Chapter 16 (STC) Series 7

Floor Trading

The information included on an order ticket is transmitted directly to the exchange floor either electronically or by phone from the member firm's office. The member firm's clerk who is located on the exchange floor must record the time the order was received. As with stock trading, the highest bid price and the lowest offer price are given the highest order priority. Therefore, an investor placing a market order will normally buy at the offer and sell at the bid. If trading is halted in the underlying security of a particular option contract, all of the trading involving that security's option contracts will also be halted on the options exchanges the Series 7 Examination may require a person to demonstrate her ability to locate a contract's specific premium. Using the previous table, let's identify the premium for the IBM January 120 call. First, find the 120 strike price in column 2, then move across to column 3 and line up with the January expiration

Holding Period of Acquired Shares

When an options investor is in a position to acquire stock, his holding period begins when the option is exercised and the stock transaction settles.

If a broker-dealer receives an assignment notice,

it must select a client to whom the notice will be assigned. There are three methods by which this selection may be accomplished—(1) using random selection, (2) using first-in, first-out (FIFO), or (3) using any other method that is deemed to be fair and equitable. Every member firm must notify its clients as to which method is used and how it will be implemented

Weekly Summary of Option Trading

The number of options that traded during the week (the Sales column) The number of contracts that are currently outstanding (the Open Interest column) - Open interest represents the number of contracts that have not been closed out through a sale or by expiration. The high, low, and closing premium for each option series The premium's net change from the previous week's closing price The week's closing price for the underlying stock

Taxation Of Options

-Expiration of Options If an option ultimately expires unexercised, the premium will represent either a capital gain or capital loss for tax purposes. For a buyer, the premium paid is a capital loss; however, for a seller, the premium received is a capital gain -Liquidation of Options When an investor executes an opposite transaction on the same option, the result is a realized capital gain or capital loss. Remember, an opening purchase is offset with a closing sale and an opening sale is offset with a closing purchase. Exercising of Options Depending on whether an investor is in a position to buy stock or sell stock due to the exercise of an option, the exercise may result in the need to determine the investor's basis or sales proceeds. Since buyers of calls and sellers of puts are in a position to acquire stock as the result of exercise, they are required to calculate cost basis (the total cost to acquire). On the other hand, since buyers of puts and sellers of calls are in a position to deliver stock as the result of exercise, they are required to calculate sales proceeds (the total money received on delivery). Exercising Calls For call options that are exercised, the calculation of either basis or sales proceeds is simply strike price plus the premium. When a call is exercised, the owner of the call has the right to buy the underlying stock and must determine his cost basis. Exercising Puts For put options, the calculation of basis or sales proceeds is simply strike price minus premium. When a put is exercised, the owner of the put has the right to sell the underlying stock and must determine his sales proceeds.

Order Execution For a listed option, before an order may be executed on the floor of an exchange, an order ticket must be completed in full. The order ticket must contain the following information

-Whether it is a buy or sell order -Whether the position is naked or covered -The number of options contracts to be bought or sold -The name of the underlying stock -Both the expiration month and exercise price -Whether the order is for a call or a put -The terms of the order (e.g., market, limit, stop, etc.) -Whether it is an opening or closing transaction − Basically, orders are entered to either open a new position or close a previously opened position. Bids and Offers Options markets provide two-sided quotes and typically have $.05 pricing increments; however, some options currently trade in $.01 increments

As covered earlier, the holder (owner) of an option may dispose of the option through any of the following means:

1. Expiration 2. Liquidation 3. Exercise

Hedging—Buying Stock and Buying Puts

1. The hedge is put in place on the same day that the stock is purchased. 2. The hedge is put in place after the stock is purchased (the next day or later), but prior to establishing a long-term period in the stock. 3. The hedge is put in place more than one year after the stock is purchased

