The View From The Pit

The largest trading pit at the Chicago Board Options Exchange has the feel of a frat-house party. The 300 casually dressed floor brokers and market makers, mostly men in their 20s and 30s, engage in backslapping camaraderie, cracking jokes and snapping gum between trades. But their game is deadly serious. That becomes apparent when you watch their eyes, fixed on huge electronic bulletin boards flashing market data, and hear them yelling their trades.

I got a trader's-eye view recently when I spent a day at the CBOE pretending to deal in options. My guide, Mitchell Kasper, a market maker with Chicago-based Hull Trading, asked me where I thought the market was heading. That's a question plenty of individual investors are asking as the bull market charges on. Options exchanges see this as an opportunity to sell individuals portfolio insurance to protect their gains--or to bet on further gains if they're still in an upbeat mood. So the exchanges have rolled out contracts on popular market indexes. Last fall, the CBOE launched options on the Dow Jones industrial average. The Chicago Mercantile Exchange started the E-mini, which is based on the Standard & Poor's 500-stock index.

On that January morning, I felt bearish. I decided to buy 20 puts on the S&P 100-stock index--known as OEX--expiring in February with an exercise price of 450. My puts gave me the right to sell the index in February at a set level--450. The index was at 454 now, but I thought the market would fall more than four points, so my puts would gain in value. One put covers 100 times the index value, so my 20 puts were equivalent to $900,000 worth of stock. My cost, at $900 per contract, was $18,000.

If my order had been real, it would have gone directly to the pit. If you're placing an order with your stockbroker, the trade takes more time to run through the system. The broker sends the order electronically to the exchange, which then directs it to one of four areas, depending on its type and size.

At the CBOE, the Retail Automated Execution System (RAES) fills smaller transactions that fit specific definitions, such as index or equity option orders of 10 or fewer contracts that can be executed immediately. If you're willing to pay the market price, your order is filled right away. Other smaller orders are routed to booths surrounding the pits. Clerks wave hands to signal orders or carry them to the floor brokers who represent the brokerage firm and execute the trade.

Larger contracts are transmitted directly into floor brokers' computers and immediately executed. If you want to buy or sell an option below the market price, the request gets filed in what is known as the electronic book. Your trade will go through only when the market hits your specified level. The other major options marts--the American, Philadelphia, and Pacific stock exchanges--have similar systems.

The crowd is made up of securities-firm floor brokers, independent traders who deal for brokerage houses that have more volume than they can handle, and market makers who trade for their own accounts. The exchange requires market makers to provide liquidity by bidding to buy and offering to sell options when requested by floor brokers.

When an order hits the pit, the yelling begins. The floor broker indicates which option he wants to trade. Market makers answer with a price at which they will buy and sell. The floor broker trades with the one who offers the best price.

As the day wore on, the OEX had risen four points, to 458. By then, the value of my puts was $750 per contract, down $150 from the $900 I paid. Deciding to cut my losses, I sold--and lost $3,000. But patience would have been a virtue. The market dropped seven points--and I would have made $3,000. Thank goodness it was just an exercise. Only members who have purchased seats, at $700,000 apiece, are allowed to trade in the pits. But I learned a valuable lesson. A hunch on the market's direction isn't good enough to play in this game.

Before it's here, it's on the Bloomberg Terminal.