brokerage firm might use to group strategies by levels. Traders with a great deal of experience and significant financial resources can generally receive approval for level 5 trading. This would allow them to implement any type of trading strategy, including high-risk trades like naked calls and uncovered straddles. Although the options approval levels can vary from one broker to the next, level 3 is enough for most readers following the strategies in this book. Since we do not recommend uncovered selling of options, approval beyond level 3 is unnecessary. At that point, traders can use a variety of simple strategies like straight calls and puts, as well as more complex trades such as spreads, straddles, and collars. In order to avoid the frustration of opening an account with a firm that will not allow trading in more advanced levels, new traders will want to find out the brokerage firm’s policy regarding options approval before funding an account. The best way to do this is to contact the firm’s options approval department by phone. If you have little or no experience, ask them what steps you need to take in order to trade the more complex op- tions strategies (level 3). It sometimes helps to specify which trades (i.e., spreads, straddles, collars, etc.) you intend to trade. Often, the firm will ask you to write a letter or somehow demonstrate that you understand the risks of trading options. After that, most firms will allow you to fund the account and to begin implementing those options trading strategies that interest you. 344 THE OPTIONS COURSE TABLE 12.1 Typical Brokerage Firm Breakdown Options Trading Level Strategy Level 1 Level 2 Level 3 Level 4 Level 5 Covered call writing ✔✔ ✔ ✔✔ Protective puts ✔✔ ✔ ✔✔ Buying stock or index puts ✔✔ ✔✔ and calls Covered put writing ✔✔✔ Spreads ✔✔✔ Uncovered put and call writing ✔✔ Uncovered writing of straddles ✔✔ and strangles Uncovered writing of index ✔ puts and calls ccc_fontanills_ch12_330-346.qxd 12/17/04 4:22 PM Page 344 ROLES AND RESPONSIBILITIES OF ALL BROKERS Regardless of whether the broker charges high or low commissions, all brokers are regulated by the Securities and Exchange Commission (SEC) and are required to meet certain standards when dealing with customers. Specifically, the Securities Exchange Act of 1934 puts forth certain provi- sions that all brokers must adhere to. • Duty of fair dealing. This includes the duty to execute orders promptly, disclosing material information (information that a broker’s client would consider relevant as an investor), and charge prices that are in line with those of competitors. • Duty of best execution. The broker has a responsibility to complete customer orders at the most favorable market prices possible. • Customer confirmation rule. The broker must provide the investor with certain information at or before the execution of the order (i.e., date, time, price, number of shares, commission, and other information). • Disclosure of credit terms. At the time an account is opened, a broker must provide the customer with the credit terms and, in addition, pro- vide credit customers with account statements quarterly. • Restriction of short sales. This rule bars an investor from selling an exchange-listed security that they do not own (in other words, sell a stock short) unless the sale is above the price of the last trade. • Trading during offerings. Rule 101 prohibits the broker from buying a stock that is being offered during the “quiet period”—one to five days before and up to the offering. • Restrictions on insider trading. Brokers have to establish written policies and procedures to ensure that employees do not misuse material nonpublic (or inside) information. WHY PAY HIGH COMMISSIONS? In a world of low-cost (in some cases, no-cost) trading and strict government regulation of brokers, does it ever make sense to pay the high commissions of a full-service broker? Sometimes it does. While investors are protected to an extent by federal securities laws, they are not protected from poor invest- ment decisions. Investors often lose money in the stock market. There are risks and, in a world of do-it-yourself investing, the investor is ultimately responsible for ensuring that investment decisions are wise. The ultimate goal in investing is to preserve capital and improve your fi- nancial well-being. Investors are sometimes uncertain about the risks asso- ciated with an investment. If you are reading this book, you are probably Choosing the Right Broker 345 ccc_fontanills_ch12_330-346.qxd 12/17/04 4:22 PM Page 345 not one of them. But, at times, a full-service firm can be helpful. For in- stance, firms like Merrill Lynch, Morgan Stanley Dean Witter, and Pruden- tial have financial advisers or consultants who offer investment advice for a commission or fee. Sometimes paying a higher commission in exchange for objective financial advice is sensible. The important element in the equation, of course, is being confident that the information is objective and worthwhile. To find out, you can ask the perspective financial consultant a number of questions. The SEC has compiled a list of helpful questions to ask which can be accessed at its web site (www.sec.gov). Sometimes it makes sense to do both—that is, open an account with a brokerage firm to handle some of your retirement savings, money you have saved for an education, or other aspects of your portfolio, and then take a smaller percentage to