Wednesday, August 02, 2006

Barron's covers the CBOE's move to get into cash equity trading

Kopin Tan, who covers the options space in his weekly "The Striking Price" column for Barron's had a nice piece on the potential for the CBOE to effectively get into the cash equities trading business. Tan's points make sense, especially the fact that options exchanges are highly active customers for cash equity exchanges (think NASDAQ and NYSE) because derivative players often hedge their risk or close out positions by buying or selling the underlying stock.

See the article pasted below or follow the link here.

CBOE Seeks Its Share

By KOPIN TAN

IN RECENT YEARS, SOME OF THE FIERCEST SPECULATION at the Chicago Board Options Exchange involved not the direction of stocks, but the fate of its trading floor. Since the nation's oldest option market began pushing into electronic trading, the human throng on its floor had thinned, and traders rued the day when their 45,000 square feet might get converted into a gym, or cineplex, or bowling alley.

As it turns out, the CBOE has other designs for that space. Come January, 400 South LaSalle St. will house not just the largest U.S. option exchange, but a brand new stock market, as well. If all goes to plan, some 2,500 stocks will one day trade on the CBOE's existing "hybrid" platform, where orders can be filled electronically or through "open outcry" auctions conducted by human stock traders who will populate its floor.

At first blush, the move seems like any other in the increasing convergence of once-separate stock and derivatives markets; the International Securities Exchange (ticker: ISE) also is planning to add stocks to its electronic option menu, while the venerable New York Stock Exchange has pushed into options. Shares of NYSE Group (NYX) barely registered the new threat, and rose 4.3% after the CBOE announcement (albeit on a day when the NYSE reported strong second-quarter profits).

But while option exchanges will join a crowded field, these secondary markets can make serious inroads on the primary markets' turf. Taken as a whole, option market makers are by far the single largest customer at U.S. stock exchanges -- since these professionals must buy and sell vats of stocks to hedge their own constantly shifting risks. The ability to trade stocks in their own markets could siphon business from established stock venues.

Also, many brokerages already route their customers' option orders to large option exchanges and may not need much prodding to steer stock orders there, as well. The CBOE says its stock specialists will not act as agents for customer orders, which may appease money managers worried about the potential conflicts of interest when traditional specialists handle both their own and customer accounts.

And while the NYSE's own hybrid stock-trading platform remains an untested entity, the CBOE's hybrid platform has operated for years, and -- along with the exchange's payments to attract order flow -- have helped lift its market share to 37% from 32% over the past year.

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Like the ISE, whose stock exchange is backed by a bevy of big Wall Street firms, 45% of the CBOE stock exchange will be owned by big trading firms. These include units of Van der Moolen Holdings (VDM), LaBranche (LAB) and the privately held Interactive Brokers and Susquehanna International Group.

For many brokerage and trading firms, such investments are a "defensive hedge" against a not-too-distant future when stock trading may no longer be dominated by the duopoly of the NYSE and Nasdaq Stock Market (NDAQ), says Raymond James analyst Michael Vinciquerra.

CBOE officials, understandably, framed their move as an offensive strike. CEO William Brodsky talked about how "Regulation NMS" -- a cadre of proposed rules that essentially require orders to be filled at the best possible price -- "creates opportunities for competing stock exchanges."

But the CBOE also is defending its option turf. Exchanges like the NYSE and ISE are soon expected to link stock and option fees, essentially offering customers a discount or incentives for sending them both sets of orders. The Philadelphia Stock Exchange, for one, says it plans to link both stock and option fees perhaps as soon as September. As ambitious rivals colonize new territories, the reigning option-market king must expand his reach or risk being usurped.

Meanwhile, the CBOE should begin trading stocks well before it can get itself listed as one, even as it continued to take small steps toward the latter goal. Last week its board gave the nod to file with regulators plans to "demutualize," or turn the member-owned market into a for-profit company.

While this paves the way for the exchange to eventually sell shares to the public, its path isn't without hurdles. Because the CBOE was born when the Chicago Board of Trade (BOT) coughed up a smoking lounge for trading options, full CBOT seats today still carry the right to trade at the option market. That ownership overhang makes valuing CBOE shares tricky. Recent plans to buy back these external rights have met with little success since CBOT traders, many of them familiar with agricultural cycles, can recognize a cash cow not yet ripe for milking and are holding onto their residual rights.

As such, the registration documents the CBOE plans to file may not include a specific proposal for resolving the seat-rights issue. And regulators likely will have enough to pore over, at least for now, for this crucial detail to be submitted at a later date. But until it finds a way to persuade its historical parent to let go, the CBOE is a long way from independence.

As part of its for-profit metamorphosis, the CBOE last week also offered a glimpse of its books. In the first six months this year, revenue increased 32% to $129.6 million. Income before taxes was $32 million, up from $8.7 million in the same spell last year.

How profitable the CBOE will become as a stock-and-option market remains to be seen. But the success of cross-town derivatives peers like the Chicago Mercantile Exchange (CME) and CBOT as publicly traded stocks have egged on some fairly fierce speculation. The most recent CBOE seat to change hands went for $1.35 million -- up from about $700,000 a year ago and $299,000 in January 2005. It was the 33rd seat to fetch more than $1 million since that milestone was first passed in February.

IF THERE IS AN obvious and crowded trade in the option market, it is the purchase of calls or puts just before a company reports earnings in the hope of a big stock move. In contrast, fewer investors stick around once that hubbub dies down, even though post-earnings stock moves may prove no less substantial.

Just look at Dell Computer (DELL). Shares fell toward a five-year low below 19 after the computer maker blamed aggressive pricing and slashed profit forecasts on July 21. Since then, however, the computer maker has quietly climbed 13% to about 21.50, as bargain hunters bought shares and after Citigroup analyst Richard Gardner upgraded the stock, citing approaching catalysts like Dell's use of Advanced Micro Devices (AMD) chips in desktops, its investment to improve customer service and the potential boost to 2007 sales once the Vista PC operating system is launched.

Following Gardner's opinion, Citigroup's option strategists looked for a way to bet on an increase in stock price and a decrease in option premiums -- since Dell option prices had run up and were expensive. Among other things, they suggested selling short-term, 20-strike puts, which commits an investor to buy shares if Dell falls below that target. As an alternative, bulls might also buy a call spread in a 1-by-2 ratio -- for example, buying one January 20 call while selling two January 22.50 calls.

Both trades worked well last week as Dell shares climbed and volatility subsided. But investors looking to get in now -- the stock could still have further upside, and Citi has a 24 target on shares -- might want to make some adjustments. For example, August 20 puts were trading at a miserly 20 cents, and those looking for plumper premiums might look toward longer-term puts. Meanwhile, buyers of the ratio call spread might consider higher strike prices -- for example, buying one January 22.50 call and selling two January 25 calls. For this trade, profits are maximized as Dell approaches 25, although losses mount should shares surge above 25.

In fact, buying ratio spreads may prove appealing in the current market for other stocks, as Goldman Sachs option strategists Maria Grant and John Marshall pointed out recently. Option premiums on many stocks are high owing to this choppy earnings season, and buying calls or puts may be expensive. In comparison, buying call or put spreads in a ratio cost less while effectively positioning for a limited stock move.

Buying one option and selling two further out-of-the-money ones also creates a position that is net short volatility, which may prove wise as the earnings season winds down and if, after the Aug. 8 meeting of Federal Reserve policy makers, market volatility starts to ebb.

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