UNIT #7: MONITOR THE GENERAL OPERATION PROCESS OF OPTION TRADES

A corporation's stock is the underlying security for existing options contracts traded on the CBOE. The corporation has recently completed a spin-off of a division of its company. Regarding the spin-off and the existing options contracts, which of the following is true? A) Existing options contracts would have been adjusted according to the unique terms of the spin-off. B) Existing options contracts would have been adjusted in a standardized fashion the same as adjustments for all stock dividend and splits. C) Existing options contracts would not have been adjusted for a spin-off or similar corporate action. D) Existing options contracts would not be adjusted but instead allowed to expire with no terms unchanged. Explanation Adjustments to any existing options contracts for the spin-off, one of many typical corporate actions, would have taken place. These adjustments are all unique in accordance with the terms of the action and are not standardized as those for stock dividends and splits would be.

A

A customer's account has 20 UVW Feb 50 calls and 10 UVW Feb 55 puts. At expiration, UVW goes out at $56. What will be the new stock position and cost of the settlement? A) Long 2,000 shares of stock at a cost of $100,000 B) Long 1,000 shares of stock at a cost of $55,000 C) Long 2,000 shares of stock at a cost of $110,000 D) Long 1,000 shares of stock at a cost of $50,000 Explanation The expiring position will result in the customer being long 2,000 shares of stock at a cost of $100,000 (2,000 shares × $50 per share = $100,000). The puts will expire worthless being out-of-the-money. The 20 in-the-money calls will be exercised at a cost of $50 per share.

A

For one's contrary exercise instructions (notice) to be effective, they must be submitted to the appropriate exchange by the cut-off time on the day of expiry established by that exchange. In this regard, the Chicago Board Options Exchange (CBOE) maintains a cut-off time of A) 5:30 pm ET. B) the opening rotation next business day. C) 4:30 pm ET. D) 11:59 pm ET. Explanation For one's contrary exercise instructions (notice) to be effective, they must be submitted to the CBOE by the established cut-off time of 5:30 pm ET (90 minutes after the close).

A

For small-market orders and small executable limit orders, the electronic order routing/execution system may select automatic execution. Which of the following statements about these orders is not correct? A) The execution is sent directly to the designated primary market maker. B) Each order is executed against an order on the limit order book or a market maker's quote. C) The order is sent directly to the trading post on the exchange floor. D) The orders bypass the commission house booth and floor broker on the exchange floor. Explanation For quicker action, the system bypasses the commission house booth and floor broker on the exchange floor and instead sends the order directly to the trading post on the exchange floor. Each order is executed against an order on the limit order book or a market maker's quote, and the notice of execution is sent directly to the broker-dealer.

A

Listed equity options would not be adjusted for which of the following actions in the underlying security? A) A cash dividend of $0.50 B) A 2:1 stock split C) A stock dividend of 2% D) A 1:5 reverse stock split Explanation Options contracts are adjusted for stock splits, reverse stock splits, stock dividends, and rights offerings. They are not adjusted for ordinary cash dividends.

A

Most firms use an electronic system or program to transmit orders to the floor of an exchange. The person who represents these orders on the floor for the broker-dealer is A) an exchange member. B) a floor official. C) a market-maker. D) a clerk. Explanation The exchange member represents the broker-dealer on the floor.

A

The Options Clearing Corporation (OCC) utilizes which of the following methods to assign exercise notices to member broker-dealers? A) Random basis B) First in-first out (FIFO) C) Last in-first out (LIFO) D) Predetermined format Explanation OCC uses a random basis. Broker-dealers usually use FIFO, and LIFO is not used.

A

The writer of an equity call option who is exercised A) must deliver the stock in two business days. B) must deliver the stock in one business day. C) can enter a closing transaction any time before exercise settlement. D) can enter a closing transaction on the day the exercise notice is received. Explanation If exercised, call writers must deliver the underlying stock within two business days.

