| The
Penny Pilot Program
As
noted, stock options currently
are priced in increments of
a nickel (0.05) for options
priced at less than $3.00 and
a dime (0.10) for those
priced at $3.00 or more. In
fact, if you enter an options
order at a price that is not
expressed in the proper nickel
or dime increment, the order
will be rejected. The Securities
and Exchange Commission has
long been concerned that the
nickel and dime increments lead
to larger than necessary bid/asked
spreads and result in too-high
payments for order flow. Accordingly,
the SEC has mandated the launch
of a Penny Pilot Program,
in which options on participating
stocks and ETFs will be quoted
in penny (0.01) increments.
The
SEC in 2001 accomplished a similar
sea change in stock price quotations.
As you may recall, not all that
long ago stocks were quoted
in 1/8th and 1/4 increments.
The SEC forced the industry
to accept decimalization,
meaning quotes in pennies or
penny fractions. This change
increased liquidity and order
flow and has saved investors
and traders countless amounts
of money.The same problems -
high spreads, particularly -
infect the options markets.
Think
of the new pilot program as
"decimalization" for
stock options. It is precisely
that in a way, because stock
options currently are quoted
in large increments of tenths
and twentieths, just
as stocks used to be quoted
in eighths. Of course, every
quotation that is not in round
dollars involves a fraction,
and even a penny increment is
a fraction; a very small fraction
but a fraction nonetheless.
And "decimalization"
does not really apply to this
pilot program, since the tenths
and twentieths now in use are
decimal fractions.
But
decimalization is not the point:
large price quotation increments
are.
As
discussed below, the use of
large quotation increments results,
in my opinion and in many others'
opinions, in a less effective
market for stock options. The
SEC, which uses the term "penny
pricing" for the pilot
program, obviously suspects
that allowing stock option quotes
in penny increments might have
the same beneficial effects
as it did for stocks.
Program
Launch
The
Penny Pilot Program will be
launched on
January 26, 2007
by the options exchanges. Options
on 13 participating stocks and
ETFs will be quoted in penny
(0.01) increments when the
option price is less than $3.00
and a nickel for premiums $3.00
or greater, except for the QQQQ,
which will feature penny increments
for all strikes.
A
group of 13 stocks and ETFs
were chosen for the pilot program,
selected because they cover
a full range of trading characteristics.
ETFs are exchange-traded
funds, also known as tracking
stocks - these funds issue stocks
that essentially track a selected
index. For example, the Nasdaq-100
Trust (QQQQ) tracks the Nasdaq
100 index. These stocks and
ETFs will participate in the
pilot:
| Stock
or ETF
|
Symbol |
| Week
beginning January 26, 2007: |
| Whole
Foods Market |
WFMI |
| Week
beginning February 2, 2007: |
| General
Electric |
GE |
| Microsoft |
MSFT |
| Week
beginning February 9, 2007:
|
| Agilent
Technologies |
A |
| Advanced
Micro Devices |
AMD |
| Caterpillar |
CAT |
| Flextronics
International |
FLEX |
| Intel
Corporation |
INTC |
| iShares
Russell 2000 Index |
IWM |
| Nasdaq-100
Trust |
QQQQ* |
| AMEX
Semiconductor HOLDRs Trust |
SMH |
| Sun
Microsystems |
SUNW |
| Texas
Instruments |
TXN |
*All
premiums will be quoted in penny
increments, both above and below
$3.00.
Note that not all the 13 participants
will be included in the program
at the onset on January 26th,
some being included in a roll-out
over several weeks. Only Whole
Foods Markets will be included
the first week, General Electric
and Microsoft will be added
the second week, and the remaining
participants will be included
the third week.
The
Penny Pilot Program will run
for 18 months and its results
will be evaluated by the market
as well as the SEC. I will be
surprised if penny pricing does
not eventually become a permanent
part of the options landscape,
but it may take several years.
The
Pros and Cons
As
with any new things, the Penny
Pilot Program has its supporters
and detractors. The naysayers
(ex: the Options Committee of
the Securities Industry Association)
contend that penny pricing will
disadvantage retail investors
(you and me, that is)
in comparison to institutions
and professional traders and
that penny increments will hurt
liquidity and result in poorer
execution of option trades.
But... it must be remembered
that the brokerage industry,
which profited hugely from the
spreads created by quotation
in 1/8th increments, predicted
decimalization would bring about
the death of the American stock
market, when in fact decimalization
was a huge winner for traders
and investors, especially us
retail players. The only losers
in decimalization were the market
makers, which no longer had
a fat profit built into every
trade.
