The name of the game for brokerages is DARTs, or Daily Average Revenue Trades. The object is to increase DARTs month by month, no matter what happens to the market overall. Online brokers strive to keep their numbers up by expanding their core offerings—the ability to trade stocks, options, mutual funds and bonds—with additional research and services.
Consumers are most familiar with the same products that were traded under the Buttonwood tree on Wall Street at the end of the 18th century—stocks and bonds. Options trading dates back to at least the 17th century and the Dutch tulip markets, but options did not become a mainstream product until the mid-1970s.
Technology made alternative investment vehicles accessible to the retail consumer in the waning years of the 20th century. The evolution of the derivatives and commodities markets, and the exchanges devoted to the trading of these products, all came together to make new types of equities available via online brokers.
Today, the types of equities and derivatives are diverse and plenty, and retail consumers can easily access many of these products online, lowering the barriers to entry for investors. Newly defined equities have been introduced to keep DARTs growing, but they dont seem to be popular—yet—with the trading public.
SSFs (single stock futures) were rolled out to the marketplace in the fourth quarter of 2002. An SSF is a contract to deliver the underlying asset, in this case the underlying equity, on the delivery date specified by the contract. Each contract is worth 100 shares of the underlying stock. A $1 change in price of the underlying stock equates to $100 for the futures contract.
Unlike options, which have an asymmetrical payout algorithm, the payout in futures is symmetric. The buyer of an option can lose, at most, the amount of the premium paid, but the upside is much larger.
The seller of an option can make, at most, the amount of a premium, but can lose much more depending on the change in the underlying stock price. With a futures contract, you can lose as much as you can gain.
The fact that no security is actually purchased at the time of the transaction results in some of the technical challenges of SSFs pertaining to cost basis, buying power, margin and other aspects of the product.
In effect, the holder of the contract has only a profit or a loss. Although it had been proposed decades earlier, the SSF had been banned by the regulatory bodies for more than 20 years since it was a combination of a future and a security, making it difficult to regulate.
Another new equity is the FRO (Fixed Return Option). FROs have existed in the OTC (over-the-counter) market for some time, where they are known as binary or “all-or-nothing” options. As the name suggests, a binary option either pays or it doesnt, and the payout is fixed or discontinuous.
As an OTC product without any exchange backing, the binary option has been employed only by institutional customers. With FROs, however, the Amex seeks to bring the product into the mainstream with exchange listing and liquidity providers. Like the “put” and “call” of its cousin, the traditional option, there are two primary components of the FRO, “finish high” and “finish low.”
A contract returns $100 if the underlying security finishes high, closing above the strike price at expiration, or if it finishes low, closing below the strike price. A closing price “at the money,” that is, at the established strike price, pays the buyer nothing, and the proceeds go to the seller.
Plans for the initial roll-out of FROs propose that 30 underlying securities will receive FRO listings. These underlying securities will comprise 20 equities, five ETFs (exchange-traded funds) and five indexes.
The objective of the initial listing is to select the listings pursuant to existing criteria set forth in Rules 915 and 916 governing initial listing requirements and continuous listing requirements, respectively, for exchange-traded options.
The stocks that will most likely inspire FROs are among the most heavily traded. On the Nasdaq, expect to see FROs for Microsoft, Intel, Cisco, Dell, Amgen, Comcast and Oracle. On the NYSE, youll see General Electric, Exxon, Pfizer, Citigroup, Wal-Mart and American International Group.
Innovation can create complexity. While some vendors have chosen to back away from support of the SSF as a result of the technological challenges and absence of immediate retail-customer demand, others have moved forward to create access for the retail consumer in the hope that the unique offering will pump up their DARTs.
Both the fixed return option and the single stock future offer economically viable alternatives to the equity markets for both the educated retail and institutional investor. Given the exotic nature of these products, it is incumbent upon the providers—primarily exchanges and online brokers—to develop effective investor-education programs.
A major barrier to the slow acceptance of SSFs is confusion on the part of the average investor. SSFs appear to be very risky, which causes the average retail investor to back away from the monitor and put down the mouse.
The TowerGroup estimates that active options traders currently account for just 5.2 percent of all online traders. There are about 1 million customers of online brokers who have been approved for options trading but are sitting on the sidelines. Those who are actively trading futures number a mere 0.6 percent of individuals with online accounts.
The TowerGroup states, “Examining the market for the SSF, or in this case the market for retail futures trading in general, one concludes again that this space remains unpenetrated and plagued by the same stigmas as the options market, namely that it is a speculators market and that the associated risk is outside of the online investors purview.”
Developing the technological infrastructure to support these exotic products, according to the TowerGroup, differs greatly. There may be an advantage in accepting the FROs, since it requires little infrastructure build or change requirements by online brokers who cater to the active trader.
But an online broker will have to develop specific presentation layers within its customer portals and broker desktops. In part to distinguish the FRO marketplace from the traditional options marketplace, online brokers will need to create specific order entry screens and support tools that the consumer can utilize for the FRO.
Market structure for the FRO will be very close to the structure for todays options. The American Stock Exchange will be the host and market center for the FRO. As they do for traditional options, designated exchange members will provide liquidity for FROs and assist in maintaining orderly markets.
From the exchanges perspective, there will be little in the way of technological infrastructure change necessary; most of the cost for development of the FRO will be associated with marketing and administrative requirements. TowerGroup estimates that Amex will spend less than $500,000 to bring the FRO to market, as opposed to the tens of millions of dollars the exchanges spent to bring SSFs to market.
The market-sizing data shows that there is room for growth in the retail options arena, which can be extended to FROs. With almost 1 million “options approved” online customers waiting on the sidelines, online brokers have a good place to start pumping up their DARTs.