A

WXY has a 50,000 contract position limit. A customer has a combined total of 44,000 long calls, (9,000 in-the-money calls, and 35,000 out-of-the-money calls). Which of the following trades is the customer permitted to make? A) Sell 4,000 in-the-money puts and sell 2,000 out-of-the-money puts B) Buy 5,000 in-the-money calls and sell 2,000 out-of-the-money puts C) Sell 2,000 in-the-money puts and sell 5,000 out-of-the-money puts D) Buy 4,000 in-the-money calls and buy 5,000 out-of-the-money calls Explanation The customer can sell 4,000 in-the-money puts and sell 2,000 out-of-the-money puts, resulting in a 50,000-contract position on the same side of the market. It does not matter if the contracts are in-the-money or out-of-the-money. The rule established by options exchanges prohibits an investor from having a net long or short position of more than a specific number of contracts on the same side of the market.

A

Which of the following are the intrinsic values specified for automatic exercise by the OCC following the final trading rotation? 1. $0.01 in-the-money for customers 2. $0.50 out-of-the-money for customers 3. $0.05 out-of-the-money for firms 4. $0.01 in-the-money for firms A) I and IV B) II and IV C) I and II D) II and III Explanation Automatic exercise by the OCC occurs when contracts are in-the-money by $0.01 for customers as well as firms.

A

Which of the following is required to deliver do-not-exercise instructions? A) Contrary exercise notice B) Notification of assignment C) Automatic exercise notice D) Notification of allocation Explanation There are times when, even though a contract is in-the-money, the holder may choose not to have it exercised. In these instances, a contrary exercise advice form or notice is required to deliver the do-not-exercise instructions.

A

A position limit report must be filed once a customer or member firm acquires, on the same side of the market and same underlying security, A) 300 or more option contracts no later than the close of business on the third business day following the day on which the transaction or transactions requiring the filing of such report occurred. B) 200 or more option contracts no later than the close of business on the next business day following the day on which the transaction or transactions requiring the filing of such report occurred. C) 1,000 or more option contracts no later than the close of business on the third business day following the day on which the transaction or transactions requiring the filing of such report occurred. D) 500 or more option contracts no later than the close of business on the next business day following the day on which the transaction or transactions requiring the filing of such report occurred. Explanation Once a customer or member firm acquires 200 or more contracts on the same underlying security and side of the market, a report must be filed no later than the close of business on the next business day following the day on which the transaction or transactions requiring the filing of such report occurred.

B

A registered representative notices that an option premium seems to be too low relative to the contract strike price and the price of the underlying stock. This is most likely because A) the issuing corporation for the underlying stock has asked that the exchange lower the premiums to make the options more attractive for smaller investors. B) the option contract has been adjusted due to a spin-off. C) the exchange decided that the contracts should be split. D) the issuing corporation for the underlying stock is buying back their own securities in the open market. Explanation If an option appears mispriced relative to the value of the underlying stock, and the option's strike price is seeming either too good or too bad to be true, the most likely reason is that the option contracts have been adjusted due to a spin-off.

B

After adjustment for a 2:1 stock split, an XYZ Oct 40 call is exercisable for A) 200 shares at 40. B) 200 shares at 20. C) 100 shares at 40. D) 100 shares at 20. Explanation On an even split, adjustments are made to the strike price and the number of contracts. On odd splits, the number of contracts is not adjusted.

B

All of the following elements of a listed stock option may change as a result of a stock split except A) the exercise price. B) the expiration month. C) the contract size. D) the premium. Explanation After a stock split, the option's contract size, strike price, and premium change. The expiration month is not affected by a stock split.

B

All of the following statements regarding customer notification methods are correct except A) each member firm must preserve its method of allocation for three years. B) each member firm must select customers to receive notifications. C) each member firm must have fixed procedures. D) each member firm must obtain prior approval from the exchange. Explanation Each member firm must have fixed procedures, obtain prior approval from the exchange, and preserve its method of allocation for three years. The firms do not select the customers to receive the notifications; the first in-first out method selects the customers.

