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This year will end with about 860 million total options contracts traded; this will be a new record, eclipsing 2001's banner year by about 80 million contracts. But all is not joy in Optionsville.

For all those whose lives are touched by options, from retail investors to professional traders and market makers to the exchanges themselves, 2003 has been full of challenges, changes and transitions.

Just as the silver cloud of the surging stock market is ringed by the black lining of scandal and malfeasance -- is that term so 2002 yet? -- the options industry is also facing upheaval and scrutiny about how its business is conducted, as questions about the integrity of marketplace persist.

"The U.S. options markets are in urgent need of reform, even more so than the


or other equity exchanges," said Sam Lek, a former director at Bear Stearns and current CEO of Lek Securities, a New York-based brokerage and clearing firm. Lek believes "the U.S. needs stricter regulation to level the playing field for all investors." Ironically, he thinks one of the biggest abuses has been allowing exchanges to distinguish between retail orders, and market maker or broker/dealer orders, thereby giving priority to retail orders if price was equal.

However, Lek believes that by making marginal price improvements, specialists can still technically adhere to the letter of the law by filling orders at the national best bid or offer, but can step in front of customer orders and take advantage of the fact that most retail traders cannot respond quickly enough to fractional changes in price. This leaves their standing limit orders ripe for plucking when the market moves. "The theory behind the rule was well-intended, but now it is being totally abused. I'm not against specialists, but there is no reason for anyone to know the origination of any order," Lek said, believing that the resulting discrimination works against the public. He thinks the policy "should be abolished."

Electronics Killed the Specialist Star?

But even Lek acknowledges that electronic trading "is certainly a step in the right direction" toward leveling the playing field. Given that the International Securities Exchange, the first all-electronic options exchange, has become the market-share leader, wiping out more than 20 years of dominance by the Chicago Board of Options Exchange in less than three years' time, it seems evident that electronic trading is the future of the industry.

This trend will continue with next year's opening of the

Boston Options Exchange, or BOX, another all-electronic exchange. This exchange will not only have no specialists, it will take orders on a pure time/price priority -- meaning retail traders get no preferential treatment over broker/dealer or market-maker orders. "This BOX continues the evolution of electronic trading," said Brian Sandberg, a principal of Gander Capital, a New York-based hedge fund. While the structure and arguments for and against the BOX were touched on in an

earlier article, the debate is far from over, and I'm sure it will only rekindle when trading commences some time in the first quarter of 2004.

But BOX officials are confident that they are creating an exchange that will meet current market needs."The growth in option trading is due to increased volume by institutional and professional traders. By allowing them to become order-flow providers without an equity investment, we are targeting the growth segment of the business," said Alan Grigoletto, the BOX's Chicago and San Francisco representative.

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The BOX will be prepared to commence trading 10 days after it receives approval from the overburdened

Securities and Exchange Commission

; at that point we'll revisit the subject and be able to provide a more in-depth assessment. The launch of the BOX might also coincide with the ultimate demise of the American Stock Exchange, which operated on the specialist system. Gain one exchange, lose one exchange -- that's recycling in the name of progress.

The VIX Drip

The other big issue of the year has been the steady, continuous decline in option volatility. This has confounded traders in multiple ways. The first people affected are those who seemed convinced that the each time the VIX slipped below another 5-point threshold, from 40 to 35 to 30 all the down to the current level of 15, it was a sign of complacency and a market top.

Vix Takes a Dive
Options volatility has declined while market soared.

"People failed to remember three important things: One, volatility typically drops as markets climb; two, we were coming off of an unusually high level of implied volatility that was the result of 9/11 and buildup to the Iraq war; and three, the current implied volatility is merely a reflection of the real or historical volatility of the market," said Frederick Ruffy, an options analyst with Optionetics. Currently, the

S&P 500

's actual 30-day historical volatility is a mere 11%.

This leads to the general lament among options traders of all stripes. "It is just really difficult to make money trading in the current environment," said Michael Schwartz, chief options strategist at Oppenhiemer. "They are too cheap to sell, and buying has become like Chinese water torture," says Schwartz.

Still, most traders view purchasing the currently cheap options as the safer route. "How badly can you get hurt jumping out the first-floor window?" wondered Adam Warner, an independent options trader and contributor to

Street Insight


Steven Smith writes regularly for 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.