Options trading like 'crack cocaine for brokerages,' say critics

Discount brokers look to boost revenues from high-commission trading; this worries some critics

Nov 30, 2011 @ 7:29 am

Glyn O'Connell is the kind of customer online brokerage firms like TD Ameritrade Holding Corp. (AMTD) and Charles Schwab Corp. (SCHW) want.

“I've spent more than $10,000 in commissions in past years,” said O'Connell, a TD Ameritrade customer who lives in Brisbane, Australia, and transitioned from stocks to options and futures. “You can easily recover that, but it adds up.”

Brokerages such as TD Ameritrade, Schwab, Fidelity Investments, E*Trade Financial Corp. and Scottrade Inc. are focusing on expanding their trading businesses beyond equities as stock-trading revenue has declined and the volume of options contracts has hit record highs, said Javier Paz, a senior analyst at Aite Group, a research firm. They see options as a way to diversify revenue sources and as a “launch pad” for investors to adopt futures and currency trading, he said.

“Options (SPX) are kind of like the crack cocaine for brokerage firms,” said Andrew Stoltmann, a securities attorney in Chicago. “They're easy money, huge commissions and they tend to be extremely addictive for those who actually trade them.”

Those commissions mean there's an economic incentive for brokers to entice clients to add options to their portfolios even though they can be risky and complicated, Stoltmann said. He said he's received about 15 calls in the past six months from investors related to options trading compared with zero in the past five years before then.

Options Trading Rises

Trading volume for options has risen every year since 2002, and through October it's up 22 percent, according to the Chicago-based OCC, which clears and settles all options trades. Equity-trading volume on average has declined 14 percent on the New York Stock Exchange and 9.1 percent on the Nasdaq (NDX) this year through October compared with the same period a year earlier, data compiled by the Securities Industry and Financial Markets Association show.

Options users averaged 31 trades a year compared with 24 for non-options users, according to a 2010 survey prepared for the Options Industry Council, an industry education group.

Options give the right, without the obligation, to buy or sell a security, a commodity or an index's cash value at a set price by a specific date. Investors use them to generate income, improve returns, hedge against declines or speculate on market performance. The hedging capability gives investors “sleep insurance” with proper education about them, said Alan Grigoletto, director of education for the Chicago-based Options Industry Council.

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Investors may lose money faster trading derivatives such as options and futures if they don't know what they're doing because those assets have higher leverage, Paz said.

It's also vital that the technology that brokerages provide for options investors, such as downloadable software, works seamlessly because traders rely on accurate pricing and fast execution of trades to take advantage of quick market swings, said Alex Camargo, an analyst on the securities and investment team at Boston-based financial-research and consulting firm Celent.

Options are profitable for brokers because they have high commissions and as investors become more educated on options, they use more complicated strategies requiring multiple contracts, according to an August study by Celent.

TD Ameritrade, for example, charges $9.99 for each online options order plus 75 cents per contract, according to its website. There's also an options exercise commission of $19.99 for some clients, according to Kim Hillyer, a spokeswoman. The firm charges $9.99 for each online stock trade.

Volatility Is Good

Investor confidence is fragile because of the financial crisis in 2008 and continued market volatility, which has increased competition to attract and retain the active trader rather than those who buy and hold stocks, the Celent study said.

Volatility is good for active traders, who may have more of an opportunity to make money and invest than when markets are sideways, said Steve Sanders, senior vice president of business development for Group Inc. (IBKR) The Greenwich, Connecticut-based online brokerage has about 186,000 users, Sanders said.

The Chicago Board Options Exchange Volatility Index, or VIX, increased 7.7 percent to 34.47 last week. That's above the 20.55 average over the 21-year (VIX) history of the gauge derived from Standard & Poor's 500 Index options.

‘Split Second Timing'

O'Connell, the Australian investor, said he started trading stocks about two decades ago, moved to options around 2005 and switched to futures a couple of years ago so he could execute orders in pre- and post-market hours.

“Any day trader is working on grabbing small movements on a regular frequency,” said O'Connell, 50, who hasn't traded as often this year because of an illness. “It's all about that split second timing in execution.”

Getting existing brokerage clients to trade more frequently is the focus for firms, said Paz of Boston-based Aite Group. About 21 million U.S. households held stocks outside of their retirement accounts in 2009 and about 1.9 million were active traders, according to Aite Group estimates.

Firms such as Schwab, the largest independent U.S. brokerage by client assets, and TD Ameritrade, the third largest online brokerage, have opted to increase their active trading businesses by acquiring competitors.