B

An order management system (OMS) usually has a pop-up feature that is activated if a limit is reached. The actions that follow must be all of the following except A) documented. B) overridden. C) identified in the written supervisory procedures. D) reviewed by the ROP. Explanation All of the controls and their parameters need to be identified in the written supervisory procedures, reviewed by the ROP, and documented. LO 7.a **This question deals with material not covered in your LEM, but it relates to recent student feedback

B

An order management system (OMS) usually has a pop-up feature that is activated if a limit is reached. The actions that follow must be all of the following except A) identified in the written supervisory procedures. B) overridden. C) reviewed by the ROP. D) documented. Explanation All of the controls and their parameters need to be identified in the written supervisory procedures, reviewed by the ROP, and documented. LO 7.a **This question deals with material not covered in your LEM, but it relates to recent student feedback

B

Broker-dealers may use which of the following methods to allocate exercise notices (assignments) to customers? A) An approved random method B) Any of these C) Any other approved method that is fair and reasonable D) An approved first-in-first-out (FIFO) method Explanation Broker-dealers may allocate exercise notices (assignments) to customers on a random basis, using a FIFO method, or using any other method that is fair and reasonable. However, all methods requires prior approval and customer notification before being applied.

B

Commonly referred to as the notification of allocation method (e.g., randomly, first in-first out), each member firm must A) inform its options customers, in writing, of how it allocates exercise notices (assignments) only, but not the exchange. B) inform its options customers, in writing, of how it allocates exercise notices (assignments), report its proposed method of allocation to the exchange, and obtain approval of the exchange to use the proposed method. C) inform the exchange, in writing, of how it allocates exercise notices only, but not its customers. D) inform its customers and the exchange, in writing, with no exchange approvals required. Explanation A firm must inform both its customers and the exchange, in writing, of how it allocates exercise (assignment) notices and obtain prior approval from the exchange as to the method of allocation proposed.

B

Each of the following settle next business day except A) exercise of an index option. B) exercise of an equity option. C) trade of an equity option. D) trade of an index option. Explanation Exercise of equity options results in a purchase or sale of the underlying stock. Stock transactions settle regular way— T + 2 (in two business days).

B

Equity option contracts will be adjusted for all of the following except A) corporate events like mergers, spin-offs, and takeovers. B) cash dividends. C) even and uneven stock splits. D) stock dividends. Explanation Equity option contracts are adjusted for stock dividends and even and uneven stock splits as well as corporate events but not for cash dividends.

B

FINRA can require member firms to submit a report on all positions at the firm. The report must be submitted A) by the close of business on the following day. B) within two business days of the request. C) within one business day of the request. D) by the opening of trading on the following day Explanation FINRA can require member firms to submit a report on all positions at the firm. If requested, the report must be submitted within two business days.

B

If a writer of an XYZ equity call option is assigned, which of the following may be delivered to the OCC? A) Any listed security of comparable value B) The underlying security C) Cash equal to the market value of the underlying security D) An index option based on an index containing the underlying security Explanation When a call is exercised, that security must be delivered by the assigned writer. The contract does not allow settlement in cash or securities of equivalent value.

B

Renalda has had sporadic activity in her account in the past quarter. She has purchased 10 April 30 calls, 10 April 35 Calls and 5 July 30 calls. She has also purchased 10 April 35 puts and 10 July 35 puts. At the April expiration, the underlying security closes at $34.75. What would be the new stock position and transaction settlement balance? A) Renalda will receive 1,000 shares at a debit of $30,000. B) Renalda will have no position in the stock and a credit of $5,000. C) Renalda will have to deliver 1,000 shares for a $35,000 credit. D) Renalda will have a position in the stock and a zero balance. Explanation Renalda will have no position in the stock and no additional cost. The July calls and puts do not expire in April. The 10 April 35 calls expire out-of-the-money, leaving the April 30 calls to expire in-the-money, resulting in a debit being long 1,000 shares at $30,000 (1,000 shares × $30 = $30,000). Renalda also has 10 April 35 puts which expire in-the-money. The puts would result in a credit with the sale of 1,000 shares at $35 (1,000 × $35 = $35,000). The buying of 1,000 shares and the selling of 1,000 shares would net zero. The $30,000 debit and the $35,000 credit would net $5,000.