Elizabeth
King, Associate Director of
the SEC's Division of Market
Regulation, stated in a May
2006 speech that, "Unlike
in the stock market, where payment
for order flow virtually disappeared
following the move to decimal
quoting, payment for order flow
and internalization practices
have become more pervasive in
the options markets than they
were in 2000. So what does this
trend indicate? A firm's receipt
of payment for order flow or
its decision to route orders
to an affiliated dealer does
not, by itself, violate best
execution obligations. Though,
the examinations by Commission
staff did reveal that most firms
examined have been unwilling
to pursue better prices for
a meaningful amount of their
order flow that may be available
in penny auctions offered by
several exchanges. A broker
cannot ignore price improvement
opportunities for its customers
because it could impact the
payment for order flow or internalization
arrangements it has in place."
That kind of sums it up for
me.
Proponents
like myself believe that penny
pricing will result in more
competitive pricing, reduce
payment for order flow, reduce
costs and tighten spreads, pretty
much the same way decimalization
did for stocks. Despite the
dire predictions of the brokerage
industry, I don't think the
sky will fall as the market
makers all get out of the option
business.
To
illustrate my concerns about
the current nickel and dime
quotation increments, let's
take a look at some simple,
everyday examples. Our first
example underlines the point
that daytrading in particular
and the surge in retail investing
in general never could have
arisen without decimalization
of the stock markets.
Example:
Suppose back in the 1990s
before decimalization a retail
trader had bought stock at
20-3/8, then decided seconds
later the trade was a mistake
and immediately sold the shares,
without there being any change
in the stock's price quotations
in the meantime. The trader
would have gotten only 20-1/4,
because when stocks were quoted
in 1/8th increments, 1/8th
was the minimum possible spread
between the bid and asked
prices.
THAT
is the effect that fixed increments
have. They create artificial
spreads, which benefit the market
makers, never you and me. It
is tougher to make money when
the market is taking that kind
of spread out of your hide.
Since price quotations currently
must be in increments of 0.05
or 0.10, the minimum bid-asked
spread is one increment
and the spread must be expressed
in multiples of that increment.
Thus on a $4 premium the minimum
spread is 0.10, and the next
smallest possible spread is
0.20, then 0.30, and so on.
Now
think about the relative proportions
of these increments to the price
of the stock or option: a 0.10
quotation increment is far greater
in proportion to a $5 option
premium than the old 1/8th (0.125)
increment was to a $20 stock,
for example. If a 1/8th increment
is abusive or at least inefficient
on a $15 stock, what should
we consider a 0.10 increment
on a $3.25 option premium? A
better - or I suppose worse
- example yet: how about a 0.05
increment on a $0.30 premium?
In that last example the 0.05
increment, and thus the absolute
minimum spread, is fully 1/6th
the entire premium. Isn't that
just faintly outrageous? Wouldn't
a one- or two-cent spread be
far more advantageous to the
trader?
If
you are feeling a little abused,
I don't blame you.
Allow
me to quote Elizabeth King again:
"Moreover, a limited
analysis by the Commission's
Office of Economic Analysis
indicates that, for the most-actively
traded options, the national
best bid and offer is at the
minimum increment for more than
50% of the trading day. Such
statistics suggest that the
existing nickel and dime increments
are keeping spreads artificially
wide. Penny increments could
be expected to narrow spreads.
And narrower spreads directly
benefit customers."
I couldn't have said it better.
Suppose
a call option is quoted 4.05
x 4.45 (bid and asked), which
presents a 0.40 spread. You
might suppose that dime increments
are partly to blame, but a 0.40
spread is huge, almost 10% of
the entire premium. Such a huge
spread results in actuality
from lack of liquidity, due
to lack of demand. How much
difference will penny pricing
make in the size of such illiquid
spreads? It will be interesting
to see, but I doubt we'll see
that much difference, because
the nickel and dime increments
are not, in and of themselves,
causing the large spreads.
Thoughts
on Its Utility for Covered Call
Writers
If
you write covered calls or trade
options on any of these 13 equities
and ETFs once the pilot program
kicks in, the penny increments
will allow you to place a tighter
order where the premium is less
than $3.00 (over $3.00 the
increment will remain a nickel
in the pilot program).
When
a covered writer enters a net
debit order on trade entry
(meaning that the limit price
entered is the debit after netting
the call premium against the
stock price), there already
is some price flexibility. For
example, if the stock is $20
and I want to write the 20 Call
bid at $1.00, I can enter the
order as a net debit limit with
reasonable assurance of a quick
fill if the limit entered is
$19.00 - that after all is market
in this example. I might, however,
enter the order as $18.95, or
$18.97, say, in an attempt to
pick up a few extra pennies,
since the smaller the debit
- the less I pay - the better
the return I stand to make.
I
leave it to the broker to get
the order filled, shaving the
pennies on either leg of the
trade - I don't care where.
Keep in mind that the stock
order in a covered call is going
to a stock exchange or market
maker in the stock, while the
option order goes to an options
exchange or market maker. It's
not as if the same market maker
or specialist is handling both
the stock and option order,
thus there is no one entity
that can "net" out
the two legs of a covered call
trade. If you are shaving pennies
for a better fill, it has to
come from one or both legs.
