Options Trading Grows Up

Electronic systems are making the market more efficient -- and alluring to investors

In the orchestra of financial instruments, options have long played second fiddle. Institutions have used options for years to hedge their investments, but beginning investors have struggled to grasp the arcana of options contracts. And until recently, only a handful of firms have made markets in options.

Now, options trading is suddenly catching fire. In April the number of contracts traded in the U.S. hit all-time daily and monthly highs of 11 million and 124 million, according to the Options Clearing Corp. Those high-water marks come on the heels of a record year in 2004, when 1.2 billion contracts changed hands, up 30% from 2003. Some 91.5% of those contracts -- which give the right but not the obligation to buy or sell stocks and other items at predetermined prices in return for a premium -- were for equity options based on stocks or stock indexes.

Indeed, stock-based options trading climbed faster than any other category. That's a surprise. Stock prices have churned for months, pulling volatility down to low levels. Normally options trading benefits from high volatility, which increases both the premiums buyers will pay for options and the potential profit on trades. But despite low premiums and volatility, investors are happily writing call options on stocks they own, so-called covered calls, to increase their returns with little risk that their stock will either be called away or fall sharply in price.

Also behind the surge is the rise of electronic systems that have made trading far easier. This has encouraged institutions to hedge against rising interest rates, falling oil prices, or an appreciating dollar. Institutions now account for 50% of options trading today, vs. 30% before 2000, says Michael Walinskas, executive director of the Options Industry Council trade group. The new technology has allowed many hedge funds to become market makers and drive large volumes of trades. Citadel Execution Services, the broker-dealer affiliate of Chicago hedge fund Citadel Investment Group, is the International Securities Exchange Inc.'s (ISE ) biggest market maker, accounting for about 10% of the exchange's revenue.

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E*Trade Financial Corp. (ET ) founder Bill Porter primed the trading boom when he launched the first all-electronic options market, the New York-based ISE in 2000. In just four years, it vaulted to No. 1 in equity options volume. That pressured older markets such as the Chicago Board Options Exchange to add electronic trading to their floor trading.

As a result, options markets have grown more liquid. Because electronic systems match buyers and sellers quickly and precisely, spreads, or the gaps between offering prices and asking prices, have narrowed, making trading more attractive. At the CBOE, which is still No. 1 in total trading volume, average spreads have halved since electronic trading began in 2003.

Electronic trading also has made it easier for institutions to make markets in options. Market makers provide liquidity by holding inventories of certain options for trading. Traditionally, they had to maintain large staffs on trading floors -- an expensive proposition. On electronic exchanges, that's not necessary. "You can make markets in 800 options with two people," says Joe Sellitto, director of derivative products at E*Trade. Morgan Stanley (MWD ), which didn't make a market in options before 2000, has become one of the largest market makers on the ISE.

Retail investors, too, are contributing to the rise in trading volume. At optionsXpress Holdings Inc., an online brokerage dedicated to options investing, daily average revenue trades in the first quarter were 20% higher than the same period in 2004. Although experienced investors use options primarily to hedge bets on stocks, their strategies are growing more sophisticated as they use online tools to learn how to trade. At this rate, options won't play second fiddle forever.

By Justin Hibbard in San Mateo, Calif., with Adrienne Carter in Chicago

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