Why You Need Options

Courtesy : Alexandra Zendrian

Excerpts from interview with Gary Katz

Gary Katz is head of the International Securities Exchange and is one of the best informed commentators on institutional and retail options trading.

Forbes:How should retail investors look at options trading?

Gary Katz: The options industry in the U.S. has been primarily a retail product and was from its inception until about the time I arrived and the International Securities Exchange was formed in 2000. And it's as a result of our moving into this space and bringing some of the efficiencies of our model into that marketplace that the product has become sufficiently liquid to attract institutional investors. It remains used about 50% of the time by retail investors, so we estimate that half of our volume is from the retail marketplace.

They are using it for a number of different strategies. One of them is to hedge potential risk. So if they believe that a security that they own might go down in value, they are able to buy put options to hedge to minimize that risk. Or they're able to enhance the returns on securities that they already own, and that's a strategy called a covered call, where they sell call options against some securities they own. Or they can simply use the product for speculation. And I think we have a healthy mix of all of those.

There have been musings about options being too sophisticated for retail investors. What do you say to that?

I'd say that they are a much more flexible instrument than simply owning or selling stock. And as a result, it requires education to learn all the different strategies that can be used with the product. Once you learn them, they are not that challenging. You certainly don't need a graduate degree to do so, but it does require taking the time upfront to learn the terminology and learn some of the rules of how this marketplace works. But once you do so, you're able to trade them the same way you do stocks or bonds and they're offered by all the broker-dealers that offer those other instruments and it's a mainstream product.

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How have options volumes been doing lately?

They're doing great. 2009 has been about the same level as 2008, which for any industry globally is something they would be proud to say these days. And if you look over the last 10 or 15 years, the industry's been growing at a compounded growth rate of about 20% to 25%. So it's a wonderful business and it's primarily a result of the product being understood by more individuals, support information that's available due to the Internet that brings to the users information that was only available in the past to very sophisticated traders and competition between the different exchanges that trade these products have really helped to lower the cost of trading, and it's helped the industry grow tremendously.

What are the two different types of options exchanges, and what impact do they have on retail investors?

I'm not sure that for the retail investor that the exchange really matters because the broker-dealer that they use, whether they're using a full-service firm like a UBS or a Morgan Stanley or a Goldman Sachs, or whether they're using a discount broker like Ameritrade, E*Trade or Schwab, that customer, once they provide an order to their broker, you're going to guarantee that they're going to get the best price no matter what exchange that order is routed to. So a lot of the back office work is being done for them so that once they make the decision, they're assured that they're either paying the least when they're buying or selling it for the most when they're trying to get out of a position.

So orders that go to a maker-taker exchange are treated the same way as if they went to a payment for order flow exchange?

Well it depends on who you use. Every broker-dealer has different policies. But I think it's safe to say that features like payment for order flow have helped to lower the commissions that customers pay at firms that do accept payment for order flow. And it has helped to provide firms with funding that is then translated into better technology, better Web sites and infrastructure that support the customers that are using the product.

The customer doesn't pay for order flow. So when you hear the term payment for order flow, that's liquidity providers that are saying to a brokerage firm. "If you send me your flow, I will pay you for that." So when a brokerage firm routes their order flow to a certain exchange or specific liquidity provider, that brokerage firm, at the end of the month, is going to receive a certain amount of money based on how many orders they sent to that environment. If someone at the end of the month receives, say, half a million dollars, as a result of payment for their flow, they're able to use that half million dollars in many different ways. They can use it to lower the commissions they charge to customers or they can use it to reinvest in their infrastructure to provide better support to the customer.

Do you think that the options market will continue to have these two types of exchanges in the future?

When maker-taker started in options, I remember the media saying to us, "Well, that's the end of the ISE's model. And maker-taker is going to take over just as in equities." And we always felt that that was not going to be the case. Initially, maker-taker exchanges represented about 21% of the average daily volume in the industry. That was at the very beginning when it was new and everybody was getting used to it. But now it represents about 16 to 17% of the average daily volume in the industry. So it's actually diminished a little bit.

There's a place in the industry for both, and I hope that they both remain because it works well together and it gives the customer choice as to where they send their flow and it keeps the markets competing with each other. But I don't think one is going to make the other go away. And I don't think one is going to dominate the other. But they will coexist.

Why do you think the maker-taker model is different in the equities market than in the options market?

Well there are a number of differences, and many of them are subtle. The one very basic difference between the two is the number of products in equities vs. the number in options. And I'm just going to throw out some numbers that are not exact numbers. But there are about 5,000 different stocks trading in the United States. Whether they're on the New York Stock Exchange or Nasdaq OMX Group or over-the-counter market, there are about 5,000 companies that are traded. In options, at the ISE, and we don't trade them all, there are 250,000 different products. Because for every one stock, we could have up to 200 to 300 calls and puts in all the different months in all the different strikes. And as a result, if you think about Yahoo!, as an example, there's only one price that it's trading at. Everybody sees a bid and ask for Yahoo!.

So all the supply and demand focuses at one single point of sale. That's how we describe it. Everything comes down to that one spot where it trades. But in Yahoo! options, there isn't a single point of sale because there are 300-plus series that are trading. So most of the time, the options market needs market makers, or liquidity providers, otherwise the screens would be empty. You don't have natural two-sided flow to make a market. And as a result, there's a relationship between the liquidity providers and the customers or the order flow takers that doesn't exist in the equities world but does exist in the options world. And so maker-taker works very well in equities; it hasn't worked as well in options.