Acquiring Competitors

“By acquiring those platforms the companies get a built-in base of higher-net-worth investors that trade more frequently as well as more powerful functionality such as analytics and complex-order support,” said Andy Nybo, head of derivatives at research firm Tabb Group.

TD Ameritrade bought options broker Thinkorswim for about $749 million in 2009, according to Bloomberg data. The Omaha, Nebraska-based firm acquired 87,000 retail client accounts through the purchase, said spokeswoman Hillyer.

Schwab paid about $710 million for OptionsXpress Holdings Inc. (OXPS), which had 397,400 client accounts as of June 30, according to Alison Wertheim, a spokeswoman for the San Francisco-based firm. That deal, which closed Sept. 1, will allow Schwab to offer futures and foreign exchange trading, and to expand its options capabilities, said Brian McDonald, senior vice president of the firm's active trader and core client experience groups.

“Most of our active traders start with equities, then move into options and then some of the other derivatives such as futures and forex,” McDonald said.

‘Bigger Appetite'

Options traders at Schwab have three times the amount of assets held at the company, six times the trading activity and 25 percent longer tenure compared with its average retail client, according to the Celent study.

“Our interest in options is a direct result of client interest,” said Wertheim. “We've seen a much bigger appetite among affluent investors who are looking at options trading as a means of generating income, and also from clients who trade actively and are looking for more sophisticated options.”

Since investors who buy and sell options generally trade more frequently and are more sophisticated, they're very price and service sensitive, said Camargo of Celent.

Harvey E. Cohen, 43, of Miami Beach, Florida, traded as much as $60 million in options contracts during his five years as a TD Ameritrade customer, he said. Cohen, who formerly worked as an analyst for Salomon Brothers and NatWest Securities, said he repeatedly experienced problems including pricing and order delays and an inability to access his account following TD Ameritrade's integration of Thinkorswim.

‘Initial Hiccups'

“They always blamed someone else for the pricing and execution problems,” said Cohen. After complaining to executives including Steve Quirk, who oversees the firm's offerings for active traders, TD Ameritrade closed Cohen's accounts and those of his family members, he said. That forced Cohen to move his money to E*Trade.

TD Ameritrade's Chief Executive Officer Fred Tomczyk, 55, declined to comment on individual clients. Tomczyk said the company had some “initial hiccups” when integrating the Thinkorswim platform causing some clients to have trouble accessing their accounts. “That's not unusual for an integration, particularly one of that size,” he said in a telephone interview last month. “Today all of those issues are behind us.”

Record Trades

The acquisition of Thinkorswim has been a success, said Tomczyk. In fiscal year 2011, TD Ameritrade saw record net new assets of $41 billion and record average daily client trades of 399,000. Derivatives trading has increased to 32 percent of daily trades from 14 percent for fiscal 2009, Tomczyk said.

Fidelity, E*Trade and Scottrade are improving their existing capabilities and promoting investor education about options.

Fidelity expanded its options tools this summer by providing streaming prices for the web-based version of its active trader platform, said Gregg Murphy, senior vice president of brokerage products. The Boston-based mutual-fund company, which is the second largest online broker, has seen about a 21 percent compound annual growth rate in average daily options trades as of September this year compared with five years earlier, Murphy said.

Options Education

The focus at E*Trade is to promote options trading education among its existing customer base and prospective clients, said Christopher Larkin, senior vice president for retail trading and client service at the New York-based company, which acquired options firms in 2004 and 2006. This year E*Trade has hosted 78 live and web-based options-focused events reaching almost 10,289 participants, and introduced new tools for options traders at the end of October.

Scottrade, which started offering a separate platform called OptionsFirst through third-party technology four years ago, is holding national user summits, local branch office seminars and hiring more people for options education, according to Brian Bachelier, assistant director of active trading services for the St. Louis-based broker. Since 2010, executed options contracts at Scottrade have increased by almost 19 percent.

‘Wiped Out'

Bank of America Corp.'s (BAC) online wealth-management service, Merrill Edge, also offers options trading. Starting next month, options pricing will drop to $6.95 a trade plus 75 cents per contract as the standard pricing from $8.95 a trade and 75 cents per contract, said Selena Morris, a spokeswoman for the Charlotte, North Carolina-based bank.

“Options are at the forefront of brokers and brokerage firms' collective minds,” said Stoltmann, the securities attorney. “But I don't think most investors appreciate the true risks of these things. It's like rocket fuel on a fire and people can be wiped out very, very quickly.”

--Bloomberg News--


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