trade options in a self-directed online ac- count. For example, you might split your portfolio into 75 percent conser- vative investments and 25 percent with more aggressive options trades like long-term bull call spreads. CONCLUSION If you are motivated to the point that you want to invest in stocks, finding a broker and opening an account are relatively straightforward tasks. Over the long run, however, finding a broker to meet your particular in- vestment needs can prove complicated. If you plan on doing one or two trades and are not seeking help with respect to your overall financial plan, a discount broker who simply executes your orders is appropriate. How- ever, if you are not sure about whether the investment is a wise one, a full- service broker, while charging higher commissions, may offer you objective and worthwhile information. Therefore, the first step in select- ing a broker is determining the level of financial advice you need, if any. Regardless of whether you trade one or a hundred times a month, bro- kers have a duty to execute orders promptly and at the best possible price. While it is difficult to monitor the brokerage firm from the time your order is submitted until the time it is executed, there are some things you can do. If you trade actively, monitor the market in real time and watch your trade take place. In addition, consider submitting limit orders (priced between the bid and the offer). Finally, if you have a bad trade—or in Street parlance, a bad fill—contact your broker’s customer service depart- ment and find out what happened. If the problem persists, remind them of their “duty of best execution.” If that doesn’t work, change brokers. 346 THE OPTIONS COURSE ccc_fontanills_ch12_330-346.qxd 12/17/04 4:22 PM Page 346 CHAPTER 13 Processing Your Trade M ost investors never realize the number of steps required for a trade to occur and the incredible speed involved. Technology has made this process almost unnoticeable to the average investor. When you contact your stock or futures broker, you begin a process that, in many cases, can be completed in 10 seconds or less, depending on the type of trade you want to execute. There are various types of orders that are placed between customers and brokerage firms. The faster technology be- comes, the faster a trader’s order gets filled. Let’s take a closer look at what happens when you place an order. EXCHANGES Stocks, futures, and options are traded on organized exchanges through- out the world, 24 hours a day. These exchanges establish rules and proce- dures that foster a safe and fair method of determining the price of a security. They also provide an arena for the trading of securities. Over the years, the various exchanges have had to update themselves with the ever- increasing demands made by huge increases in trading volume. The New York Stock Exchange (NYSE)—probably the best known of the ex- changes—not too long ago traded 100 million shares as a high. Today we see 700, 800, 900 million, and even 1 billion shares trading in a day. Stocks, futures, and options exchanges are businesses. They provide the public with a place to trade. Each exchange has a unique personality and competes with other exchanges for business. This competitiveness 347 ccc_fontanills_ch13_347-370.qxd 12/17/04 4:23 PM Page 347 keeps the exchanges on their toes. Exchanges sell memberships on the exchange floor to brokerage firms and specialists. They must be able to re- act to the demands of the marketplace with innovative products, services, and technological innovations. If everyone does his or her job, then you won’t even know where your trade was executed. In addition, exchanges all over the world are linked together regard- less of different time zones. Prices shift as trading ends in one time zone, moving activity to the next. This global dynamic explains why shares close at one price and open the next day at a completely different price at the same exchange. With the increased use of electronic trading in global markets, these price movements are more unpredictable than ever before. The primary U.S. stock exchanges are the New York Stock Exchange, the American Stock Exchange (Amex), and Nasdaq. There is a host of oth- ers that do not get as much publicity as the big three. However, each ex- change certainly produces its share of activity. These include the Pacific Exchange in San Francisco, the Chicago Stock Exchange, the Boston Stock Exchange, and the Philadelphia Stock Exchange. The major inter- national exchanges are in Tokyo, London, Frankfurt, Johannesburg, Syd- ney, Hong Kong, and Singapore. The primary commodities exchanges include: Chicago Mercantile Ex- change (CME); Chicago Board of Trade (CBOT); New York Mercantile Ex- change (NYMEX); COMEX (New York); Kansas City Board of Trade; Coffee, Cocoa and Sugar Exchange (New York); and the Commodity Ex- change (CEC). The Commodity Futures Trading Commission (CFTC) and the National Futures Association (NFA) currently regulate the nation’s commodity futures industry. Created by the Commodity Futures Trading Commission Act of 1974, the CFTC has five futures markets commission- ers who are appointed by the U.S. President and subject to Senate ap- proval. The rules of the SEC and the CFTC differ in some areas, but their goals remain similar. They are both charged with ensuring the open and efficient operation of exchanges. EXPLORING THE FOREX The term FOREX is derived from “foreign exchange” and is the largest financial market in the world. Unlike most markets, the FOREX market is open 24 hours per day and has an estimated 1.2 trillion in turnover every day. The FOREX market does not have a fixed exchange. It is pri- marily traded through banks, brokers, dealers, financial institutions, and private individuals. A common term in the FOREX arena you will run into is “Interbank.” 