By most counts, 2004 was a banner year for the option industry. There was more volume, more competition, more access and more acceptance of options by the mainstream as a valuable instrument for investing. The net result is that investors now enjoy access to the most open and cost-efficient options markets ever. Yay options!

According to the Options Clearing Corp., option volume crossed 1 billion contracts in November, marking the first time trading has surpassed that milestone in one calendar year. The final tally for 2004 should come in around 1.2 billion contracts, a 31% increase from 2003. Average daily volume has been 4.6 million contracts, a similar percentage increase from 2003's average daily volume of 3.6 million contracts.

Juiced by Electricity

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Many factors are responsible for the incredible volume growth, but probably the most important one has been the expansion of electronic trading. It has reduced the cost and increased the accessibility of option trading: Commission fees have declined dramatically, with many online brokers now offering rates around $15 per trade, which is comparable to equity transactions.

Just a few years ago, even as several thousand shares of stock could be traded for $10 or less at many well-known brokerage firms, the commission fees on options were still hovering at $50 or more. Paying $100 per round trip to trade an item with a notional value that can be as low as $20 is very unappealing for small-lot traders. It certainly would start the position in a deep hole.

Electronic trading platforms, the related linkage between exchanges and smart order routing, have resulted in tighter bid/ask spreads and better fills, which effectively lowers execution costs. This is not to say you can't still encounter a market that "moves away" as soon as you enter an order, or other frustrations associated with trading in an illiquid market. But on the whole, markets are more transparent, quotes are honored and orders are better represented than they have been in the past.

Also, the ability to enter a two-part or multistrike order -- a buy-write, simple spread and butterfly are examples -- as a single transaction has drawn more hedging and limited-risk-type trading. This has resulted in a higher percentage of orders being filled.

Success Breeds Disruption

It's no coincidence that two of the entities that best represent the new era of electronic option trading have filed to go public in 2005 to capitalize on their success and fund future growth.

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The International Securities Exchange (ISE) was the first all-electronic exchange. In its four years of existence, it has become the equity option market share leader. OptionsXpress is an online brokerage firm with progressive offerings of spread trading and analytic tools that have helped fuel tremendous account growth. I expect these to be two of the most-discussed IPOs in 2005, and they should provide a good barometer for the health of the trading industry.

The ISE's success has forced more established exchanges, most notably the Chicago Board of Options (CBOE), to accelerate the implementation of its electronic platform. It also has the lesser exchanges such as the Philadelphia Stock Exchange and the American Stock Exchange fighting to stay alive and considering "strategic alternatives," such as merging or selling themselves to other exchanges or larger financial institutions.

Ned Bennett, a co-founder and CEO of OptionsXpress, expects "more consolidation of not only the exchanges, but among the specialist and market-making firms" as well.

This is not all good. Bennett cites the takeover of stock trading on the Pacific Stock Exchange by Archipelago Exchange, or ArcaEx, which is owned by the likes of

Goldman Sachs

(GS) - Get Report

and

Merrill Lynch

(MER)

, as an example of the exchanges becoming an extension of the clearing and brokerage firms. It has been rumored that the next logical move will be for ArcaEx to take control of the options trading on the Pacific Exchange, which Bennett says "will bring a legitimate increase in competition to the ISE and CBOE but ... also highlights increased control of the exchanges by the financial institutions, which control the trading volume."

As Bennett sees it, the problem is that the industry is approaching a point at which there are "not enough brokers to adequately bring buyers and sellers together and provide the liquidity to a market that keeps growing."

Bennett says another negative result of the increase in competition has been the move toward allowing market-makers to trade in penny increments. "The Boston Options Exchange started this with their PIP

price improvement period, which provoked the ISE to adopt its PIM

price improvement mechanism, neither of which substantially help public customers," Bennett says.

He believes the net result is to allow firms to internalize orders and for exchanges to try to keep market share by executing an order at a better price without showing the order to the full open market.

Citigroup's

(C) - Get Report

recent purchase of SLK's option specialist business is seen as a means to gain access to an electronic platform and provide better service to institutional or high-volume clients.

But Bennett thinks that the push toward demutualizing exchanges and making them publicly owned, for-profit entities will ultimately be a positive force in the trading landscape. "People like competition, and publicly owned exchanges will not only force more accountability and transparency, but more innovative products and more efficiency," he says.

And so "more" seems to be the watchword again in 2005. Keep your eye on this space for more developments.

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 1989 to 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.