But since the option leg has
to trade in nickel or dime increments,
how much harder does that make
it to get a great fill? This
is particularly a problem when
the stock is heavily traded
with a small spread, meaning
that it is more difficult to
knock a few pennies loose.
Example:
Using my example above of
trying to run a covered call
trade at a debit of $18.97,
I am trying to pick up an
extra $0.03 somewhere when
market on the trade would
be $19.00. >From where will
those pennies come? As things
stand today, the option specialist
or market maker does not shave
its price by a few cents -
any price change must be the
0.05 or 0.10 increment. If
the option market maker or
specialist will drop its price
a nickel or dime, I'll get
my desired fill. But if it
won't, the only place to pick
up the 0.03 is off the stock
price. If the stock has a
0.01 or 0.02 spread there
simply isn't room. In that
case, my only real hope of
a fill at $18.97 would for
the stock to move down a few
cents during the day.
Here
again we see the effect of these
large increments on our covered
call writing, its direct effect
on trying to get better fills.
Thus
I suspect that the primary effect
of penny increments for covered
writers will be quicker fills
where the stock is heavily traded
with little wiggle room to shave
pennies off, because it will
be easier to shave those pennies
off the call leg of the trade
with a net debit order. I could
easily be wrong, though, because
penny increments may force more
realistic and much tighter spreads
in options, in which case it
will tougher to get a fill that
is much better than market.
I doubt it though, because even
the most heavily traded option
is not that liquid compared
with stocks you should be writing
covered calls on. But guess
what?
Tighter
option spreads will mean that
the quotes are fairer and the
spread much smaller to begin
with.
Nickel
and dime increments would not
seem to have impeded the options
markets unduly, since the market
is growing each year at a torrid
pace (2006 was another CBOE
volume record, as were 2005
and 2004), but I do think these
large increments pick our pockets.
And I think we will see an increase
in options volume coincident
with a general changeover to
penny pricing in a few years.
Let's
leave the big spreads where
they belong: on lousy, illiquid
options. We shall see what we
shall see, and covered writers
may benefit less than I suppose,
but I certainly expect penny
pricing will be a major and
very beneficial innovation in
option markets.
This
issue's Question and Answer:
Terms
of Non-Standard Options
Question:
My
broker would not allow me to
write calls on a particular
stock through their online platform
(they told me to call in) because
the call option was "non-standard."
How can I find out the terms
of non-standard options?
Answer:
When
a company undergoes certain
events (split, reverse split,
merger, spinoff, certain dividends,
etc.), the options on the company's
stock are adjusted. Adjusted
(or non-standard) options
can call for delivery of a different
number of shares than the usual
100 shares, require the delivery
of more than one company's shares
and have other non-standard
terms. Frequently, the option
symbols and sometimes the strike
prices themselves will change.
You never, ever want to write
a non-standard call without
knowing the terms. That fat
premium might not look so good
after you understand the adjusted
terms and deliverables - this
is why volume dries up in non-standard
options once the adjustment
is announced, though they may
continue to have a high open
interest; all the volume goes
into the standard options.
The
adjustments on a stock are spelled
out in a Research Circular
for that unique event. Where
symbols and/or strikes change,
it will include a list of the
existing and adjusted symbols
and strikes. To get the details
on non-standard options go the
CBOE
Contract Adjustments
page and enter either the company
name or the root of the
adjusted option symbol (ex:
if the symbol is ZZKAL, the
root is ZZK). This will bring
up a list of research circulars.
Select the most recent one for
the company; some of these circulars
can be old, covering events
from the late 1990s. You will
usually see the applicable circular
right away; if there is a corrected
circular, check it first.
How
do you know if an option is
non-standard? Easy: visit the
optionsXpress.com
option chains page
and type in the stock
symbol, the type
of chain desired
(either "calls"
or "covered calls")
and the expiration
month desired, then
click the View Chain button.
The chains pulled up will include
only standard, unadjusted options.
If the option symbol you are
checking for is not in
the chain for the month being
viewed, this indicates the option
is non-standard. (There is
a way to pull up a chain that
includes non-standards, if you
want further confirmation -
just tick the box that says
include non-standard options.)
This chain page is part of the
CallWriter Research Page and
is instantly accessible from
our Real
Time Lists™ for
CallWriter members, but anyone
can check the optionsXpress.com
chains page.
Note:
CallWriter attempts to filter
out non-standard options from
our Real
Time Lists™
- and we get almost all (close
to 99%) of them out, although
one gets through from time
to time. The great thing about
using CallWriter is that you
can check, right from the
list, whether an option is
non-standard with a single
mouse click.
If
you believe that knowledge is
power, nowhere is that more
true than knowing when options
are non-standard. I
will soon be issuing a lengthy
special report that explains
non-standard options, the events
stock options are adjusted for
and how options are adjusted,
and more. It will be the most
exhaustive treatment on the
subject published anywhere.
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