The Volume Fixation
As is often the case at the start of a new year, the options world is abuzz with talk of volume numbers and market share. Every firm has released its own numbers in an attempt to shape the volume narrative of 2009. Media outlets around the globe have also trumpeted the many options volume records that fell by the wayside in 2009.

This fixation on volume is not entirely surprising. After all, given the dismal trading numbers from Q1 2009, it is amazing that last year's overall numbers even approached the record level from 2008. (If you listened to any episodes of Options Insider Radio last year, you know that the bulk of our guests were bearish on overall 2009 options volume.)

Quantity vs. Quality
Contract volume has grown exponentially over the past decade, but the question remains whether that growth has come at a price. With an established exchange looking to go public, and upstart exchanges looking to carve out their own niches in this crowded marketplace, there has never been a greater focus on contract volume and market share. But this volume fixation has caused many to overlook the growing chasm between overall contract volume and the actual quality of those contracts.

Determining the quality of an options contract is a difficult and ultimately subjective process. Any given contract can offer a myriad of economic utilities to different market participants. The same contract can represent a speculative tool to a customer, a commission to a brokerage firm, a transaction fee to an exchange and a layoff opportunity to a liquidity provider. Given these varying possibilities, it is natural to assume that higher contract volume leads to more economic utility for all participants. However, when you dig beneath the surface, that assumption begins to unravel.

The Perils Of The Liquidity Provider
One only has to spend a few minutes with liquidity providers to realize that the volume explosion has not been the economic bonanza many expected. Putting aside the deleterious effects of payment for order flow and penny pricing, today's volume simply does not offer as many opportunities as it once did.

There was a time when a liquidity provider's bid/ask spread was sacrosanct. Those days vanished nearly a decade ago. A significant portion of today's volume arrives at the trading floor in a neat package with counterparties already arranged. These "crossed" trades are often executed on the bid/ask spread that was established by the liquidity providers.

All that remains is for the exchange to put a stamp of approval on the transaction and collect its fee. Specialists and a few other market participants can sometimes carve off portions of these crossed trades. But that amounts to little more than table scraps when compared to the flood of trades that are crossed on a daily basis.

The simple truth is that a significant percentage of today's option volume is off-limits to a large number of market participants. (Unfortunately, there is little hard data to correlate this since no firms release their crossed trade percentages. But anecdotal evidence points to crossed volume being well north of fifty percent in many option products).

Poor Execution Quality Remains A Problem
Ever since the advent of penny pricing, "poor execution quality" has been the signature lament of the institutional options trader (this is one reason that so many institutional orders arrive at the exchange pre-packaged). With many option products displaying insignificant size on their penny-wide markets, institutional traders often have difficulty executing large transactions. When they do receive a fill, the resulting execution is often spread across a confusing array of price points.

Poor execution quality is usually dismissed as a problem that only affects the largest institutional players in the options market. Unfortunately, that simply is not the case. The Options Insider team spent a great deal of time in 2009 speaking to retail options traders around the country. The feedback that we received was alarming, to say the least. Poor execution quality was easily the most common complaint that we heard from the retail community. These were not professional traders masquerading as retail customers. These were everyday ten-lot and twenty-lot retail traders, yet the options market was not meeting their needs as customers.

It is taken as gospel within the options community that tighter spreads have only served to benefit retail customers. But the damage inflicted on the liquidity provider community may finally be spilling over into other market segments. Even with volume at record highs and bid/ask spreads at record lows, many retail customers still can't get their trades done.

Predatory Volume
Readers of The Options Insider have long been aware of the impact of dividend trades on the options market (see Can The Numbers Be Trusted: Part One and Can The Numbers Be Trusted: Part 2 for more information on these and other volume exploits).

In the world of exchanges, market share and volume are paramount. As a result, every options contract has some basic utility, if only as a means to keep score among the combatants. This has lead to certain market participants incentivizing volume exploits that, at best, have little economic value. At worst, these trades actually prey upon the ignorance of their customer base.

The dividend trade is the most common of these volume exploits. According to a recent analysis by the ISE, dividend trades accounted for a significant percentage of overall options volume in 2009. In fact, if these volume exploits are expunged from the tally, overall options volume actually decreased by 0.1% in 2009. Something is very wrong when volume exploits have become so pervasive that they can skew results for the entire options market.

What Are We Celebrating?
When you look past the volume records and the press releases, we are left with a marketplace that is still rife with problems. A large percentage of the current volume is  simply off-limits to most participants. The resulting markets in many option products are tight but thin, making it difficult for both retail and institutional traders to accomplish their trading goals. At the same time, the drive to generate volume at any cost has polluted the options market with a host of volume exploits.

There are obviously many people who still draw a great deal of economic utility from the options market. But "volume growth at any cost" has become a far too common refrain in the options world. It would be more productive to focus on improving the quality of the existing volume rather than dumping more dubious contracts into an already polluted pie. This would improve the overall experience of all market participants by delivering more economic utility across the board.

Some of these changes would be relatively simple to implement (e.g., an industry-wide push to stem the growth of volume exploits, etc.). Others would require more time and regulatory effort (e.g, removing underperforming classes from the penny pilot, establishing clearer rules on crossed volume, etc.). But the benefits to all market participants are clear, especially when compared to yet another year of unchecked, and perhaps even misleading, volume growth.

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