Options Trading Evolves, a Penny at a Time

This is the first part of a two-part article on the fast and furious changes in the options market's pricing and platforms.

When the options market's penny pricing pilot program was introduced in January 2007, I had a feeling that order entry and exaction would become more complicated and difficult. This has proved to be the case. The option industry has been playing a game of cat-and-mouse to try to find a balance between, on the one hand, enabling individuals and institutions to take advantage of electronic trading and, on the other hand, tackling the challenge of handling orders in penny increments.

Scott Morris, CEO of the Boston Options Exchange, which spearheaded trading in pennies, said there are tighter market quotes in terms of the bid-offer spread, but the liquidity might not be as visible. "By not being able to see the true 'depth' of the market -- that is, just how many contracts are for bid or sale within a price span of, say, a 10-cent range -- professionals and institutions might be reluctant to enter large market orders because of uncertainty about the price at which it will be filled."

Peter Bottini, executive vice president of trading at OptionsXpress (OXPS - commentary - Cramer's Take), agrees, adding, "For some issues such as the Spyders, it makes sense, but many listings have clearly lost liquidity."

Bottini expressed concerns that echo those of many in industry when he said, "There may be an increase in liquidity, but without the transparency to see, that may make it difficult to take advantage of tighter markets."

Penny Wise?

While the exchanges have generally been diplomatic in their approach to adopting penny pricing, it would be difficult for them to publically resist a change that theoretically benefits retail traders. Both Bottini and Morris say that tighter quotes created by penny trading allow customers who trade fewer than 20 contracts to enter market orders -- that is, without a firm price limit -- more frequently, with the comfort of knowing they are getting a fair price.

---

Steven Smith writes regularly for TheStreet.com. In keeping with TSC's editorial policy, he doesn't own or short individual stocks. He also doesn't invest in hedge funds or other private investment partnerships. He was a seatholding member of the Chicago Board of Trade (CBOT) and the Chicago Board Options Exchange (CBOE) from May 1989 to August 1995. During that six-year period, he traded multiple markets for his own personal account and acted as an executing broker for third-party accounts. He appreciates your feedback; click here to send him an email.

To read more of Steve Smith's options ideas take a free trial to TheStreet.com Options Alerts.