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While it may not receive the same amount of coverage as the investment-banking league tables, the Options Clearing Corp.'s year-end tally of volume and exchange market share is widely anticipated within the options industry. According to the numbers, 2006 was another banner year, with total options volume hitting a record 2.02 billion contracts. That's a 35% increase over 2005 and marks the fourth consecutive year of 30%-plus volume growth.

Finding Common Ground

Once again, the big drivers include the increasing role of hedge funds, which now make up nearly 25% of trading volume in both equities and options, and the adoption by traditional mutual funds of options as a tool for generating income and reducing risk. This is most evident in the growth of covered-call and buy-write funds, which have raised some $100 billion over the past two years.

In addition, there has been a trickle-down effect, as retail investors also embrace options for money management rather than pure speculation. In fact, a recent survey by Schwab ( SCHW) of 2,000 of its option clients revealed that more than half use options for income generation and some 46% are using options as part of their retirement-planning portfolio.

Thanks to entry into options by mainstream brokers such as Schwab, E*Trade ( ET) and OptionsXpress ( OXPS), which have all emphasized educational and trading tools, options are slowly but finally shedding their "too risky" and "too complicated" labels. The steep drop in commission rates has also been instrumental to overcoming costly barriers to entry, as options-trading fees are now basically in line with equity transactions.

The continued growth of exchange-traded funds has provided an efficient vehicle for both professional money managers and self-directed traders to use options. ETFs such as the Spyder Trust ( SPY), the Nasdaq 100 Trust ( QQQQ) and iShares Russell 2000 Index ( IWM) are typically the most-active options, trading collectively an average of more than 350,000 contracts a day.

Slicing a Bigger Pie

While stock and commodity exchanges have been participating in a global consolidation, the options industry is now up to six separate exchanges. When the Nasdaq ( NDAQ) enters the business later this year, it will be seven, thanks to an expanding pie that has allowed even the smallest exchanges to show growth. But a shift in market share and the fact that 30% annualized growth cannot continue indefinitely might finally lead to some mergers in 2007.

The main battle is still between the Chicago Board Options Exchange (CBOE) and the International Securities Exchange ( ISE), which together make up more than a 60% market share.

But the big surprise is how well the CBOE has rebounded over the past two years. It had its world turned upside down when the ISE launched the first all-electronic exchange in 2001, and it saw its market share slip from nearly 70% to 25%. However, the CBOE has regrouped, refocused and revamped its exchange to include a hybrid and remote electronic trading and has been rewarded by having its market share increase to 33% from 31% over the past year. In its favor is its stranglehold on S&P 500 and other index options.

The ISE has seen its market share slip fractionally to 29.19%, even though it still garners 32% of all equity option volume. The CBOE is preparing for an initial public offering sometime this year, and having access to fresh capital and a tradable currency will only make it a more formidable force. And much like the Chicago Board of Trade ( BOT) (from which it was spawned) is now merging with its longtime bitter rival Chicago Mercantile Exchange ( CME), the CBOE might then be in a position to pursue what is now an equally unfathomable an alliance or merger.

The biggest winner on a percentage basis was the Philadelphia Stock Exchange (PHLX), which saw its market share increase to 14.05% in 2006 from 10.46% in 2005. This was mainly a result of the PHLX getting an electronic platform in place and being able not only to compete but also to leverage its being the home of some tech indices, including the SOX.

This stands in contrast to the American Stock Exchange (Amex), which squandered its exclusive listings on ETFs and many of the largest energy issues and saw its market share decline to 9.98% from 13.85%. The exchange has finally added electronic trading to its open outcry, but it will be hard pressed to regain market share. However, seat prices have gained some 30% to $300,000 over the past year, mainly on hopes of a merger.

Its most likely partner would be the Boston Options Exchange (BOX), which became the second all-electronic exchange when it launched in 2004. Unfortunately, since then, its market share has hovered just above 5% and showed some slippage last year. But the BOX is well financed, as some of the biggest investment banks and market makers like UBS, J.P. Morgan ( JPM) and Interactive Brokers were founding equity partners, so it has a built-in liquidity base and the wherewithal to expand or finance a purchase of a regional exchange.

The dark horse is Arca, which is now owned by the New York Stock Exchange ( NYX). Arca's market share has held steady at a respectable 11% over the past two years. But since its initial public offering last March, the NYSE has made no bones about wanting to re-enter and grow its derivatives business. As the NYSE's proposed merger with Euronext is proceeding, I expect that will give it a global presence to push for combining options and equities on one seamless platform.

Through all this, the big winners continue to be customers, both professional and retail, who are enjoying an unprecedented decline in fees and an increase in access to information and trading tools. Enjoy it while it lasts.

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; click here to send him an email.

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