Online Brokers Breaking into Options Action

Last week, when the International Securities Exchange, an electronic options exchange, introduced itself to the investing world, it named among its investors three brokerage firms with significant online capability: E*Trade (EGRP Quote), Ameritrade (AMTD Quote) and Scottsdale Securities. The institutional investment community might have scoffed, but the firms' desire to pony up millions to join the project is a sign that they want a larger share of options traders' business.

Full-Service Brokers Remain Wary

The online brokerage sector has become a force to be reckoned with in the options world. This at a time when full-service brokers remain reluctant to recommend options for many clients even though they retain active options strategists.

There's good reason for that stance: Options have cost major brokerage firms dearly in the form of client lawsuits. At their worst, options are used by the gutsy but ill-advised to speculate; their endeavors turn into costly lessons.

"Full-service firms have had trouble promoting options products," said one full-service firm options pro. At the Options Industry Council conference in Scottsdale, Ariz., last April, Salomon Smith Barney options strategist Kevin Murphy said he was using LEAPS strategies to get in the door of the firm's branches because brokers were less leery of using such longer-term products.

Online Action Picking Up

Brokers may be leery, but online traders are not. About 32% of our online brokers survey respondents said they've traded options online in the last 12 months. Those in the hallowed halls of the Chicago Board Options Exchange have noticed.

The exchange's Web site has been jazzed up to include new information (yes, TSC included) and tools. "The options investor tends to be active and self-directed, and geared toward electronic-order entry," says John Roberts, the CBOE's head of marketing. "And there is a new generation of investors who gravitate to the idea of trading electronically."

There are few statistics that any options organization will provide, but, in the options exchange community, Schwab (SCH Quote) and Fidelity are known as serious providers of order flow (that is, they have large volumes of options trades from their mostly individual clients). (Neither firm could be reached for comment.) And the idea of the ISE was hatched by E*Trade's chairman, William Porter, whose firm had become a conduit for options orders.

Of the eight most-used brokers in our survey, only Datek doesn't offer options trading, though it says it plans to sometime next year. The other seven brokers scored in a range between 3.4 (Waterhouse, a unit of Toronto-Dominion Bank (TD Quote)) and 3.9 (Discover Brokerage Direct, a unit of Morgan Stanley Dean Witter (MWD Quote)) in the options-trading category out of a total of 5 points. The results show that customers aren't as satisfied with options trading as they are with some other features.

Two smaller brokers won top marks in options trading, according to the survey. Brown & Co., a subsidiary of Chase Manahattan (CMB Quote), scored 4.4, and Dreyfus Brokerage Services, a unit of Dreyfus, which is an affiliate of Mellon Bank (MEL Quote), scored 4.3. (Brown and Dreyfus are two of the five smaller brokers we'll be looking at Friday. While neither score is as statistically solid as the results for the eight bigger firms, Dreyfus had a larger error range on this issue than Brown.)

Should You Trade Options Online?

While the CBOE and other options exchanges execute most retail-sized options orders (generally 20 contracts or less) electronically once they reach the floor, there is an advice factor that can make a difference in options-trading success.

The online broker may be less expensive when it comes to options-trading commissions, but positioning -- not commissions -- may be the most-important factor in traders' overall success. An adviser can help you pick the right strike price and premium, even if you choose your own underlying equity.

"From a broker, you'll get input on which is the best option to use for a strategy. A good broker will be more familiar with delta or theoretical value," says Michael Schwartz, the senior options strategist at CIBC Oppenheimer. He adds that, on larger orders, it helps to be with a firm with its own traders. "On larger and more complicated orders, I'd rather have someone in the crowd."

As far as having someone in the crowd, some online firms are able to do that part. San Francisco-based Mr. Stock, for example, is a unit of Group One, one of the largest and most-important options market-making firms.

That affiliation will help ensure that orders get filled well. The firm also provides expertise on strategy, though not on stock selection.

"People who trade options are generally more financially educated, more market savvy than other investors. They are not people who get stock tips. They know what they want, and they don't need to go to a full-service broker to get strategies," says Gary Sharenow, a managing director at National Discount Brokers, who estimates that about 6% of his firm's overall volume is in options.

The presence of the individual in options trading is sure to keep growing, and nascent marketing efforts by the exchanges are a big part of that. Still, even brokers that have ventured ahead remain a little gun-shy about pushing them. Brown & Co., for instance, doesn't throw the O-word around lightly, but the company's ads can regularly be found next to Barron's Striking Price column.

"My guess is that a lot of the larger firms that used to hold your hand with options don't do as much, so it's the customer's decision to trade options," said Gary Katz, the head of marketing and business development at the ISE. "The customer feels less of a responsibility to do it through his full-service broker."

The technical side of this online brokers survey was conducted by , October 1998.