Exercising Options Contracts

A member firm is allowed to accept an exercise notice after the OCC's cutoff time, but only in cases where errors have made been in good faith or where exceptional circumstances exist relating to a customer's ability to communicate with the member firm. Assignment Due to Exercise Remember, equity option trades settle on the next business day following the trade date, or T + 1. On the other hand, since the exercise of an option involves the purchase and sale of the underlying stock, settlement of an exercised option occurs in two business days (T + 2). Non-Equity Option Expiration Both stock index and foreign currency options also expire at 11:59 p.m. ET on the third Friday of the expiration month. On the day of expiration, narrow-based index options cease trading at 4:00 p.m. ET, while broad based index options cease trading at 4:15 p.m. ET. Also on the day of expiration, customers who intend to exercise must submit their exercise notices by 5:30 p.m. ET. T-bill option contracts expire quarterly in March, June, September, and December.

Discretion Accounts

A member firm may not exercise discretion in a client's option account unless it is preceded by the client's written authorization. Additionally, an account must be approved for discretion by an ROP and a written record of the approval must be maintained.

Puts Bought on Day One—Married Puts

An investor who buys shares of stock and, on the same day, buys a put option on that stock has created a married put position. If this is the case, the investor's cost basis in the stock represents the cost of the stock plus the cost of the option.

Options Communications (two forms)

Correspondence is defined as any written or electronic messages that are sent by a member firm to 25 or fewer retail investors within any 30-calendar-day period. These retail investors may be any type of client—existing or prospective. Retail Communication This category is defined as any written or electronic communication that is distributed or made available to more than 25 retail investors within a 30-calendar-day period. All materials prepared for the public media in which the ultimate audience is unknown are considered retail communications. All options-related retail communication must be pre-approved by a Registered Options Principal (ROP); however, this pre-approval requirement does not apply to correspondence. Instead, options correspondence is subject to the same review and general supervision requirements that apply to all forms of communication with the public

The Market Place for Options

Currently, listed options trade on the following exchanges: The Chicago Board Options Exchange (CBOE) NYSE Mkt LLC (formerly NYSE AMEX or the American Stock Exchange) Nasdaq OMX PHLX (formerly Philadelphia Stock Exchange) The International Securities Exchange (ISE)

Supervision Of Options Activities

Every member firm is required to develop and implement written procedures for carrying out these activities which must be included in the firm's written supervisory procedures (WSPs) manual. The procedures must be implemented under the supervision of a designated Registered Options Principal (ROP). The ROP is normally an officer or general partner of the member firm who has qualified by examination to serve in this role. -The Registered Options Principal (ROP) is specifically responsible for the firm's compliance program as it relates to its options activities. The ROP performs an audit function to determine that these activities are conducted in compliance with current applicable rules and regulations.

Adjustments to an Option Contract

If a corporation executes a stock split or pays a stock dividend, its option contracts must be adjusted. In some cases, an adjustment is made to the number of option contracts, while in other cases, it is the number of shares underlying the contract that must be changed. However, in all cases, the exercise price of the option will be adjusted proportionately Even Stock Split Any split for one (e.g., 2 for 1, 3 for 1, etc.) is referred to as an even stock split. When a corporation executes an even stock split, the adjustments made to existing option contracts are an increase in the number of option contracts an investor owns and a decrease in the exercise price of the contracts. Odd Stock Splits When an odd split is executed (e.g., 3 for 2, 5 for 4, etc.), the adjustments made to existing option contracts are an increase in the number of shares underlying the contracts and a decrease in the exercise price of the contracts Reverse Stock Split In an effort to increase the market price of its stock, a corporation may choose to execute a reverse stock split. With a reverse stock split, the adjustments made to existing option contracts are a reduction in the number of shares the contract represents and an increase in the exercise price of the contract. . Again, the contract's aggregate value will be the same before and after the adjustment Stock Dividend An option contract is also adjusted for a stock dividend on the ex-dividend date. The adjustments made are identical to those made for an odd stock split Cash Dividend Cash dividends are considered the property of the investor who owns the stock as of the record date. The holder of a call will receive the dividend on the underlying security as long as the option is exercised before the ex-dividend date. The owner of a put option who holds the underlying stock must wait to exercise the option until the ex-dividend or after in order to retain the dividend on the stock

Puts Bought After One Year

If an investor buys shares of stock and establishes a long-term holding period, a subsequent put purchases does not affect the client's holding period in the stock Under IRS rules, if a stock's holding period has been established as long-term (i.e., held for more than one year), it is considered long-term regardless of subsequent hedging actions.

