A potential merger between Nasdaq and the Philadelphia Stock Exchange (PHLX) could quickly make Nasdaq a substantial player in the options market. The Philadelphia Stock Exchange is the third-largest options market with 15 percent market share, after the Chicago Board Options Exchange and the International Securities Exchange, respectively, notes Senior Analyst Brad Bailey of Aite Group. Nasdaq has been vocal about its desire to enter the options market, and has even set a goal of garnering 20 percent of the market. "A merger with Philadelphia would give it 15 percent market share immediately. Strategically it makes sense for Nasdaq and it would bring Nasdaq immediately up to speed in the options market,” Bailey asserts.

The PHLX is a prime target for Nasdaq because it has major market makers and liquidity providers, Bailey asserts. “A lot of people have wanted to buy it, but Sandy Frucher [the exchange’s CEO] wants not only a financial investment, but a strategic alignment that would offer a way for the exchange to generate more liquidity. So, strategically, this makes a lot of sense,” says Bailey.

The big question, Bailey notes, is how Nasdaq is going to pay for the exchange. According to published reports, the exchange could be valued between $250 and $300 million, and Nasdaq has taken on more than $1 billion in debt in recent years to fund other ventures.

Bailey suggests that potentially, Nasdaq could sell its shares in the London Stock Exchange and use that money, considering its attempt to purchase the LSE was rebuked.

Bailey points out that even before the NYSE and Euronext deal, NYSE had acquired an options business through its alignment with Archipelago. Arca bought the Pacific Exchange to gain exchange status but also for its ability to trade options. It was a good strategy because options have taken off in recent years and is poised for continued expansion and even “explosive” growth, says Bailey.

There has been more than 30 percent growth a year in options and this is only the beginning, predicts Bailey. He sees the current regulatory environment — including the move to penny pricing in options, which will tighten spreads and make options trading cheaper and more attractive to some — a reason that volumes will rise. In addition, the recent change to portfolio margining requirements that better align the margin requirements with the risk of the various legs of these structured products, will mean that less capital is tied up and more can be put to work in the market place.

Lastly, the market has seen tremendous growth in volatility strategies — which use options to hedge equities positions, as well as other positions — and has resulted in an increase in the volume of options being traded by institutions. Before the year 2000, approximately 80 percent of options were traded by retail investors. Now that number is only about 50 percent.

The options market is only expected to continue to grow, and major brokerage houses are even starting to offer or are working to build algorithms for this marketplace. "All the brokers are experimenting with smart routers," Bailey says. Many of the brokers are trying to port over their algos from cash-equities to options, he notes. It’s not a matter of when it will happen, it’s happening already, Bailey asserts.