How is the flash trading debate going, and do you get to keep your flash order?

They have asked us to explain to them what is different about the options market from the equities market and why flash should be allowed in one if it's not allowed in the other. And while we own 31.5% of Direct Edge, full disclosure, and we certainly care about what's going on in the equities market, and we don't think it should be banned from the equities market, our focus today is making the argument to the Securities and Exchange Commission through the public process to help them understand the differences between the two markets and why flash is valuable, why it's good for the customers and why their concerns of a two-tiered market doesn't exist for us because we don't have a small subset of members that hear the flash broadcast. We broadcast that out to all of our members. And why that eliminates any risk of front-running that seems to be a concern in the equities market. We think there are a number of differences between the two marketplaces and that's where we're going to focus on when we put out our comment letter.

How did flash trading start, and what's the purpose of it?

Speaking of it just on the options side, the simplest way to think about it is if a customer sends the ISE an order and we're not the best market, remember I said that no matter who you give your order to there's a guarantee that you will trade at the best market. So ISE would be forced to route that order to another market center that had a better price, which could be a maker-taker market. And if it is a maker-taker market, now that customer would have to pay the taker fee when they trade on that market. But if it stays at the ISE, we do not charge customers anything for the contracts that they trade here. Purely from a fee perspective, that customer would want their order traded at the ISE. By using flash, we're able to provide the same price as what's on the taker market but for free.

Additionally, there's a certain percentage of the time, and it is significant, that our market makers actually provide an even better price than what's available on the taker market by being given this chance to respond in the flash process. So there's price improvement even over the current market that that customer's expecting to get. So that's a second very important benefit for flash.

And third, and this is not talked about very much these days, is not the actual trade itself but post the trade. What's the customer service like? If the customer suddenly realizes that they made a mistake, I didn't mean to buy a call, I meant to buy a put, they can call up the exchange and they can say, "I made a mistake." At the ISE, we have a relationship with that customer and we're going to help to unwind that trade or to find a market maker who's willing to help that customer out. If that trade didn't occur here because we had to send it somewhere else, it's much harder to provide that level of customer service. To a firm and to a customer, those relationships are important and we work very hard to maintain those relationships. Those are the positives, and they're very simple and, from our perspective, the customer has a choice. We don't have force them to come here and use flash. They can send their order anywhere they want.

I don't think that there's anything wrong with flash. I fundamentally believe that the customer's getting the best of both worlds by exchanges being allowed to flash as long as it's being done properly. I believe it should be flashed to everybody. I don't think it should be a subset of members. And certainly that should be made available to everybody at a price that's not discriminatory. You shouldn't create a pricing mechanism where only the biggest firms can pay for it, and by doing it that way, you really are creating two tiers. But as long as you're flashing that order to everybody, and everybody can respond to it and give price improvement, that's a win-win for the customer.

And to be blunt, the exchanges that are saying this shouldn't be allowed are not saying it because they want to do the right thing for the customer. The maker-takers say that, "I want you to have to come to me. I don't want to you want you to come to the ISE, I want you to come to me." Why? Because they get a rebate when they trade against it, they're the maker. So they're not saying, "I give the customer something better," in fact they know fully that they're actually making the customer pay more.

But why do they want it so badly? They get the money that the customer pays. They're the maker. And unfortunately it's rare for an exchange or market maker to say it that way; they prefer to say, "This is not good for competition and if you don't make flash go away, I won't be able to complete my quoting and you won't get the best quote." But the fact is that flash has been here for the past three years. The maker-taker markets about 20% of the time are the better price, so they are competing, and they are providing a great quote and it's an ecosystem that's working extremely well. And this is just each entity pitching its own book, as we like to say.

How are the short-sale regulations going, and why is it important for options market makers to have an exemption from this rule?

It's still with the SEC. They recently put out another concept or how they might limit short-selling and they asked everyone to comment on that. In all of the different ideas that the SEC has laid out for limiting short selling, we have expressed how important it is that market makers be exempt from a ban on short selling. And the reason that's so important is market makers are the ones providing the two-sided market in options all the time.

Ninety-eight percent of the time in the quoted market, in the screens that you see in the options market, liquidity is from the market makers because there's so many different series. If a market maker is not able to hedge a trade, then they're not willing to make a two-sided market. That is, if a market maker takes a position where they would then have to sell stock so that they're hedged, they're selling the stock short; they don't own it. If they're not able to do that, then they're not going to be willing to make a tight market in that option.

And the reason that's so important is that, if you were an options customer and two months ago you bought an option, and you've been told that, you've gone to these classes and you've been trading in the options markets continually, that this is great, there's so much liquidity, I can buy something, I can sell it when I want, and then all of a sudden something happens that requires a ban on short selling. If market makers are not able to continue to provide quotes, what you bought two months ago, you're not going to be able to sell now. So that's, I think, a fundamental promise that's been broken to an options customer that has nothing to do with the concerns of selling short. You're just trying to get out of your options position. More importantly, when those market makers go away and bad traders know that they're not there anymore, they're going to put up prices that are very advantageous to them and they're going to hurt the customers that are trying to come out of the market. And that's exactly the opposite of what the SEC is trying to achieve.

So the market makers provide an invaluable service to the industry, they're there with sides, 98% of the time it's them, and all we're saying is if you want the options industry to continue to function flawlessly, you need to allow them to continue to make markets, and they can only do that with the hedge exemption.