348 THE OPTIONS COURSE ccc_fontanills_ch13_347-370.qxd 12/17/04 4:23 PM Page 348 Originally this was just banks and large institutions exchanging informa- tion about the current rate at which their clients or themselves were pre- pared to buy or sell a currency. Now it means anyone who is prepared to buy or sell a currency. It could be two individuals or your local travel agent offering to exchange euros for U.S. dollars. However, you will find that most of the brokers and banks use central- ized feeds to ensure the reliability of a quote. The quotes for bid (buy) and offer (sell) will all be from reliable sources. These quotes are normally made up of the top 300 or so large institutions. This ensures that if they place an order on your behalf that the institutions they have placed the or- der with are capable of fulfilling the order. Just as with other securities on other exchanges, you will see two numbers. The first number is called the bid and the second number is called the ask. For example, using the euro against the U.S. dollar you might see 0.9550/0.9955. The first number is the bid price and is the price at which traders are prepared to buy euros against the U.S. dollar. Spot or cash market FOREX is traditionally traded in lots, also re- ferred to as contracts. The standard size for a lot is $100,000. In the past few years, a mini-lot size has been introduced of $10,000 and this again may change in the years to come. They are measured in pips, which is the smallest increment of that currency. To take advantage of these tiny increments it is desirable to trade large amounts of a particular currency in order to see any significant profit or loss. Leverage financed with credit, such as that purchased on a margin ac- count, is very common in FOREX. A margined account is a leverageable account in which FOREX can be purchased for a combination of cash or collateral depending what your broker will accept. The loan in the mar- gined account is collateralized by your initial margin or deposit. If the value of the trade drops sufficiently, the broker will ask you to either put in more cash, sell a portion of your position, or even close your position. Margin rules may be regulated in some countries, but margin require- ments and interest vary among broker/dealers; so always check with the company you are dealing with to ensure you understand its policy. Although the movement today is toward all transactions eventually finishing with a profit or loss in U.S. dollars, it is important to realize that your profit or loss may not actually be in U.S. dollars. This trend toward U.S. dollars is more pronounced in the United States, as you would ex- pect. Most U.S based traders assume they will see their balance at the end of each day in U.S. dollars Preferably you want a company that is regulated in the country in which it operates, is insured or bonded, and has an excellent track record. As a rule of thumb, nearly all countries have some kind of regu- latory authority that will be able to advise you. Most of the regulatory Processing Your Trade 349 ccc_fontanills_ch13_347-370.qxd 12/17/04 4:23 PM Page 349 authorities will have a list of brokers who fall within their jurisdiction and may provide you with a list. They probably will not tell you who to use but at least if the list came from them, you can have some confi- dence in those companies. Just as with a bank, you are entitled to interest on the money you have on deposit. Some brokers may stipulate that interest is payable only on ac- counts over a certain amount, but the trend today is that you will earn in- terest on any amount you have that is not being used to cover your margin. Your broker is probably not the most competitive place to earn in- terest, but that should not be the point of having your money with them in the first place. Payment on the portion of your account that is not being used, and segregation of funds all go to show the reputability of the com- pany you are dealing with. Policies that are implemented by governments and central banks can play a major role in the FOREX market. Central banks can play an important part in controlling the country’s money supply to ensure finan- cial stability. A large part of FOREX turnover is from banks. Large banks can literally trade billions of dollars daily. This can take the form of a ser- vice to their customers, or they themselves might speculate on the FOREX market. The FOREX market can be extremely liquid, which is why it can be desirable to trade. Hedge funds have increasingly allocated portions of their portfolios to speculate on the FOREX market. Another advantage hedge funds can utilize is a much higher degree of leverage than would typically be found in the equity markets. The FOREX market mainstay is that of international trade. Many com- panies have to import or export goods to different countries all around the world. Payment for these goods and services may be made and re- ceived in different currencies. Many billions of dollars are exchanged daily to facilitate trade. The timing of those transactions can dramatically affect a company’s balance sheet. Although you may not think it, the man in the street also plays a part in today’s FOREX world. Every time he goes on holiday overseas he nor- mally needs to purchase that country’s currency and again change it back into his own currency once he returns. Unwittingly, he is in fact trading currencies. He may also purchase goods and services while overseas and his credit card company has to convert those sales back into his base cur- rency in order to charge him. The key impression I would like to leave you with about the FOREX is that it is more than the combined turnover of all the world’s stock markets on any given day. This makes it a very liquid market and thus an extremely attractive market to trade. 