New World Coming The options marts lurch into the electronic age By KOPIN TAN THE NEW COMPUTERS ARRIVED this month, more than 120 multi-processing giant Unixes at 400 South LaSalle St. Not that the Chicago Board Options Exchange lacks computers; its existing mainframes already generate enough warmth to keep the seven-floor, 350,000-square-foot building heated in the Illinois winter. Consider the additional terabytes as the ammunition the CBOE needs to guard its future, as it moves next month to combine electronic trading with its trading floor. And the oldest U.S. options exchange isn't the only one at a turning point. The 30th anniversary of listed options trading in the U.S., on April 26, comes at a crucial time for many, with exchanges, brokerages and trading firms fighting to stay ahead of the vast changes wrought by technology, competition and a prolonged bear market. Take a good look around you at the annual Options Industry Conference this week in Orlando, Fla. Not everyone you see will make it to next year's shindig. "Over the next 10 years, the people left standing will be those who can best facilitate the frictionless transfer of risk capital," says Thomas Peterffy, chairman of Interactive Brokers and a backer of the proposed electronic Boston Options Exchange, or BOX. Brokers will have to lower commissions. Market makers who act as middlemen will have to post firmer quotes with tighter spreads between bid and ask prices, and have deep-enough pockets to handle the market's increasingly large orders. And, at the exchanges, the race is on to develop a flatter, more open market that also can handle complex trades, and which investors can access cheaply and quickly. The push to automate is just the start. The U.S. remains the world's only major market where much of the trading still occurs manually. Floor-based exchanges are now scrambling to add technology to lower costs and improve speed. And regulatory prodding to link the option markets electronically this year will further up the ante. "With linkage, traders will have to match the (market's) best price to win orders, and prices will become even more uniform and spreads tighter," says Michael Schwartz, Oppenheimer's chief option strategist. This raises a rather rude question: Will we still need five exchanges selling essentially the same product? And if not, which will be first to go? "You'll still need multiple destinations for different types of orders, but you don't really need five exchanges," says Christopher Nagy, a director of trading at Ameritrade Clearing. "With greater electronic access, the value of having a physical presence on the floor will diminish," says Larry Gage, a market maker and director at the Philadelphia Stock Exchange. "But a floor will survive, at least one, since there's always an advantage to being on the floor, especially when markets get crazy." Trading costs and speed of access will become even bigger competitive factors. "Options are leveraged instruments whose prices can move more than the underlying security's, so there's a big premium on time," says Kenneth Leibler, chairman of the Boston Stock Exchange. Specialists and market makers, too, are looking at a changed world. Profits from bid-ask spreads are threatened. Volume increasingly is dominated by large orders from or between institutional investors -- a development that owes much to the trading floor's success as a boot camp for options talent. At every hedge fund that trades options, it seems, there is a floor graduate who learned the tricks of the delta-neutral trade (that is, a hedged volatility bet insensitive to stock-price fluctuations). "Three or four years ago, you had a bigger pool of customers who were fundamental or directional buyers, and a small group of delta-neutral traders," says Simon Yates, Credit Suisse First Boston's head of equity derivatives trading. "Now you have many more volatility players, and they are harder to trade against." For the first three decades -- and many say those were the good old days -- the push was to build a market, to establish the product. The business was peopled by those who stood side by side on the trading floor, who took the risks and reaped the rewards. Now there are electronic exchanges, like the International Securities Exchange and BOX and Eurex, which want in on the action by 2004. There are market makers with centralized systems feeding quotes to tightly-staffed trading operations. There are boutique brokerages that focused on options when few did, and their customers now trade combinations like butterflies and condors when others are still learning to write covered calls. They crowd the fringes like newcomers at an old boys' club they hope to join and change. For them, these are the good old days. 4/19/03