regarding institutional investors' level of participation in the options market, experts believe institutions currently account for half of the volume.

Phil Gocke, managing director of the Options Industry Council, Chicago, said that, based on anecdotal evidence, "the numbers I have heard about the institutional business are 40% to 60% of the overall options business. My estimate is 50%. It's not only hedge funds, but pension funds, endowments, money managers. … Most of their orders come through a large brokerage firm acting on their behalf, and they end up hedging that exposure in the listed market."

Quoting options in pennies instead of 5 and 10 cents is bound to create a volume explosion that NYSE Arca banks on to gain market share. The former Archipelago electronic communications network, which NYSE Group acquired last year, is introducing pricing incentives to achieve that goal. It will rebate some of the fees it charges for trading options to the brokers who bring liquidity in the penny pilot stocks.

"Like in the equity world, there will be some growing pains and adjustments to pennies in the options world. But firms will adapt and thrive. The tightening of spread will increase volume," said NYSE Group Vice President Jon Werts.

Mr. Werts expects the quote explosion under a penny regime to put an emphasis on cutting-edge trading technology. "In a penny world, speed will become more important. We are fortunate that, with our new system, we have tremendous speed and capacity," he said.

Nasdaq officials also see a new opportunity in the technology challenge that increased capacity and speed will pose in a penny-quoting environment, despite various plans to "mitigate" or curb message traffic. It plans to launch another options exchange later this year that will operate as a pure electronic open book.

"As changes such as the penny pilot change the options market, we see an opportunity to leverage Nasdaq's technology and market structure within the options market," said Nasdaq Vice President Adam Nunes.

Another major change that may further boost options volume will come in April, when portfolio margining becomes the methodology a broker can apply to customer accounts. Until now, brokers had to set different margin requirements for each asset class, such as equities or options. The new method will allow them to net the exposure of the customer's entire portfolio, thus freeing up capital to invest more.

Jason Ungar, director of Ansbacher Investment Management Inc. in New York, agreed this will have a definitive impact on trading volume.

"We write options on the S&P futures on the CME, and the reason is the favorable margin requirement in the futures market. But this can be done on the CBOE as well for S&P options. We'll certainly explore trading on both exchanges, because index markets are the most rapidly growing markets in the world."

Bruce Goldberg, chief marketing officer at the ISE in New York, concurs. "The new guidelines for portfolio margining more fully recognize the value of options as a risk management tool within the context of an investment portfolio. Overall, this is a very positive development for the industry and for investors."