From the March 01, 2007 issue of Futures Magazine • Subscribe!

Options on futures: At the tipping point?

Back in the ‘90s, a confluence of factors made self-directed online trading possible. Driven by a booming economy and concerns about retirement, a contingent of baby boomers, armed with ever cheaper and ever better computing power and internet connectivity entered the markets and a legion of self-directed retail stock traders with ever more sophisticated interests and skill sets emerged. Online stock trading flourished, despite the setback of the tech stock implosion.

“After the tech bust, [retail traders] started looking for ways to protect their portfolio; lock in those gains,” says James A. Binder, manager of public relations at the Options Industry Council. “That’s the great thing about options: there’s a strategy to cover just about any market outlook.” Equipped with technology- enabled trading and educational resources, and more comfortable making their own trading and investment decisions, retail traders discovered that options were a way to make money in any market with less capital and less risk than trading the underlying stock. Online equity options trading flourished.

But until recently, online trading of options on futures lagged. Despite many advances, supporting price quotes for hundreds of option strike prices on hundreds of futures contracts and delivering them in real-time was a major challenge for the exchanges, which were struggling with the technological and political difficulties of online futures trading. They could afford to wait. And so options on futures remained a refuge for the entrenched interests of floor traders.

As a result, options on futures still trade predominantly in open outcry markets.

That is changing. The Chicago Mercantile Exchange (CME) with Globex and the Chicago Board of Trade (CBOT) with LiffeConnect both say their technology is sophisticated enough to handle more complex options, and electronic option volume continues to grow. Electronic trading has finally taken hold at the New York Mercantile Exchange on Globex and at the New York Board of Trade, which has merged with the electronic Intercontinental Exchange.

As these publicly held exchanges persist in their quest to maximize shareholder value, they are going to increasingly focus on automation. In the same way that online futures trading followed the path blazed by stocks, it is likely the growth of options on futures will mimic the growth of equity options and migrate online providing greater profitability for the exchanges and creating more opportunities for retail traders to trade options on futures online.

THE TECHNOLOGY COMES OF AGE

“Our futures options have grown substantially, mostly based on improved technology,” says Tom Boggs, associate director of equity products at the CME. With options, unlike futures, there can be hundreds of different price points for hundreds of futures contracts within each month, and creating a system that provides real-time comprehensive quotes has been a major challenge to bringing options on futures to the screen.

But those improvements in computing power and bandwidth have finally delivered us to the point where mass quoting is a reality. The CME’s mass quoting system is now capable of compressing 200 quotes into a single message and sending a refreshed message once every second, which allows them to continuously update and change their pricing.

“It’s a fairly dramatic efficiency,” Boggs says. “Prices get updated as rapidly as the underlying security moves. We don’t have stale quotes, which gets rid of bad orders and unhappy customers.” In addition, there are protections built in that allow market makers to quote without the fear that all of their quotes get hit at once.

And on the customer side, the CME offers free live quotes, which gives the retail trader a mechanism to look at prices before they call their broker, thereby helping to dispel the information disadvantage that retail traders have endured, at a cost, in the past. “And that transparency is one of the key electronic elements that has helped us to grow,” Boggs says, adding that transparency has led to more liquidity and tighter markets.

“With free live quotes and compressed quoting, there’s no mystery,” Boggs says. “You are going to walk into that order with a better sense of where you want to price an option, and we have a chance that the option pricing might be tighter. So it can lend itself to improved pricing and less uncertainty about the price. And you have the speed. It’s very fast and so there is an element of certainty that is important to investors.”

Especially when contrasted with placing multiple phone calls to your broker for confirmation that your trade has been completed.

BENEFITS AND DRAWBACKS

The ability to see price changes in real-time is a huge benefit. “The bid might be 50¢ or 60¢ all day long and for whatever reason it pops up 15¢ or 20¢,” says Barry W. Kosoris, principal of K4 Capital Management LLC. “When you are watching a real-time screen you can trade instantly. You can grab that. But if you have to call in an order and wait for someone to take it into the pit, by that time someone else has already grabbed that deal.”

Another benefit is the certainty of executing your own orders and receiving instant confirmations of those order fills. “I still remember, I bought some gold calls and I ended up making a lot of money on them, but it was almost two weeks before they could figure out what price my options executed at when I sold them. And I kind of got the feeling that there was some arbitrary stuff going on there. I just didn’t know where I stood,” Kosoris says. With self-directed electronic trading, he feels more secure. “You click on a number and you’ve got the trade, pretty much. You don’t have to rely on other people to make the trades for you. Everything is right at your finger tips.”

While online trading allows for faster entry, a quality floor broker can make a big difference for options that trade in a pit. “If you are doing mass-volume execution through an online platform, you are not likely to get favoritism from a floor trader in a market like crude-oil options,” says James Mound, head analyst at Moundreport.com. “Bid-offer spreads can be fairly wide and a good floor broker can tighten that spread for you substantially; and because of the volume of business you are doing with him, he will fight for that $20, $30, $40 in between the bid-offer for someone who is going to be doing 300 orders with him that day.”

Unless it is an exceptionally large order, that kind of an edge is simply not available in electronic markets, such as equity index options, because of the anonymity and transparency. That is why, though, more than 90% of equity option orders on the Chicago Board Options Exchange are executed electronically. Approximately 35% of the volume is still executed on the floor.

“When you are doing it online, they don’t know who you are,” Mound notes, adding that in New York markets, floor brokers can trade their own account simultaneously and take the other side of a smaller orders and really take advantage of those anonymous electronic orders, especially in highly volatile markets.

PRICING

For options on equities, there has been a lot of downward pressure on commissions and the cost-plus model has prevailed. Options exchanges actually pay for order flow. Each trade has a base cost of between $7 and $20 plus a per contract fee of between 75¢ and $1.25. One recent entry, OptionsHouse Inc. may be the first to offer a single flat rate, with no per-contract charge.

“We think that the natural progression is to move to something like what we are offering, which is lower prices where you are paying for execution with high quality tools and customer service and simplified structures,” says John Hass, chief executive officer of OptionsHouse.

Within the futures markets, any number of pricing models are available, ranging from the high tech, to the high touch. “As more and more products go electronic, brokerage firms realize efficiencies. Some of those efficiencies are eventually passed along to the retail trader in the form of lower commissions,” says Dan O’Neil, principal of online brokerage firm XpressTrade LLC. “Pricing pressure is sort of one of the facts of life in the futures industry.”

He adds that as the bid-offer spreads tighten up, and as volume and liquidity improve, he would expect to see reductions in commission rates. But he warns that, as in all industries, you usually get what you pay for.

Many of the online brokers offer extremely low commissions. Interactive Brokers charges between $2 and $3 per contract for most options on U.S. futures. That should draw retail interest because it is not uncommon for retail traders to be charged upward of $50 and more per roundturn on options trades.

Commissions for options on futures are dependent on exchange fees, the size of your trading account, your trading volume and the specific contracts you trade, with electronic markets generally being less expensive. As a result, they are as variable as commissions on futures.

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