B

The internal controls of an order management system (OMS) can be set to include all of the following except A) dollar limits for the number of option contracts per user or customer. B) buy orders versus sell orders. C) dollar limits per order entered for the branch office or firm. D) volume limits for the number of shares entered for the branch office or firm. Explanation The internal controls of an OMS cannot be set to buy orders versus sell orders. The OMS can be set for symbols that the firm usually does trade. All the other controls can be set by an administrator. LO 7.a **This question deals with material not covered in your LEM, but it relates to recent student feedback.

B

The latest an option contract can be exercised is A) 11:59 pm ET on the third Friday of the expiration month. B) 5:30 pm ET (4:30 pm CT) on the third Friday of the expiration month. C) 4:30 pm ET (3:30 pm CT) on the third Friday of the expiration month. D) at any time by the holder. Explanation The latest the holder can exercise an option contract is 5:30 pm ET (4:30 pm CT) on the third Friday of the expiration month.

B

The terms of outstanding option contracts on XYZ stock may be adjusted due to XYZ Corporation declaring any of the following except A) a 3:1 stock split to enhance the marketability of its stock. B) an increase in the quarterly cash dividend, reflecting an exceptional rise in income. C) a 1:3 reverse stock split to boost the market price of its stock. D) a 10% stock dividend in addition to the regular cash dividend. Explanation Option contracts are not adjusted for cash dividends. For stock dividends, stock splits, and reverse splits, the OCC adjusts the terms of outstanding options to reflect the change in number of shares of the underlying stock.

B

When a customer of a member firm wants to exercise a contract, the firm must notify A) the exchange where the contract was traded. B) the Options Clearing Corporation (OCC). C) the Chicago Board Options Exchange (CBOE). D) FINRA. Explanation The firm would notify the OCC that one of its customers wants to exercise a contract.

B

When applying the exercise limit rules, who could be considered as acting in concert? A) A registered representative who makes recommendations to nondiscretionary customers B) A registered representative who has discretionary control over 10 customer accounts C) Many options customers of the same brokerage firm acting independently on a recent recommendation published by the firm D) An institutional trader acting on a recently released earnings report Explanation Acting in concert rules apply to position limits and exercise limits. Individuals acting together with knowledge of each other's activities, or having one person control a number of accounts, may be acting in concert.

B

While looking at an option chain for ABC stock, you find two calls with the same strike price but with slightly different exchange listing symbols. In addition, the strike prices seem odd, and at least one of the contracts appears mispriced when comparing its strike price and the price of ABC stock. Which of the following describes how the situation should best be recognized and/or handled? A) The mispricing indicates that an arbitrage opportunity exists and should be acted upon as quickly as possible before the price disparity narrows or disappears. B) The odd strike prices might indicate that a nonstandard adjustment was made to either one or both contracts for a corporate action rather than a stock dividend or split. An attempt to verify this should be made using a contract adjustments page or online information typically offered by an exchange C) Two differing symbols with the same strike price indicate that a proposed corporate action has not yet been finalized; but if it is, the first option shown in the chain will have its contract terms adjusted to become the second option shown in the chain. D) The differing symbols, seemingly mispriced contract, and having two put or call options with the same strike price available on the same security indicates that a standard adjustment was made for a conventional stock split or dividend. Explanation An attempt to verify this should be made using a contract adjustments page or online information typically offered by an exchange. The different symbols, seemingly mispriced contracts, and having two put or call options available on the same security are all indications that a nonstandard adjustment was made for a corporate action such as a merger, acquisition, spin-off, or tender offer. These are unlike the standard adjustments made for conventional stock splits or dividends, and the terms are unique to the particular circumstances of the action. To avoid trading errors, an attempt to verify the reason and terms of the adjustment should be made. Most exchanges where options trade maintain a link or page on their websites listing and detailing all adjustments made, both standard and nonstandard.

B

A clearing member firm is required to allocate assignment notices to holders of short positions by using established procedures. Which of the following would least likely receive a notice? A) Customer B) Market maker C) Floor broker D) Proprietary trader Explanation A floor broker acts strictly as an agent and does not hold any positions. Market makers, proprietary traders, and customers all hold positions.

