Like the geeks and wallflowers of grade school who are left alone to play with their ham radios, only to later eventually blossom into the brilliant, beautiful and wealthy adults who are envied by all, option traders seem to be finally coming of age. After years of being ignored, overlooked or being treated as fifth wheels on their double dates with stock and mutual fund investors, those in the options set are being invited to dance with the biggest and most popular names in brokerage.
You Can't Be Too Rich or Too Active
The Options Industry Council's
2005 study of the options investor released this April helps explain why brokerage firms have turned more aggressive in their courtship of option traders. The study, which was conducted by Harris Interactive, is consistent with existing perceptions of the personality profiles of option traders: Option traders view themselves as financially savvy, with "above average investment knowledge, consider investing as "an important part of their life" and feel comfortable "taking high levels of risk." They are also more likely to try new products, and by a wide margin say they trade for short-term speculative gain. Nonoption users say they are decidedly long-term investors.
More compelling are the statistics showing that option traders indeed have more money and are more active than nonoption users. Over 41% of option users have net income above $100,000 per year, compared with just 28% for nonusers. More than 32% of options users have a net worth in excess of $500,000, compared with just 17% of nonusers who sport that level of liquid assets. More than 45% of option users have made 51 or more stock trades over the past year, compared with just 12% of nonoption users.
For online firms that measure success and growth on per-transaction basis, having an active customer base is crucial to their bottom line. Many studies have shown that of the some 20 million online stock accounts, only about 10% can be considered ones that are held by active traders. Yet this small group accounts for something like 75% of retail trading volume. If you are trying to lure active traders, the option waters are an obvious place to throw your line. They are teeming with some of the most hyperactive investors. All of this comes against the backdrop that overall option volume surged some 31% in 2004 and is on pace for 20% to 25% growth in 2005.
There are only so many of these prized trading accounts to go around, and the need to keep growing revenue per account is certainly one of the driving forces behind consolidation and recent merger talk in the online brokerage business. Aside from supposed synergies and economies of scale,
unsolicited and so far unsuccessful bid for
was no doubt partly a move to grab the latter's more active, though less affluent, customer base and boost its daily average revenue trades (DART), a common yardstick of brokerage firms to measure bottom-line growth. So far, Ameritrade's transaction-based model does not seem to be a good fit with E*Trade's one-stop financial firm, which includes banking and lending services.
A Cheaper Date Now
So for now the approach has been to appeal to option traders' sense of economy, as firms such as Ameritrade, E*Trade,
( SCH) and most recently Fidelity Investments have cut their fees on option transactions across the board. Whereas most of them charged between $15 plus $1.75 per contract, now all offer rates in the range of $10 plus $1 per contract or less, depending upon the assets you hold in your account and the level of trading activity. This is a major concession, given that until recently, option trades were billed at $30-$40, plus per-contract costs, and provided firms with a profit margin several magnitudes higher than equity transactions.
A "lack of understanding" was cited by 71% of nonusers as the top reason for not trading options. This helps explain why most brokerage firms feel that education is a key to growing their retail option business. Trying to convert a nonoption user into a user can be a costly task with only a minimal conversion rate.
To Know Me Is to Love Me
This also highlights why these mainstream firms may come up short in luring or maintaining active option traders. While the study did a fine job describing the who -- white, married, middle-aged males -- and the when -- frequently -- of the people using options, it did not discuss the specifics of where or how they decide to conduct their trading. What I can say is that option traders, due to their higher level of knowledge, and self-esteem, tend to be much more demanding and discerning in who they choose as their brokerage firm.
The fact is, active option traders already have a choice of some outstanding firms. Examples include
( OXPS), Interactive, Thinkorswim and even CyberTrader from Schwab. These focus on their needs and have been offering commission rates equal to or below the recent reductions by more mainstream firms.
"The new tools and option offerings from the big brokers will always be just a small part of their business," says David Kalt, the president and CEO of OptionsXpress. To that end, he doubts these "bolt-on" products and services will be able to match the tools and execution offered by his or other option-centric firms. He goes so far as to say "we would actually welcome more consolidation in that we have historically picked up market share that results from a certain level of alienation and displacement that comes with change in platform."
Kalt notes that most option traders typically separate accounts broadly divided between banking and long-term savings, and their active trading. Upheaval gives OptionsXpress a chance to show they have a superior service and platform, "land new lucrative accounts and hopefully retain the whole account for both new and existing customers." His confidence that OXPS service can win customers over has no doubt been bolstered by the fact the firm has been named
best online broker for a record two years running.
Investing in Option Trading
OptionsXpress' Jan. 27 IPO was initially a great success. But since hitting a first-day trading high of $23, it has sunk some 39% to around $14 per share. I think the shares are attractive at this level. It, and the newly public
International Securities Exchange
( ISE), are two of the few pure plays on option volume growth. But OptionsXpress' metrics and business model make it a much more promising candidate for sustaining double-digit revenue growth over the next few years. The ISE came on like gangbusters, upended the options industry and grabbed a dominant 32% market share. But now it's stagnating just as other exchanges are upgrading technology and planning their own IPOs. I expect ISE's market share to remain in the 30% range and its growth will come solely from an expanding pie.
OptionsXpress is still a relatively small-cap company: As of Wednesday, its market cap was around $850 million. It operates in a profitable niche and is doing it better and more nimbly than most of its larger competitors. It can grow both organically and through some acquisitions for some time before one of those laws of large numbers drags it down. Just this past April, it added 6,200 new accounts on an absolute basis. This is a relatively small number for most firms, but to OptionsXpress, it was a 6.5% increase, and over the last 52 weeks, it has shown 71% account growth and the number of transactions has increased by 85%. Few other firms are showing that type of account growth or trade growth: The industry averages are 15% and 4.4%, respectively. And the new account additions are of the most desirable kind: option traders.
"The strategy behind our IPO was always about looking for ways to grow the business. That means looking and listening to all merger and acquisition possibilities in addition to continually growing our customer base internally," says OptionsXpress' Kalt. Thanks to the recent selloff and multiple compression across the brokerage sector, OptionsXpress shares now trade at a slightly more reasonable 20 times to its estimated 2005 earnings of 70 cents per share, a discount to its projected earnings growth of 28% to 90 cents in 2006. OptionXpress seems like a good way to gain exposure to brokerage firms increasing demand and publicized pursuit to open option trading accounts.
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;
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