Peeling Back the Onion - How Exploits Can Manipulate Options Volume Numbers

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CAN THE NUMBERS BE TRUSTED?
Everywhere you look, there are signs that the options business is booming. Revenues are up across the board. Each week, a press release announces that another long-standing volume record has been shattered. However, when you dig beneath the swarms of press releases and celebratory annual reports, you quickly realize that something strange is afoot. This bonanza might not be all it’s cracked up to be.

It is hardly breaking news to say that the options industry is rife with volume exploits. The debate over how to count trades like boxes, crosses and other types of specialized strategies has raged for decades. What is news, though, is the massive scale that these exploits can reach when no one is looking.

DIVIDEND PLAYS
By far the most popular of these exploits is the dividend play. These trades usually occur on a relatively small scale. However, as recently as last year, deep fee cuts elevated dividend trades to alevel of prominence that was previously unimaginable.In a business where every single contract is fought for tooth and nail, this was a very serious thing.

HOW THEY WORK
As their name implies, dividend plays can only occur around a stock’s ex-dividend date. In order to execute such a play, a trader must first establish a long position to capture the dividend. The trader then creates an offsetting short position by writing an equivalent number of in-the-money calls against his long position. This short position allows him to capture the decline in the stock that occurs as a result of the dividend.

Dividend plays are a very simple strategy that put little or no capital at risk, provide no liquidity to the underlying market and have a lifespan of only a few hours. Unfortunately, there is a catch with this strategy. It is dependent on the negligence or ignorance of the counter party in order to work. For this trade to turn a profit, the owner of the short calls has to forget to exercise his options. If he doesn’t, then the trader will be assigned on his short calls, thereby negating the profit potential of the trade.

HIDDEN IN THE SHADOWS
The primary reason for the scarcity of these trades is transaction costs. Dividend plays involve trading spreads with multiple legs. As a result, executing and unwinding these positions can be prohibitively expensive. Another reason is that the success rate on these trades is very low. A trader can only expect a small percentage of his short calls to escape unassigned.  Often, that small percentage is not enough to cover the transaction costs of the entire trade.

There is also a third reason why these trades used to happen infrequently. Dividend plays have a very negative connotation in the options world.  Many industry participants view them as an exploitive strategy that provides no liquidity or economic benefit to the marketplace.

THE FIRST WAVE
The initial wave of the dividend play explosion came in the first quarter of 2006. A quick look at the numbers from just one day reveals the impact these exploits can have on the markets as a whole.

Procter & Gamble went ex-dividend on January 18. P&G is not a high volume option, averaging only about 12,000 contracts a day. However, that changed on January 17, when its volume exploded in a flurry of dividend plays. While that was surprising, what was even more surprising was where this volume took place. The Philadelphia Stock Exchange (PHLX) and Pacific Exchange (PCX) are not usually market leaders.  However, on a day when the Chicago Board Options Exchange (CBOE) and ISE combined for a paltry 9,000 P&G contracts, the PHLX traded almost 300,000 and the PCX traded nearly 1 million contracts. The day before, these two exchanges had combined for only 2300 P&G options. Clearly, something strange was afoot.

WHERE IT ALL BEGAN
Although the genesis of this new wave of dividend trades is unknown, most fingers point squarely at the PCX. Over the past few years, the PCX has steadily slashed their fees in an effort, many believe, to specifically lure dividend plays and other types of volume exploits. “There’s no question that the PCX specifically lowered their fees to attract this type of trading,” says PHLX CEO Sandy Frucher. “After they lowered their fees, it immediately began to distort the market share numbers. As a result, we were forced to lower our fees just to protect our market share. Even though, on the chart, we’ve been a beneficiary of these trades, the truth of the matter is that our market share has been deflated as a consequence of this. I think these trades are out of control.”

Other exchanges are not the only ones concerned about the validity of these trades. The SEC began investigating the legality of dividend plays in September 2004. But, despite the concerns of their regulator and the growing ire of their competitors, the PCX continues to pursue these trades. “These trades are still within the rules, so we don’t see them as exploiting the retail investor,” says Margaret Nagle, spokeswoman for PCX owner Archipelago. “As for the validity of these trades, we don’t comment on any particular trading strategy that our clients are employing.”

THE RESPONSE
Unfortunately, dividend plays are only the tip of this dangerous iceberg. A slew of old trading exploits and volume distortions have been resurrected by these fee cuts. Interest rate plays, another popular trading exploit, have already reemerged into the marketplace with a vengeance. Although the validity of each of these trading strategies remains questionable, the large volume they attract has forced some exchanges to rethink their game plans. “We saw the huge market impact from these trades and came to the conclusion that we want every contract trading on the CBOE, period,” says Ed Tilly, Vice Chairman of the CBOE. “We’re neutral on our beliefs about these trades and whether or not they provide any benefit to the investing community. We try to stay out of that fray. If someone wants to do these trades, they can put them up on the CBOE.”

Given the growing prominence of these strategies, it raises many questions about the explosive volume numbers that are coming out of the options industry these days. At the end of the day, can these volume numbers be trusted? Does the explosive growth of the past few years reflect an actual increase in customer volume or merely the expansion of volume exploits like crosses, interest plays and dividend plays?

What, if anything, can be done to slow the growth of these exploits “The real issue is whether these trades are legal or illegal,” says Frucher. “Frankly, there are quite a few trades out there that add absolutely no liquidity or value to the marketplace, yet they occur every day. These are trades that deliberately distort volume and market share. Anyone who is involved with an exchange and says that these types of trades don’t exist is a hypocrite. Unfortunately, until we are told otherwise by the SEC, these strategies remain legal and we don’t have a right to stop people from engaging in them.”

THE FUTURE
Although regulators have yet to take any action, there have already been a few steps in the right direction. In what will hopefully become an industry-wide practice, the PHLX recently began releasing volume reports that don’t include dividend plays. Unfortunately, the PHLX’s example has not yet spurred the center of dividend play activity to follow suit. “I’m not sure what the impetus is for other exchanges to pursue this,” says Nagle. “However, We have no plans to do what the PHLX is doing. We provide only one consolidated volume number that includes all of our trades.”
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