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:

  *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.

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.