C

Capital gains and losses for securities can be either short or long term. An options position used as a hedge for a stock A) protect a short-term loss. B) is either buying a put or selling a call. C) can impact the reportable holding period for the stock position. D) can turn a short-term gain into a long-term gain. Explanation For tax purposes, the length of the holding time of the security is the holding period. Using options to hedge a stock position can impact the reportable holding period for the stock position.

C

Each exchange's automatic execution system has A) a name (e.g., BullNet). B) special criteria. C) all of these. D) unique capabilities. Explanation Each automatic execution system offers its subscribers direct electronic communication to and from the trading post or order book. Every exchange has an automatic execution system that has its special criteria, capabilities, and name (e.g., BullNet).

C

If the member firm wants to change the allocation method, it must do all of the following except A) describe to its option customers the process of how it operates. B) obtain prior approval from the exchange. C) identify institutional customers with short option positions for approval. D) notify its option customers before use of the type of allocation method. Explanation For a member firm to change the allocation method, it must report its proposed allocation method to the exchange and obtain prior approval from the exchange to use the new method. Before the new method goes into effect, all options customers must be notified. The firm does not need approval from its institutional customers.

C

Regarding the preopening rotation for options trading the Hybrid Opening System (HOSS), which statement is false? A) The HOSS will accept orders and quotes. B) The HOSS will disseminate to floor brokers, market makers, and designated primary market makers' (DPMs) information about orders in the eBook that remain from the previous business day and any orders submitted before the opening. C) Spread orders and contingency orders participate in the opening trade or the determination of the opening price. D) The HOSS for the class is permitted to enter opening quotes. Explanation Spread orders and contingency orders do not participate in the opening trade or the determination of the opening price. For a period before the opening of trading in an underlying security, the HOSS will accept orders and quotes. The HOSS will disseminate to floor brokers, market makers, and DPMs' information about resting orders in the eBook that remain from the previous business day and any orders submitted before the opening. The DPM for the class must enter opening quotes.

C

The Contrary Exercise Advice instructs the OCC to not exercise certain in-the-money contracts automatically. The rule states that the firm would needs to submit the form by A) 60 minutes after the close of the options on the third Friday of the expiration month. B) 30 minutes after the close of the options on the third Friday of the expiration month. C) 90 minutes after the close of the options on the third Friday of the expiration month. D) 90 minutes after the close of the options on the third Friday of the expiration month, unless an extension was granted. Explanation The rule states that the deadline is 90 minutes after the close of the options. A 4:00 pm ET closing plus the 90 minutes make the deadline 5:30 pm ET.

C

The functions of the OCC include all of the following except A) adjusting contracts for stock splits. B) clearing transactions in listed options. C) regulating trading on options exchange trading floors. D) guaranteeing financial performance for listed options contracts. Explanation The OCC clears, processes, and guarantees the performance of options transactions. It does not, however, regulate the market. The exchanges govern the trading of options contracts.

C

The impact of assignments for customers not prepared can bring on an unwanted chain of events, including all of the following except A) unplanned taxable events. B) capital deposits or margin calls. C) time value loss. D) the interruption of strategy timing. Explanation The time value loss would not be an unwanted impact of an assignment because exercised contracts usually do not have any time value.

C

Which of the following delivery and payment requirements for an uncovered assignment is correct? A) Deposit full cash payment of the aggregate exercise price in the case of a call option. B) Deposit the underlying stock in the case of a put option contract. C) Deposit the required margin as promptly as practicable in accordance with regulations. D) Deposit the option contract for next-day settlement. Explanation Deposit the required margin as promptly as practicable under Federal Reserve Board regulations. The option contract is short. You would deposit cash for an assigned put contract and stock for an assigned call contract.

C

A broker-dealer decides to change its method of allocating exercise (assignment) notices. Which of the following is true? A) Notification to the exchange is not required when a change is made. B) Notification to the exchange is required, but no approval for the change is needed. C) Customers need not be notified when a change in exercise notification takes place. D) Customers of the broker-dealer must be notified in writing. Explanation When a firm decides to change its method of exercise allocation customers must be notified in writing, and the exchange must be notified as well. In order for the firm to implement the change, the exchange must grant approval.

