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Options Trading Booms as Investors See Cheap Way to Play Markets

Options trading is booming as both individual and institutional investors discover a cheap way to play the markets.

During the first quarter, options volume rose 27.6%, compared to a 5.2% increase in the stock market volume, according to Options Clearinghouse.

Options give an investor the right to buy or sell a security at a set price. Because they can be bought at a fraction of the cost of the actual stock, it's a cheap way to bet on a stock's direction without owning it.

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AP

“The growth in the industry has just been terrific,” said Ed Tilly, vice chairman of the Chicago Board Options Exchange, which is one of six registered exchanges in the U.S. that trade options.

Also fueling the growth is the emergence of electronic trading, which has lowered transaction costs and made the options markets more transparent. There also has been increased education, which has allowed both retail and institutional investors to better understand various investment strategies using options.

"The educational efforts...have created a more sophiscated investor," said Bruce Goldberg, chief marketing officer at International Securities Exchange. "A smarter options user is able to trade over the long term and be more successful."

These educational efforts have been driven by the exchanges, money managers such as Fidelity, and even online brokerges such as Ameritrade, eTrade, and OptionsXpress.

Although retail investors drove the initial interest in options, there is increased trading volume coming from institutional investors, especially hedge funds, as they use options to limit their risk and gain added leverage from their investments.

“It’s a very powerful product,” said Susan Milligan, executive director of the Options Industry Council, which was formed by the exchanges in 1992 to help educate the public about the benefits and risks of exchange-traded equity options.

"I think it is so flexible," Milligan said. "You can use it to speculate. You can use it to hedge or to protect yourself against downturns in the market, or improve a return on a stock you own."

The rise of electronic trading has helped increase the transparency of the options market, and that helped encouraged greater participation, according to Andrew Wilkinson, senior market analyst with Interactive Brokers.

“People are able to take more risk because they know how to offset risk in markets around the world,” Wilkinson said.

With this week’s pullback in stock market ratcheting up concerns that volatility will increase in the months ahead, it is possible there could be even greater growth in options volume in the months ahead.

Trading Volume, Year-to-Year Percentage Change, By Market

Year
Stock Market
Options Industry
1999 +27.9% +25.0%
2000 +48.3% +43.1%
2001 +10.6% +7.5%
2002 +3.3% -0.1%
2003 -3.3% +16.3%
2004 +5.5% +30.2%
2005 +3.6% +27.3%
2006 +12.8% +34.8%
Sources: Options Clearinghouse Corp.; Securities Industry and Financial Markets Association

There also could be other catalysts. First, there seem to be an ever-growing range of new products for investors to use such as exchange-traded funds and index-linked products.

Also, electronic trading platforms have made it possible for institutions to do electronically what was once done on the trading floor.

In addition, the industry is testing the effects penny pricing, which allows options to be traded at a penny, instead of nickel, on the market. The trial, which is being conducted on 13 active options series, is still in its early days, and the results have been mixed so far.

The Securities and Exchange Commission also has approved new rules governing portfolio margins that could benefit certain types of large investors, such as hedge funds.

"When you think about this product, it is still early in this ball game," Goldberg said.

Christina Cheddar Berk is a News Editor at CNBC.com. She can be reached at christina.cheddar-berk@nbcuni.com.