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Will Penny-size Option Quotes Help Traders?

Posted by Pete Stolcers on June 12, 2006

Option Trading Question

Today Joe M. asked, “What are your thoughts on exchanges quoting options in pennies instead of nickels and dimes? It seems like it should narrow the spread.”

Option Trading Answer

I’ve heard many people write on the topic and I do have an opinion - I don’t think it will materially affect your profitability. It can’t hurt, but I don’t think it will make much of a difference.

Market Makers/Designated Primary Market Makers/Specialists (MMs) have an obligation to make a two-sided market (post a bid and an offer). The exchanges have a rule set that dictates how wide that market can be and the minimum size (10 contracts) that must be honored at that price. It is based on the nature of the underlying stock (volatility, price, volume…) and it gives the MMs a tremendous amount of latitude. The “cushion” is there to protect them and to make this function rewarding. Remember, they are forced to take the other side of a trade that no one else is wants. They pay the exchanges for this privilege.

This role used to be handled entirely by humans. Now sophisticated programs have been built to handle the process. The role of the “Floor Trader” has been greatly reduced and “off-floor” personnel monitor aggregate positions/risk/systems. The algorithms are based on the price of the underlying stock, the bid/ask of the particular option and the size and price of the last trade for each option. They know if the other side is an individual or an institution. If you execute an options trade, chances are the other side is an electronic quote.

If an individual with deep pockets wanted to play MM they couldn’t because their transaction costs are too high and they can’t adjust their markets. Every time an order is canceled, the exchange charges the brokerage firm (if there cancel quota has been met) and they in turn charge the account. If individuals were able to compete, they might be bold enough to improve the market on one side of the trade and the penny change might narrow the spreads. Until then, the MM’s are the only game in town and their auto quotes are based on where the other firms/exchanges are quoting the same option. I know they are. I traded against these disparities for 3 years and I used a sophisticated program to identify when they were out of line with each other. I watched the auto quotes evolve and that “loop” has been closed. I am certain the programs that once put greater weight on properly pricing the option now give more weight to where the crowd is. They do not want to be the solo bid/offer. 

If one MM firm wanted to be a little more competitive, they might be willing to forego a penny to get the order. However, they know others will join and everyone’s profit decreases. There is no incentive to engage in this practice. The function of MM is concentrated in a handful of large trading firms that have spent hundreds of millions of dollars on programming, have the lowest cost of capital, miniscule transaction costs and access to OTC (“off-floor”) markets. They have no desire to cut each others throats.

Liquidity is one of the biggest issues faced by the option markets. In very liquid options where there is a great deal of order-flow (1000+ contracts/day), the pennies may make a small difference. In those instances you may be trading against other retail customers. In ill liquid options where the MMs are the other side, expect no change.

Option Trading Comments

  • On 02/10, Harian Metro said:

    hi..i’m doing research about it too and i hope i could share some knowledge about it too with you in the future..well explained there, thanks

  • On 04/08, Pk said:

    Pete - I have to strongly disagree with you on this. Pennies make a HUGE difference if you’re trading in OTM contracts, especially those under .50. For nickel/dime options, the smallest possible spread for a fifty center amounts to 10% of the option. I assume the MMs take on average at least half of that or 5% of each trade. What about .10 x .15 contracts? Now the nickel becomes 50% or 33% depending on your stance. So the MMs pocket 17%-25% on all those trades. Multiply by two sides and it’s even more ridiculous. And forget about even trading options less than a dime! With penny spreads, like on AA, NEM, INTC, AAPL or any of the other stocks in the penny pilot program, you can actually make money trading options under .50 all the way down to a single penny! That can also be very powerful if you need to close your positions at expiration.

    And as far as liquidity, trading in pennies actually makes the options more liquid. This is good for the overall market. It’s just like the difference between when stocks traded in 8ths (12.5 cents) vs. pennies as they do now. The MMs lobby against penny options for the flimsy reason of “too much information” going through the quote systems. “It might overload the quote servers.” As a computer programmer, I can tell you that is pure BS. The streams are coming in realtime, so many ticks per minute. That has nothing to do with the increments carried by those streams.

    The sad truth is MMs want to gouge us on every trade, even those where there are 2 active traders. Narrowing the spread to pennies reduces their take by a factor of up to 5 on very liquid options. Bottom line: smaller increments will always benefit the retail trader by enabling narrower spreads. The lower the premiums, the more this is true.

    I personally try to stay away from low priced illiquid options that are not in pennies. For a complete list of penny traded options, readers may wish to go here: http://www.888options.com/help/faq/general.jsp#26

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