D

A customer is assigned on 14 minioption call contracts. Which of the following is true? A) The customer can receive cash or securities equal to the current market value of 140 shares of the underlying security. B) The customer is obligated to deliver 1,400 shares of the underlying security. C) The customer will receive 1,400 shares of the underlying security. D) The customer is obligated to deliver 140 shares of the underlying security. Explanation A customer assigned is obligated to deliver the underlying security to the party that exercised the contract. Because minioption contracts overlie only 10 shares each, an assignment on 14 contracts necessitates the delivery of 140 shares (14 contracts × 10 shares) by the writer of the contracts to the holder of the contracts.

D

An assignment to take delivery of stock or to sell stock takes place when A) the contract is sold to a buyer. B) the contract is $0.01 (one cent) in the money. C) the writer (seller) exercises the contract D) the holder (owner) exercises the contract. Explanation An assignment takes place when the holder or owner of an option exercises their right to take delivery of the stock or to sell the stock. The option writer is assigned and obligated to deliver the terms of the options contract.

D

If a public customer gives no instructions, the customer's stock option contracts will be automatically exercised if, at expiration, they are in-the-money by which of the following amounts? A) $1.00 or more B) $0.05 for retail customers and $0.10 for institutional customers C) $0.01 for retail customers and $0.05 for institutional customers D) $0.01 or more Explanation The OCC exercises equity options in-the-money by $0.01 or more for customer and firm accounts at expiration. This will occur unless the OCC receives instructions not to automatically exercise.

D

The customer can instruct the Options Clearing Corporation (OCC) not to automatically exercise certain A) any of these. B) at-the-money-contracts and allow them to expire worthless. C) out-of-the-money contracts and allow them to expire worthless. D) in-the-money contracts and allow them to expire worthless. Explanation By filing a Contrary Exercise Advice (CEA), the customer can instruct the OCC to not automatically exercise in-the-money contracts and allow them to expire worthless. At-the-money and out-of-the-money contracts would not be automatically exercised, so there would be no need to fill out a CEA.

D

Upon the exercising of a contract, the Options Clearing Corporation (OCC) selects a firm on A) an exchange-approved method for notification. B) any of these. C) a first-in-first-out (FIFO) basis. D) an automated, random basis. Explanation When a firm notifies the OCC that one of its customers wants to exercise a contract, the OCC selects a firm on a random basis to which it assigns the exercise.

D

When a customer of a member firm wants to exercise a contract, the firm must notify A) FINRA. B) the exchange where the contract was traded. C) the Chicago Board Options Exchange (CBOE). D) the Options Clearing Corporation (OCC). Explanation The firm would notify the OCC that one of its customers wants to exercise a contract.

D

Which of the following methods do broker-dealers usually use in assigning option exercise notices? A) Smallest positions first B) Dutch auction C) Largest positions first D) First in-first out (FIFO) Explanation A firm usually assigns an exercise notice using the FIFO method. The firm may not consider the size of a customer's position. Random selection is another acceptable method.

D

Which of the following statements regarding exercise and position limits for jumbo contracts is true? A) Jumbo contracts will only be combined with minioption contracts when calculating position and exercise limits. B) Jumbo contracts will never be combined with regular standard or minioption contracts when calculating position and exercise limits. C) Jumbo contracts will only be combined with regular standard contracts when calculating position and exercise limits. D) Jumbo contracts will be combined with regular standard and minioption contracts when calculating position and exercise limits. Explanation Jumbo contracts will be combined with both regular standard and minioption contracts for calculating position or exercise limits on any underlying. For position or exercise limit purposes, each jumbo contract equals 10 regular standard contracts, and 10 minioption contracts equals one regular standard contract.

D

Your firm has an institutional customer that insists on having direct access to the marketplace. Orders placed or executed by the institutional customer are A) subject to counterparty risk. B) required to have an institutional error account funded by the institution. C) all of these. D) the responsibility of the firm. Explanation Any securities trading would be done through the market participant identifiers (MPID) of the member firm, which specifically identifies the firm and makes the firm responsible for all its trading activity. LO 7.a **This question deals with material not covered in your LEM, but it relates to recent student feedback.

D