Option Investor
Trader's Corner

Pinching Pennies

HAVING TROUBLE PRINTING?
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You're buying a far out-of-the-money (OTM) SPX call for under $3.00. Don't you remember something about options under $3.00 being priced in penny increments? You think you do.

You type in all the parameters of your options trade, including a limit price of $2.83, and click on "Preview Order." You're greeted with a warning similar to the one shown below:

Oops, maybe you remembered that $3.00 thing wrong. Or maybe options on the SPX aren't among those that trade in penny increments. Yet, a few days later, you're talking with a trading friend who tells you that he successfully entered an OTM bull call debit spread on the SPX with a debit price of $2.83.

So, what's up with the penny increments? What orders can you place for penny increments and what ones require decimal increments of $0.05 or higher?

Back in the summer of 2006, Securities and Exchange Commission Chairman Christopher Cox sent a letter to major U.S. options exchanges. That letter asked the options exchanges to start quoting options prices in penny increments rather than in increments of a nickel or dime. Not all options would be quoted in the new program, then slated to begin January 29, 2007. Instead, the program would be a sort of pilot program to try out the new pricing.

The program actually began January 26, 2007, the first day of the Penny Trading Pilot Program. The program chose a security that seemed to best approximate the average security to premier options quoted in penny increments. That security was Whole Foods Market (WFMI). Others were soon phased in, including options on Microsoft (MSFT) and General Electric (GE) the next week. Eventually, thirteen options classes were slated to be part of the pilot program, according to an SEC release.

Stocks had long traded in pennies, and market makers, of course, had also long been trading options in penny increments, but not quoting them in those increments. Nothing had prevented them from doing so at certain exchanges, as a SEC press release at the time noted. Those exchanges permitted trading in penny increments. It was just that none were quoting them that way. Some proponents of the new program felt that the tighter spreads would eliminate the order-flow payments some brokerages made to the exchanges.

Most retail traders thought options quotes in penny increments was a good idea, envisioning tighter spreads and perhaps fairer prices when forced to enter market orders. Some pundits worried that some factors related to the new quoting system would lead to more liquidity but less transparency and some hesitancy on the part of big money players to place trades. Some worried that the SEC was just putting a foot in the door of a program that would ultimately require quotes in penny increments for all options, and that just wasn't going to be workable for options on all securities. It wasn't workable to quote in pennies in illiquid instruments.

The pilot program saw results that might have been somewhat predictable in the first three issues tested. At first, spreads narrowed in WFMI options, but then options were soon being quoted in nickel and dime increments again. GE followed a somewhat similar pattern, but it took a while for spreads to widen in MSFT as quotes gravitated back to nickel and dime increments again. In the early days, market watchers concluded that the higher the volume and the more liquid the instrument, the more likely it was that the options would remain priced in penny increments, particularly near the at-the-money (ATM) strikes.

However, as I look at front-month options chain on WFMI, the first issue to have options quoted in penny increments, I see options being quoted in penny increments as many as three strikes on either side of the current price on the put side and throughout most of the chain on the call side. Spreads seemed to have narrowed again.

The first 13 issues included in the pilot program included WFMI, GE, MSFT, IWM, QQQQ, SMH, AMD, INTC, CAT, TXN, FLEX, SUNW, and A. In September, 2007, the program was expanded to include XXP, SPY, NYX, AAPL, CSCO, MO, XLF, DNDN, T, AMGN, C, YHOO, AMZN, QCOM, MOT, GM, RIMM, XLE, FCX, DJX, DIA, COP, OIH, and BMY.

Since the pilot program first began with those options in WFMI, the exchanges have gradually increased the securities in which options may trade in penny increments when the option is priced less than $3.00, although the program is still labeled a pilot program. On March 28, 2008, for example, the options industry expanded the list of eligible securities by 28. Those new securities included GS, CFC, BAC, EEM, MER, RIO, EMC, XOM, WMT, HD, VLO, AA, DELL, SNDK, PFE, EBAY, HAL, LEH, JPM, WM, F, TGT, AIG, NEM, VZ, MNX, SBUX, and BSC.

Traders can read about the program on the CBOE site at the following link: http://www.cboe.org/hybrid/pennypilot.aspx

What's the future of the pilot program? Will more securities eventually be added, including the SPX? Not if the CBOE has anything to do with it. In its "Penny Pilot Report-September 28, 2007 through January 31, 2008" to the SEC, the CBOE "expressed its concern that much of the data from the first nine months of the Pilot Program reflect negative consequences for the options industry" and said that the CBOE was "justifiably worried." The CBOE believes that some issues with options quoted in penny increments have suffered from decreased liquidity, volume and quote traffic.

Nevertheless, some brokerages such as Interactive Brokers are setting up an auction system that allows their customers to enter orders in penny increments on all equity options, not just on the issues included in the pilot program. See your specific broker for the conditions under which these orders can be submitted as well as for information on how they're filled or sent to the exchanges.

So, while traders might be able to enter orders for combination-type option trades on the SPX in penny increments if the price is below $3.00, they're going to have to wait a while until they can do so on single options for the SPX.
 

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