Expanding Your Options

The recent influx of new electronic-trading systems for options is revolutionizing the market place - but are traders ready?

David Kalt is revolutionizing the way that retail investors trade options and is upping the ante for firms that want to service online-options traders.

A little over two years ago, Kalt, a computer-science engineer, launched OptionsXpress, Inc., an online-option-trading upstart. Since then, the Chicago-based firm has grown to 28,000 accounts and "Any given day," he says, "we could represent 5 percent of the CBOE's (Chicago Board Options Exchange) total volume."

"We've become a player. We now have the critical mass to be able to achieve some of the things we set out to do."

Most recently, the firm launched Xspread, which Kalt likens to an electronic-communications network for spread trades. It sends spreads to the market in seconds and provides a transparent view of all open spread-trade orders. That includes three-legged trades, such as butterflies and collars, and four-legged trades, such as condors.

"We set out to basically level the playing field and give retail investors the tools some institutional guys have so they can make more intelligent decisions.

OptionsXpress signifies the metamorphosis that is sweeping the options business - at both the retail and institutional level - as everyone from the firms that trade options to the exchanges and clearing houses scramble to adopt new technology to automate the outdated way that options trade.

It's revolutionizing the way that investors operate in the options market. Take Steve Oliveira - he's gone from trading options for clients as a New York City-based retail broker, to trading options full time using his own account. He specializes in biotech stocks and uses a direct-access system offered by Terra Nova Trading, LLC.

What used to be a laborious process of phone calls and placing orders is now "condensed into clicking a button," he says. But the big advantage, he says, came with the 2000 launch of the International Securities Exchange (ISE), an electronic-options exchange. "It's the best thing to come to the options market," he says, adding, "It's improved the liquidity and speed of executions."

The infrastructure changes that are sweeping the options world come at a time when stock-market-trading volumes have slumped, but options have held their ground.

According to the Options Industry Council, a non-profit education group, the yearly cleared contract volume for all products in 2002 was 780 million, down slightly from 781 million last year. However, since the 1970s, options trading has skyrocketed. In 1973, there were only 1.1 million cleared contracts. Now, on average, 3 million contracts clear a day. Research firm TowerGroup estimates that options trading will grow at 16 percent annually between 2002-2005.

This growth has not gone unnoticed by firms looking for a slice of the commission pie. It has attracted nimble online players like OptionsXpress, ISE and the BOX, a new electronic-options exchange scheduled to launch in Q2 of 2003 by the Boston Stock Exchange.

BOX is a fully automated exchange with a transparent order book handled on a price/time priority. Trades must be at, or better than, the national best bid or offer.

Jim Kleinops, head of business development at EasyScreen plc, which makes trading solutions for equities, derivatives and bonds, says the "advent of the BOX is going to put more pressure - as has the ISE - on the physical exchanges. It will drain liquidity from them and remove the barriers to access and reduce (trading) costs."

Michael Juneman - assistant vice president in charge of the trading floor at market maker Timber Hill, LLC., part of the Interactive Brokers - says that the "ISE has forced the floor-based exchanges to adopt more technology to make trading seamless."

Kleinops agrees, noting that currently "everything is geared to maintaining floor traders. You still have voice brokers and all the large bulge bracket firms still have option-order desks where they shop for liquidity."

In many ways, the options industry is going through the same painful change that the equities market did a few years ago, as the ECNs and online brokers rocked the boat and changed the way that investors trade.

The impact is being felt. "Markets are fairer now because of the competition," says Tom Schwalen, solution manager and senior software architect for Kingland Systems Corporation of Clear Lake, Iowa.

Kingland provides order-routing and connectivity solutions for brokerages, including the Options Black Box, an order-routing and messaging-translation product that's piped into the five major U.S. options exchanges, the Philadelphia Exchange, the American Stock Exchange, the Pacific Stock Exchange, CBOE and the ISE.

Schwalen says that technology is changing rapidly in the options space as exchanges scurry to automate and introduce new order-routing capabilities. This will have an impact on firms that trade options, as they will have to beef up their own operations. The challenge for investment firms, Schwalen says, is "finding out what each one of these destination exchanges expects in terms of format for messages."

That's because "options markets aren't connected together in a market system, yet. You need to have a communications link to all the exchanges if you want to trade."

The exchanges are working on a project to link, which should go live this year, he says. In the meantime, while Financial-Information Exchange (FIX) is the preferred communications standard, he says, CMS (Common Message Switch - the communications hub between the member firms and the NYSE systems) is also heavily used and many of the exchanges have "taken liberties implementing their own version of CMS." That makes it tricky for firms and creates "protocol issues."

But are firms ready for the changes taking place? Kenny McBride, global industry manager for securities and the capital markets at Microsoft Corporation in Redmond, Wash., isn't so sure. "We're seeing bits and pieces. We're not seeing massive investment into technology at this time." The options space, he says, is a "very, very expensive market to trade in, if you get it wrong."

While firms are looking for operational efficiencies, the choppy markets have them reluctant to invest. He predicts it will be a "few years before institutions get into automation" in any kind of mass scale.

That wait could be shortsighted. Jean-Paul Carbonnier, an analyst in the retail brokerage and investing practice at TowerGroup, says option traders are attractive clients. They trade more frequently and tend to have higher account balances.

He says that most mainstream brokerage firms have been slow to add options tools and analytics, opening the doors for electronic upstarts to steal away attractive clients. That will force firms to respond whether they want to or not.

Carbonnier notes that "options traders also trade equities, and do so on a regular basis. As soon as specialty options brokerages begin to capture larger client bases and gather more of their assets, mainstream firms will have to respond." He says options investors' needs "are not necessarily overly demanding. The key to servicing this investor segment is to make the trading of options as user friendly as possible."

However, there's a caveat. "Options are much more complicated than the underlying instruments to which they're linked." The analytics are much more complicated and could be tougher to scale up to a large Web clientele, Carbonnier warns.