If You Haven’t Traded Options Before: It’s Worth Another Look

Since the introduction of exchange traded options in the 1973, they have become more and more popular. In fact, it seems that almost every month I get an email from the Chicago Board of Options Exchange (CBOE) announcing that a new record number of contracts have traded and showing the month to month and year to year increase in options trading.

What accounts for this increase in options volume? Well, while banks and other institutions have been using exchange traded and over-the-counter options for many years, the general public is beginning to recognize that options don’t have to be as risky as their reputation may imply. In fact, they can be used in many conservative ways to hedge a portfolio, provide portfolio insurance, generate a regular income, and reduce overall market exposure and risk. It is their flexibility and ability to make money in all types (bull, bear, trending, sideways, etc.) of markets that is adding to their popularity.

And, as if that’s not enough, there are 5 recent developments that, I predict, will insure the continued growth and success of the options marketplace.

1.Reduced Commissions For the old timers out there, remember when we actually had to figure commissions into the P/L of a trade to see if it would make sense to do the trade? While all expenses are important, the current commission structure at many brokerage companies has come down to the point where it’s generally no longer part of the decision process to make a trade. When choosing a brokerage company, commissions aren’t everything, but there are plenty of companies with very competitive rates out there.

2.Reduced Spreads Back in the 90’s when I was trading on the floor, each option traded on only one exchange. So, for example, if you wanted to trade DuPont options you would have to go through my crowd on the AMEX. Likewise, if you wanted to trade IBM options you would have to go through the IBM options pit on the floor of the CBOE. Well guess what, when there is no competition, spreads were very wide and sometimes "you could drive a truck through them." Short digression, for those newbies who don’t what I mean by "spread."

Option prices are quoted like stock with a Bid, Offer (also called the Ask) and Size. So a quote of 2.20 Bid 2.50 Ask 20 x 50 Size means that you can buy up to 50 contracts at 2.50 or sell up to 20 contracts at 2.20. The difference between the Ask and the Bid is called the spread. The smaller the spread, the better it is for the public retail trader.The SEC didn’t appreciate this lack of competition and late in the 90’s required that most options be allowed to trade on all exchanges. Now for example, you can trade DuPont on any of the 6 US exchanges. This increased competition between the exchanges and caused the market makers to lower their spreads.

3. Penny Spreads A more recent development adding to the reduced spreads is the introduction of trading in pennies, or penny spreads. Previously the minimum allowable spread was 5 cents for options up to $3.00, and 10 cents if the option was $3.00 or more. In February of this year, the SEC started a pilot program allowing a group of 13 popular options to trade in pennies up to $3 and 5 cents if over $3.00. The program was so successful, that last month another 22 symbols were added to the program. While it’s not clear yet if all options will trade on this basis, the door is open and there’s a real advantage to trading with these penny and 5 cent spreads.

The original 13 symbols were:

WFMI – Whole Foods
GE – General Electric
MSFT – Microsoft
IWM – Ishares Russell 2000
SMH – SemiConductor Holders
AMD – Advanced Micro Devices
INTC – Intel
CAT – Caterpiller
TXN – Texas Instruments
FLEX – Flextronics International
SUNW – Sun Micro
A – Agilent Tech, Inc.

The next group of 22 symbols are:

SPY – SPDR S&P 500
NYX ? NYSE Euronext
AAPL ? Apple Inc
CSCO ? Cisco Systems
MO ? Altria Group, Inc.
XLF ?Financial Select Sector
DNDN ? Dendreon Corp.
T ? AT&T
AMGN ? Amgen, Inc.
C ? Citigroup, Inc.
Yhoo ? Yahoo! Inc.
AMZN ? Amazon.com Inc.
QCOM ? Qualcomm Inc
MOT ? Motorola, Inc.
GM ? General Motors
RIMM ? Reasearch in Motion Ltd.
XLE ? Energy Select Sector
FCX ? Freeport-McMoRan Copper&Gold
OIH ? Oil Services HLDRS
COP ? ConocoPhillips
DIA ? Diamonds Trust
BMY ? Bristol Myers Squibb Co

4. NASDAQ Options Exchange The NASDAQ plans to launch and operate a fully electronic trading system that was developed specifically to trade options. My sources tell me it’s awesome. With their tremendous technological capabilities and seemingly unlimited bandwith, options quotes and electronic fills will likely become pretty close to instantaneous. Also, a major reason why some of the exchanges were against going to penny pricing was that there would be too many quotes refreshing at the same time for their technology to handle. When the NASDAQ options exchange opens for business, scheduled for Dec. 2007, the other exchanges will have to get up to speed or risk losing significant business to them.

5. Risk Based and Portfolio Margin Until recently, margin rules were based on the long outdated Reg T. Basically, to buy marginable securities, an investor would have to put up as a deposit or collateral 50% of the cost of the security, and borrow the rest from his broker. So if I bought 500 shares of IBM at $112/share, I would need to have 500 x 112 x 50% or $28,000 of margin available to cover the initial purchase. Risk based margin takes into account the actual risk of the position. Continuing the above example, let’s say I then add to the position by buying 5 puts with a strike price of 110 for $1,100. Well, now the most the position could lose is $2,100, so that’s the amount of margin that is necessary. In this example, it’s less than 10% of the amount based on the prior rules! Investors and traders who never even heard of options may start buying them just to get the margin relief. To be honest, as of now most brokerage firms are still following the old rules (it will take a lot of re-programming to get the computers to do this right), and the ones I know of who are allowing it require an account of at least $100,000.

The bottom line is this; the options market is evolving and going though a lot of changes. Some will stick, others may not. All of the changes so far will have huge benefits for the retail public customers. How the market makers will do it, I’m not sure, but that’s not our problem.

Stan Freifeld traded options for his own account on the Floor of the American Stock Exchange from 1994-2001. He was a Market Maker for the options on several popular equities including Dupont, Schering Plough, Walgreen's, CBS, U.S. Surgical and Biovail.When he is not trading or thinking about trading, Stan relieves his stress by playing competitive squash, competing in local road rallies with his Ferrari Cabriolet and tutoring local high school students for the SAT's. Stan is a new tutor at Online Trading Academy. The bottom line is that Stan, a long time MENSA member, is an engaging teacher with an extraordinary background in options trading and risk management. He is helpful and patient by nature and equally at ease with all levels of traders, from complete novices to advanced pros and academics. He'll be happy to teach you to trade!

Stan Freifeld traded options for his own account on the Floor of the American Stock Exchange from 1994-2001. He was a Market Maker for the options on ...