In the far, far away galaxy of options publications, you'll find numerous stories detailing the demise of the traditional options market-maker and specialist business.

Some firms are consolidating, while others are completely abandoning floor operations. Bear Stearns ( BSC) is outsourcing its Chicago Board Options Exchange floor business, and Goldman Sachs ( GS) is slashing its Spear Leeds & Kellogg unit. Susquehanna International Group has relinquished its specialist book of 78 issues on the Pacific Exchange, and Toronto-Dominion ( TD) has shuttered its specialist business on both the Pacific and Philadelphia exchanges. The list goes on.

Perhaps the main factor has been the growing success of the International Securities Exchange, or ISE, the 3-year-old all-electronic exchange, which is forcing the options industry into the 21st century.

"I don't know how they do it, but the ISE definitely stands by the markets it makes," says Larry McMillan, president of McMillan Analysis Corp., whose firm runs an options-based hedge fund, oversees managed accounts and offers a variety of options-related research and newsletters. "They don't hide orders, and execution confirmation is immediate. These are two things that have been definitely helping them grab market share."

Indeed, April marked the third consecutive month that the ISE was the leading options exchange in terms of volume and market share.

Necessary Adaptation

For some players in the options markets, these are tough times. "There are just very few issues whose options I feel offer a liquid market in which I can execute trades at a fair price," argues George Fontanills. And lest you think this is just another trader complaining about wide spreads and playing second fiddle to institutions, know that Fontanills runs the Pinnacle Appreciation Fund, an all-options hedge fund.

But while Fontanills' lament may hit a chord with many traders and touches on some of the structural issues challenging the industry, his situation is exceptional -- the size of the orders he's talking about are 5,000 to 10,000 contracts. That would make him one of the largest options traders out there.

Other professionals and money managers seem to be having better luck.

McMillan says that orders of up to 200 contracts can "typically be filled through exchanges without too much difficulty."

And Mike Schwartz, the chief options trader at Oppenheimer, a division of Fahnestock, says that "most people's main concerns are tight markets a narrow bid/ask spread and timely fills, not worrying about accommodating large-size orders, and the ISE is fulfilling that need."

Transition, not Demolition

All of the firms that are scaling back their operations attributed the moves to declining volume and reduced profit margins. The immediate impact for large and active traders is that "there are simply fewer market makers out there, and those that are, are increasingly unwilling to step up to the plate," says Fontanills.

But Schwartz thinks the firms' pullback is smart business. "As electronic linkage across the exchanges continues to get phased in, it makes it redundant to have floor operations on five exchanges," he says.

Currently the biggest beneficiaries of electronic trading in terms of savings and speed of execution have been customers.

"There is some initial disruption in the old way of doing things, but as firms realign their costs and take advantage of linkage, I hope we will begin to see an overall pickup in volume," Schwartz says.

Even Fontanills, when he puts on his other hat as president emeritus of Optionetics, an options education firm, says "the current trends toward electronic trading in the option business are definitely great news for small traders."

Still, Schwartz, McMillan and Fontanills all agree that live brokers maintain a role, based on the idea that the odds of getting a better price or filling certain spread trades are greatly increased by letting a broker work the order.

What They Like

Of course, I couldn't let these guys go without trying to get them to divulge what they're currently doing in the market. All three think options are currently cheap, and that it makes sense to be long premium whether you're bullish or bearish.

Fontanills is cautiously optimistic and has been buying call calendar spreads in some of the bigger names and the Nasdaq 100 Unit Trust to have a moderately bullish posture.

McMillan would only guide me toward the newsletter he publishes, which currently has seven bullish recommendations, five neutral positions (four long straddles and one back call spread) and no bearish bets. Schwartz, who handles high-net-worth customer business, simply says, "puts are very cheap right now, if you are interested in that sort of thing."
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.