At long last, it seems some light is being shed on one of the darkest and most frustrating mysteries in the options-trading industry: Why don't the

Standard & Poor's Depositary Receipts

(SPY) - Get Report

have any options available for trading?

As discussed

here previously, the lack of SPY options is the unfortunate result of the Chicago Board Options Exchange's longstanding exclusive licensing agreement with the Standard & Poor's division of

McGraw-Hill

(MHP)

, making it the sole exchange that can trade options based on the popular and widely tracked equity index, commonly known as Spyders. So, like some Soviet-era citizens waiting in line for bread, traders have just came to accept that one of the most basic products, a viable and competitive S&P-based options market, is not part of the system.

But some recent events hint at glasnost for options traders. These include the

recently mentioned moves by the

Chicago Mercantile Exchange

(CME) - Get Report

(or CME) to promote options on its

E-Mini S&P 500

futures and, more directly to the point, news that the Department of Justice's antitrust division is

investigating ties between CBOE and the American Stock Exchange as to whether the two exchanges colluded in some fashion to prevent the listing of Spyder options. The short story is the Amex, which created and has the rights to trade the Spyder ETF, filed a lawsuit four years ago seeking a judgment that would allow it to list related options; the suit was settled out of court for undisclosed terms.

Call me a cynic (but please don't sue me), but it seems obvious that the CBOE paid the Amex to walk away. When asked about the terms and length of the current licensing agreement, a CBOE spokesperson responded with a curt email stating: "Agreements are negotiated, private contracts, we do not make the details available." Amex declined to comment for this article.

The International Securities Exchange (ISE) was also unable to comment on its previously filed complaint letters, or almost any other matter, due to a "quiet period" stemming from its filing for an initial public offering last month. But it's clear from past statements that ISE views the CBOE's position as anticompetitive. The petitions for multiple listings and options linkage of SPX options, which the ISE and other exchanges would be willing to pay a fee, have been batted around in front of the

Securities and Exchange Commission

for three years now.

The CBOE's main index products, which include the

S&P 500

index options (SPX), the S&P 100 option (OEX) and more recently the

Diamond Trust

(DIA) - Get Report

accounted for nearly 22% of the exchange's trading volume through the first half of 2004. But the CBOE is being short-sighted in protecting this franchise; I believe CBOE's opposition to SPY options or even linking the existing SPX options to other exchanges is wrong from a market perspective and an economic miscalculation.

Make a Bigger Pie

The CBOE's main fear seems to stem from a belief that linkage or the listing of SPY options would steal market share from its prized product. But I think they are greatly missing the concept of how an expanding pie will benefit everyone. The table below lists 10 of the most popular index-based option products, their July and year-to-date volumes, and on what exchanges the options trade.

The immediate number that stands out is that the

Nasdaq 100 Trust

(QQQ) - Get Report

or "Qs" in trader parlance) whose options trade across all six exchanges, is logging 2.7 times the volume of the CBOE's exclusive SPX options. Everyone I spoke with, from individual investors to institutions or brokers that cater to each, made it abundantly clear that there would be similarly great demand for SPY.

"SPY options would offer huge benefits and have strong demand from my clients," said Mike Greenberg, vice president of institutional sales with Midwood Securities. "Right now a lot of that business simply gets diverted into the Qs."

"If someone wants to trade options on the market we first suggest looking at the Q's and then the Diamonds," added Eliot Spar, a market strategist with Ryan Beck who deals with retail customers. "If they know what they are doing and still want to trade the SPX, we strongly suggest letting one of our brokers work the order to get a better price than is quoted or how you will be filled on the auto-execution system."

Spar is far from alone in suggesting that you enter orders at your own risk in the SPX option pit.

Greenberg explained that currently "option strategies that our customers do in the Qs cannot be transferred into the SPX options. I cannot emphasize enough the importance of having nickel spreads, strikes that are a dollar apart and sufficient liquidity in the underlying is to being able to cleanly and efficiently trade and hedge positions."

By comparison, the SPX strikes tend to be $10 apart and have spreads with widths ranging from 50 cents to $2. This also touches on the issue that options liquidity is really a function of the liquidity of the underlying securities. Many investors think if they put in an order to buy 50 calls at the offer price they will be filled, but if only 1,000 shares of the underlying are offered at a given price, the option market-maker will sell only 10 call contracts. Market-makers, or professional option traders, will typically trade only the number of contracts that can immediately be offset in the underlying security.

Putting it bluntly, Ned Bennett, the COO of OptionsXpress, an online brokerage firm, said: "It's suicidal for a retail customer to try to trade the SPX options," as just too much is given away on the bid/ask spread to make economic sense. Giving away a dollar a side on $4 items tends to put people off.

For this reason, the QQQs have become something of a default product of choice. Most of my sources feel SPY options would take a greater share away from QQQ option trading than they would cannibalize the CBOE's existing SPX contract. With a potential volume of 9 million contracts or more per month, the CBOE would be one of the main beneficiaries of listed SPY options -- assuming it could grab its usual 30% market share. Also, if, as Bennett suggests, the CBOE "franchised out the right to trade SPX options" and linked the exchanges, it would most likely see substantial volume growth in that contract.

Bennett, who expressed disappointment with the CBOE's protectionism, points out that ETF options are growing at a 30% clip over the last six months alone and that many contracts are seeing volume surge 80% to 90% year over year while the SPX is losing ground. "You need liquidity and a bigger pie benefits everyone," he concluded.

The Future of S&P Options?

The

contract specifications for the E-mini S&P 500 futures and their related options make them worth just a fifth of the regular S&P futures and options; this diminished contract size not only makes it more affordable -- and therefore more accessible to retail traders -- but it also provides greater flexibility in establishing and managing option positions. This is especially true when utilizing multistrike and ratio-based strategies; it is hard to take half your profits if you have only one contract or are working literally with a 1-by-2 spread.

Some potential drawbacks and obstacles to the CME's E-mini futures include the need for a commodity or futures account to trade (currently only about 10% of the people with regular equity accounts have a futures account). Also, futures tend to trade at a premium or discount to the cash market, making pricing and hedging an even less exact proposition. This leads Bennett of OptionXpress to say "the economic benefits of trading options on futures is lost on retail customers."

He explained that that price of options on futures have a higher component of sentiment into the calculation, making them harder for market makers to price for immediate hedging purpose. The contracts must often be held until expiration, when prices converge, to realize the true and fair value. If, for example, you own September futures, Bennett thinks selling December futures or another month is a better hedge than options on futures, as he believes futures in other months provide a more liquid and symmetrical hedge. (Then again, as someone heading up an online equity brokerage firm, he may have an institutional bias against options on futures.)

Where Is the Real Thing?

While the CME might not be the answer, at least it offers an alternative to SPX options. But not having options on Spyders remains another example of established institutions, in this case the CBOE, protecting their members' interests over what is best for investors and the industry. It should not be a surprise that the CME -- which is pushing the envelope in creating new products and challenging the sanctity of the CBOE's exclusive listing -- is a publicly traded company having to answer to shareholders, not just members.

For now, if you want to trade the broad market options, you have to play according to the CBOE's rules and incur the usuriously wide spreads born of a monopolistic market. Or just shuffle along and try to find a reasonable replacement strategy or product. That's just the way it is.

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 invites you to send your feedback to

steve.smith@thestreet.com.