Online Commission War Heading for Options Market

Technology is about to do for trading options what it did for trading stocks -- make it cheap and easy.

At the end of May, the first all-electronic options exchange, International Securities Exchange, will start trading. This is expected to push down commissions. And online brokers will most likely be among its best customers.

The result is likely to be a price war like the one that drove online equity trading into the mainstream in the mid-1990s. At the same time, regulators are pushing the industry for better links between exchanges to make options prices clearer, which will only make options more attractive to small investors.

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Changes in Exchanges Mean New Options for Trading Options

One of the biggest indications that online options trading is about to explode comes from Knight/Trimark (NITE Quote - Cramer on NITE - Stock Picks), the Nasdaq Stock Exchange market maker that made a fortune in exploding online equity trading. (A market maker matches buy and sell orders on the Nasdaq.) It recently not only bought an options market maker, the former Arbitrade, but also purchased Mesirow Financial's options execution and floor brokerage business. Some of Mesirow's customers include Ameritrade (AMTD Quote - Cramer on AMTD - Stock Picks) and E*Trade (EGRP Quote - Cramer on EGRP - Stock Picks), which also happen to be among Knight's largest stock-trading customers.

The Big Push

Most big online brokers, such as Charles Schwab (SCH Quote - Cramer on SCH - Stock Picks) and E*Trade, offer options trading. But the big push in online options trading will come when the International Securities Exchange opens for business this month. While existing options exchanges depend heavily on manpower, the ISE's all-electronic trading venue is expected to operate much more cheaply and thus charge lower floor fees -- a move that should trickle down to investors. It also will provide an all-electronic means of trading for online brokers.

The ISE will likely bring to the options market Datek Online Holdings, whose electronic execution arm, Island, was a major force in pushing down online stock trading commissions. Datek is gearing up to launch options trading by summer's end. It wouldn't discuss details, but it's expected to send orders to the ISE and the other electronic venues that the existing exchanges built to compete with the ISE, creating a technological set-up similar to the one it has with Island.

If all this activity does indeed lead to increased options trading online, it also could add to online brokers' earnings. That's because online brokerages are heavily dependent on volume to drive commission revenue.

So far, online investors have limited their options trading because of that market's complexity, high risk and expense. For example, not only is the initial commission a bit higher than for stocks, but investors may also have to pay more if they eventually buy the underlying stocks. And unlike with stocks, discount brokers must assess investors' financial and trading background for suitability. That may mean higher requirements on both the assets and trading experience fronts.

Options still represent a small percentage of equity trades -- only about 5% of investors who trade equities also trade options, according to the Options Industry Council. But based on a council study done by Yankelovich Partners, 38% of retail options traders trade options online. As a group, they're more active -- options traders annually average 14 more stock trades than non-options traders. And they're trading options more often -- six more trades a year than in 1995.

Increasing Interest

"As overall trading volumes go up and as more and more people become involved in the marketplace and as people take a bigger role in making decisions about what to invest and how to invest, you find an increased interest in trading options," says Bruce MacAlpine, senior vice president of Fidelity Online Brokerage.

MacAlpine, who's familiar with the decline of commissions in the equity business, doubts that options-trading commissions will fall. But he's in the minority.

"Ultimately, I think it's going to lower commission rates," says Scott Fullman, chief options strategist at Swiss American Securities, a Credit Suisse Group unit. "But I think it's going to take a bit of time."

"We'd like to be able to do that, to pass that [lower costs] along to customers," adds Tony McCormick, Schwab's vice president of derivative markets.

Some changes are already in the works at the existing options exchanges in preparation for the ISE's launch. Last week the CBOE eliminated all exchange fees for public customer stock option orders regardless of size or routing method. Customer fees for stock option orders that weren't electronically routed included a 9 cents per transaction fee, in addition to a 5 cents per trade match fee and a 3 cents per brokerage fee. The American Stock Exchange, the Philadelphia Stock Exchange and the Pacific Exchange also dropped certain fees.

That's how a price war starts.

Online Options: What To Pay Where
Company	Cost	Type	Minimum
Ameritrade	$25 plus $1.75 per contract. 10% discount to offline	Equity or index	$29
NDB	$20 plus $1.75 per contract	Equity or index, but cannot establish a new position by selling a put or a call. No naked calls.	$29
E*Trade	$20 plus $1.50 per contract	Equity or index, write covered options, place spreads, naked equity puts. No naked calls, no naked index options.	$29
TD Waterhouse	$30 plus $1.25 per contract.10% discount to offline	Equity or index, no straddles or spreads, naked calls ok.	$31.25
Morgan Stanley Dean Witter Online	$1.80 per contract plus 1.5% of principal amount up to 50. 20% discount to offline	Equity or index, equity option spreads and straddles, naked puts, covered calls and puts.	$35
Charles Schwab	$1.80 per contract plus 1.5% of principal, up to 50. 20% discount to offline	Equity or index, naked equity index call and puts, spreads and straddles, buy and write covered calls.	$39
DLJdirect	$35 plus $1.75 contract	Equity options, covered calls, no naked calls or puts or spreads or straddles	$36.75