Why NYSE Arca is Proposing to Expand the Penny Pilot for Options

From Todd Wilemon: Ten years ago, options were priced in fractions of dollars. The narrowest spread was a “teeny.” A “teeny” was shorthand for 1/16 of a dollar or $.0625 -- 6 ¼ cents. Next came decimalization and with it, 5-cent spreads.

In January 2007, all option exchanges started a "penny pilot program." The intent was to see whether quoting in pennies would help the retail investor. By quoting in pennies, spreads would be tighter, and this would significantly lower investors' costs. With the advent of the penny pilot the bid/ask spread has narrowed to a penny for certain option classes!

The pilot started out in twelve names. Any option at a premium of under $3 could be quoted in pennies. Those trading $3 or over would still be quoted in nickels. The exception to the rule was the extremely liquid QQQQs, where all series are quoted in pennies regardless of premiums.

With a couple expansions of the pilot, 63 names are in the pilot. These are the most active issues trading on the option exchanges, and they account for more than 50 percent of daily trading volume.

An important reminder: while only 63 names are being quoted in pennies, all option classes in all names can trade in pennies if the order is exposed to a price-improvement auction, or if an exchange chooses to trade with hidden liquidity commonly referred to by the sinister name, “dark pennies,” which the SEC approved in 2008. However, when options are not quoted and published in pennies, it inhibits the liquidity providers’ ability to get their best market published, and does not guarantee a level playing field for all participants.

NYSE Arca has filed a proposal with the SEC to expand the penny program to the top 300 most-actively traded names. This would cover about 75 percent of the daily option trading volume. We have also proposed extending the pilot through 2010. We feel this is the right way forward, giving participants the true bid/ask spread while providing the marketplace with complete transparency.

Transparency of quoted markets is a foundation principle of a fair and orderly market. The best advertising for traders is their displayed markets. Without the penny pilot, a market could be 1.20 at 1.25, yet all the trades are printing 1.21 and 1.24. So the real market was $1.21 at $1.24. The penny pilot supports price discovery. It allows traders and market makers to post their true markets.

A common complaint about the penny pilot is that it narrows spreads and decreases liquidity. To use the lingo, “size at the inside” has been reduced. “Markets that are quoted in pennies do not allow enough size to be posted and participants want to see size.” But is this really true? In other words, the spread tightens by a penny or two and all liquidity has dried up. While it is true that top of the book size does shrink when spreads are tighter (not much logic needed to figure that out), the average price of a trade will be better for the customer even if a couple levels of liquidity have to be hit to fill the order. An excellent tool to help our clients understand where the liquidity they need is resting on the book is through our proprietary ArcaBook feed.

At NYSE, we offer ArcaBook for FREE -- that’s right, FREE. ArcaBook is a real-time data feed that disseminates order-book information for both Arca and Amex Options. It allows you to gain information about the true depth and size of the market.

Another complaint is that too much data will overwhelm OPRA -- the Options Price Reporting Authority -- which disseminates all options quotes. The pilot program has been going on for 2½ years. All exchanges use data-mitigation standards so as not to overwhelm OPRA. Data mitigation is just a fancy term for restricting outbound quotes to active or quoted series.

Unlike data mitigation as implemented by other exchanges, NYSE Arca and NYSE Amex do not delay, hold back or “pulse” quote information to OPRA. Everything we send to OPRA goes out in real time. Data mitigation “NYSE style” ensures that all active series are disseminated while inactive series are not. A series is classified as active if a trade has occurred on any exchange, if there are orders in the book, if the issue trades exclusively on NYSE Amex or NYSE Arca, if it is a newly created series, or if a participant has requested that the series be "lit up." The series will stay active for 14 days after one of these events happen. Series can go from inactive (not disseminated) to active (disseminated) overnight or even intraday. Even if a series is not active, market makers are still required to quote and make markets for the series, so there is always a valid quote available; the data is just not sent to OPRA or ArcaBook. Data mitigation, as implemented on NYSE Arca and NYSE Amex, has been extremely effective, proving that quote traffic should not be a concern when considering expansion of the pilot.

It's important to note that we are not promoting expansion of the penny pilot program to illiquid names. We are targeting only the top 300 names that account for around 75 percent of the daily traded volume. We are asking to keep the same breakpoint of $3.00 for the 300 names, which simply means that all options with a premium of under $3 can be quoted in pennies, which is consistent with the current industry-standard inflection point.

Let’s revisit our previous example, where the disseminated market is 1.20 at 1.25. Two market makers are quoting the series. Market Maker A’s true market is 1.21 at 1.26; 500 up. Market Maker B’s is 1.19 at 1.24; 500 up. When we allow for quoting in pennies, we will disseminate the true market of 1.21 at 1.24; 500 up. No guessing.

Transparency, a level playing field (no favorites here) and price discovery make the NYSE the place to trade options!

Trade ‘em up!