NEW YORK (Reuters) - U.S. options market operators have agreed in recent months on the need for new automatic trading halts when stock options prices suddenly surge or plunge, in a bid to reduce excess volatility and blunt the impact of erroneous trades, according to five sources with knowledge of their discussions.
The plan, which takes its cue from a rule known as “Limit Up/Limit Down” that U.S. stock markets put in place in response to the May 6, 2010 “Flash Crash,” is still in the early stages, with market operators trying to figure out how a similar rule could be applied to options trading, the sources said.
In the stock market, if the price of a stock moves outside of a range of prices it has recently traded in for more than 15 seconds, the stock is briefly halted to give traders a chance to figure out if the move was justified, or if it might have been in error.
There are currently 12 options markets in the United States, run by Nasdaq OMX Group (NDAQ.O), BATS Global Markets, Deutsche Boerse’s (DB1Gn.DE) ISE unit, TMX Group’s BOX Options Exchange, Miami International Holdings Inc, Intercontinental Exchange Inc’s (ICE.N) NYSE unit, and CBOE Holdings Inc CBOE.O.
“This initiative makes great sense for the industry to pursue and we’re happy to work with market participants and regulators to make it a reality,” said Jeromee Johnson, who runs BATS’ options market.
Boris Ilyevsky, managing director of ISE’s options exchanges, said that ISE supports the concept of a theoretical price band for options, noting that it would be an added risk protection mechanism for the market. He said the exchange is in discussion with regulators and other exchanges, adding that “much work remains to be done to create a structure that provides sufficient protection but also allows sufficient flexibility in volatile market conditions.”
The other market operators declined to comment.
The options market plan is likely years away from being implemented. But the move by market operators highlights growing concerns over the speed and complexity of options markets, which are dominated by computerized trading, after a series of operational snafus in the markets in recent years. These include a software error by Goldman Sachs Group Inc (GS.N) in August 2013 that flooded stock options markets with bad trades, sending some options prices down sharply.
Operational risks are not limited to the options markets and there are worries that because of the interconnectedness of the ultra-fast electronic markets, a problem in one market could quickly spiral out of control and affect other asset classes.
The idea of adding Limit Up/Limit Down to the options market has merit, said Michael Schwartz, chief options strategist at Oppenheimer & Co Inc.
“It would let them be able to stop and say, ‘Did you mean to do that?’” he said. “It gives them a chance to make certain these are not erroneous and could affect other options that are trading.”
The Financial Industry Regulatory Authority declined to comment.
Market structure changes can take time to implement, as different operators must come to agreement, figure out the technical details and have regulators sign off on the plans. The Limit Up/Limit Down rule in stock markets, for example, was proposed by the U.S. Securities and Exchange Commission in April 2011. It was approved in June 2012, but not fully implemented at the exchanges until May 2014.
The task is much more complicated in options markets, which means the equities rule cannot be simply pasted into the options rule book, the sources said.
The issues include the question of whether to base the price band on the option itself, or on the underlying stock. Further, there are around 5,000 companies publicly listed on U.S. stock exchanges to which the price bands apply. But there are more than half a million options series based on those stocks, and many of them rarely trade.
Cognizant of these difficulties, options market operators have decided to take a two-step approach to bringing order to their markets, which currently operate under a disparate set of rules.
Sources previously told Reuters that the first part of the plan, which creates a uniform set of rules on how to deal with erroneous trades, is soon to be filed with regulators.
Options market operators would like to apply the price bands to options as the second phase of the plan, the sources said.
Reporting by John McCrank; Editing by Paritosh Bansal and Martin Howell