The Options Clearing Corporation

Listed options are issued and guaranteed by the Options Clearing Corporation (OCC). The OCC is regulated by the Securities and Exchange Commission and is proportionately owned by the exchanges on which listed options trade. -The OCC acts as the third party in all options transactions and functions in a similar capacity to that of the DTCC in equity and bond markets. The OCC handles the exercise of option contracts and removes counterparty risk in the event that a writer is unable to fulfill its obligation. Broker-dealers deal directly with the OCC rather than with each other

Placing Orders for Complex Strategies

Orders for complex strategies, such as spreads and straddles, involve buying and/or selling more than one option position. These types of trades are typically entered as a single order with the customer specifying the maximum premium he is willing to pay (in the case of net debt transactions) or the minimum he is willing to accept (in the case of net credit transactions).

Puts Bought After Day One

Put options that were not purchased on the same day, but prior to the establishment of a long-term holding period in the stock, are treated separately for tax purposes. If the investor has owned a stock for less than one year and then buys a put on that stock, the stock's holding period will be terminated. The holding period in the stock will not restart at day one until the put is no longer associated with the stock. To achieve a long-term holding period, a stock must be held at risk (unhedged) for longer than one year

Long-Term Equity Anticipation Securities (LEAPS)

Some of the significant advantages of these long-term options include that they: Lose their time value at a much slower pace than standard options Offer long-term protection against unfavorable movement in the market value of an underlying stock position Provide a long-term opportunity to participate in the price movement of a security

Options Accounts not suitable for every customer here are the qualifications

Step One Gather and Send: When a customer intends to open an options account, a registered representative must first gather financial and background information in order to evaluate the customer's ability to understand the nature of the investment and to assume risk. This suitability information is obtained through the process of completing an Options Account Agreement on behalf of the customer. The broker-dealer must attempt to verify this information with the customer by sending the agreement to her and having her confirm or correct the information. If there is no response from the customer concerning her personal data, the information may be considered verified Step Two: ROP Approval: Once completed, the Options Account Agreement is forwarded to an ROP to determine whether the customer meets the firm's standards for options trading. It is the ROP who ultimately provides account approval Step Three Trading: Once the ROP has provided approval, a customer is permitted to establish opening positions. Traditionally, an ROP will approve a customer to a specified level of trading based on the customer's financial status, experience, and objective. The lower the level, the lower the risk the customer may assume, while the higher the level, the higher the risk the customer may assume. -Step Four: Signature Within 15 days of receiving the ROP's approval, the customer must sign and return the Options Account Agreement to the brokerage firm. By signing the agreement, the customer is verifying that the financial information provided is correct and that he agrees to abide by the rules of the Options Clearing Corporation, the option exchanges, and the broker-dealer 1. Gather customer information on the Options Account Agreement and send both a copy of the agreement and the ODD to the customer at or prior to account approval. 2. Obtain an ROP's account approval for options trading. 3. Allow client to begin trading. 4. Obtain the options account agreement with the customer's signature within 15 days of account approval. If this is not done, only closing transactions are permitted.

Trading Floor Participants

The CBOE employs a market-maker system in which each of the options is assigned to several market makers to facilitate the trading of the contracts. Under this method, firms that are referred to as Designated Primary Market Makers (DPMs) act as principals by purchasing and selling option contracts for their individual accounts

Clearing Options Contracts

The Options Clearing Corporation is responsible for clearing option trades. Additionally, the OCC guarantees that a buyer will be able to exercise her right in the event of a deficiency (e.g., bankruptcy) on the part of a writer. In essence, the OCC removes counterparty risk from standardized options transactions by acting as a seller for every buyer and a buyer for every seller.