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In for a Penny, in for a Pound

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Perhaps you've noticed that some options are priced in penny increments while others are not. Retail traders like the idea of options priced in penny increments, but officials with the CBOE aren't exactly pounding the table about the practice.

Since January 2007, the Chicago Board Options Exchange (CBOE) has been conducting the Penny Pilot program. Starting with the first security in which options under $3.00 would be quoted in penny increments, Whole Foods (WFMI), the CBOE has added new securities every few months.

The CBOE hasn't liked the results, but when the order comes down from the head of the Securities and Exchange Commission (SEC) asking the exchanges to start quoting options prices in penny increments, you perhaps do what you're told. In the summer of 2006, the SEC's chairman, Christopher Cox, sent a letter to major U.S. options exchanges asking that they begin testing the practice of pricing in penny increments. The SEC put out a press release saying that nothing had ever prevented the exchanges from pricing options in penny increments but that none had taken the initiative to do so. Perhaps the press statement didn't phrase the comment just that way, but everyone got the message.

Traders expected tighter spreads. They thought that when they put in market orders, they would get fairer fills. Some options market makers and officials at the exchanges worried about the unintended effects, and, reading between the lines, it didn't appear that they liked being strong-armed by the SEC. Those unintended effects might include more liquidity but less transparency, they argued. They thought the SEC might be moving toward requiring quotes in pennies in all options on all securities, even illiquid securities. We've recently experienced a time when a first SEC order was expanded, so perhaps those fearing an expansion of the order weren't so far out of line.

Retail traders haven't always seen the expected tighter spreads. As the pilot program was rolled out to include options on the first, second and third securities, a predictable pattern began emerging. Spreads between the bid and ask tended to narrow at first, but then widened again into nickel and dime increments. In the early days of the program, pundits concluded that the more liquid the instrument and the higher the volume in its options, the more likely that the at-the-money (ATM) options, at least, would continue to be quoted in penny increments. As of several months ago, when I was writing a Trader's Corner article on the topic and looked at a front-month options chain on WFMI, the first security included on the penny pilot program, options were still being quoted in penny increments as many as three strikes on either side of the then-current price on the put side and throughout most of the chain on the call side.

As of October 17, 2008, with WFMI at $13.98, November put options at the $10.00, $15.00 and $16.00 strikes were quoted in penny increments, but those outside those strikes were not. Once again, most of the chain on the call side was quoted in penny increments. That didn't mean the spread was narrow for a low-priced stock, however. The $10.00 and $15.00 calls sported bid/ask spreads of $0.50 and $0.13, respectively.

Apple (AAPL) was another of the securities in the original 13 securities rolled out in the Penny Pilot program. As of October 17, 2008, with AAPL at $97.40, seven out-of-the-money (OTM) strikes on the put side were quoted in penny increments. More call strikes were also quoted in penny increments, but those were all OTM strikes, too. All the near-the-money strikes were quoted in nickel or dime increments.

JPMorgan Chase (JPM), among the group rolled out after March 28, 2008, showed a pattern similar to AAPL's. Some OTM calls and puts were priced in penny increments.

Lately, we've experienced extreme market volatility, increasing risk for market makers and market participants and widening spreads in some cases. Despite this action, at least some strikes are still quoted in penny increments.

However, the CBOE isn't happy about the results of the Penny Pilot program. Traders should know that market makers have always been able to and are still able to trade in penny increments, and some exchanges are petitioning the SEC to make sure that those quotes are not visible to the trading public. However, the CBOE, in its "Penny Pilot Report-September 28, 2007 through January 31, 2008" to the SEC, stated that the CBOE was "justifiably worried" when "much of the data from the first nine months of the Pilot Program reflect negative consequences for the options industry." The CBOE points to possible decreased liquidity, volume and quote traffic in some of the issues with options quoted in penny increments.

As noted in the previous Trader's Corner article on the topic, some brokerages such as Interactive Brokers have set up auction systems that allow their customers to enter orders in penny increments on all equity options and not just on the issues included in the Penny Pilot program. You should check with your broker to determine whether such programs are available as well as for information on how such orders would be sent to the exchanges or filled.

For most securities and exchanges, though, putting in an order to buy or sell an option in penny increments will be restricted to the issues included in the Pilot Program, as long as that Pilot Program is still in effect. How long will that program stay in effect? Will it be expanded or shut down? Will the current market upheaval impact the final decisions or the effective pricing, no matter what the SEC requests? Those are questions still to be answered. For now, to find out whether your favorite trading vehicle is included and to watch for any SEC- or CBOE-prompted changes in the program, see Penny Pilot Program.

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