350 THE OPTIONS COURSE ccc_fontanills_ch13_347-370.qxd 12/17/04 4:23 PM Page 350 HISTORY OF OPTIONS Stock options have been trading on organized exchanges for more than 30 years. In 1973, the first U.S. options exchange was founded and call op- tions on 16 securities started trading. A few years later, put options began trading. A decade later, index options appeared on the scene. Today, five exchanges are active in trading options, and annual options trading vol- umes continue to set records. Indeed, over the course of 30 years, from the early 1970s until now, a great deal has changed in the world of options trading. What was once the domain of mostly sophisticated professional investors has turned into a vibrant and dynamic marketplace for investors of all shapes and sizes. The history of organized options trading dates back to the founding of the Chicago Board Options Exchange (CBOE) in 1973. By the end of that year, options had traded on a total of 32 different issues and a little over 1 million contracts traded hands. In 1975, the Securities and Ex- change Commission (SEC) approved the Options Clearing Corporation (OCC), which is still the clearing agent for all U.S based options ex- changes. As clearing agent, the OCC facilitates the execution of options trades by transferring funds, assigning deliveries, and guaranteeing the performance of all obligations. The Securities and Exchange Commission approved the OCC roughly two years after the founding of the first U.S based options exchange. The early 1970s also witnessed other important events related to op- tions trading. For instance, in 1973, Fischer Black and Myron Scholes pre- pared a research paper that outlined an analytic model that would determine the fair market value of call options. Their findings were pub- lished in the Journal of Political Economy and the model became known as the Black-Scholes option pricing model. Today it is still the option pric- ing model most widely used by traders. As more investors began to embrace the use of stock options, other exchanges started trading these investment vehicles. In 1975, both the Philadelphia Stock Exchange (PHLX) and the American Stock Ex- change (AMEX) began trading stock options. In 1976, the Pacific Stock Exchange (PCX) entered the options-trading scene. All three became members of the OCC, and all three still trade options today. In addition, in 1977, the SEC permitted the trading of put options for the first time. In 1975, 18 million option contracts were traded. By 1978, the number had soared to nearly 60 million. The 1980s also saw an explosion in the use of options, which eventu- ally peaked with the great stock market crash of 1987. The Chicago Board Options Exchange launched the first cash-based index in the early 1980s. In 1983, the exchange began trading options on the S&P 100 index (OEX). Processing Your Trade 351 ccc_fontanills_ch13_347-370.qxd 12/17/04 4:23 PM Page 351 The OEX was the first index to have listed options. In 1986, the CBOE Volatility Index (VIX) became the market’s first real-time volatility index. VIX was based on the option prices of the OEX. In 2003, it was modified and is now based on S&P 500 Index (SPX) options. The early 1980s saw a growing interest in both stock and index op- tions. From 1980 until 1987, annual options volume rose from just under 100 million contracts to just over 300 million. After the market crash in October 1987, however, investor enthusiasm for options trading waned and less than 200 million contracts traded in the year 1991, or roughly two-thirds of the peak levels witnessed in 1987. Throughout most of the 1990s, trading activity in the options market improved. In 1990, long-term equity anticipation securities (LEAPS) were introduced. The OCC and the options exchanges created the Options In- dustry Council (OIC) in 1992. The OIC is a nonprofit association created to educate the investing public and brokers about the benefits and risks of exchange-traded options. In 1998, the options industry celebrated its 25th anniversary. In 1999, the American Stock Exchange began trading options on the Nasdaq 100 QQQ (QQQ)—an exchange-traded fund that is among the most actively traded in the marketplace today. That same year, total options volume surpassed one-half million contracts for the first time ever. In the year 2000, a new options exchange arrived on the scene. On May 26, 2000, the International Securities Exchange (ISE) opened for business. It was the first new U.S. exchange in 27 years. In addition, ISE became the first all-electronic U.S. options exchange. In 2001, the options exchanges converted prices from fractions to decimals. In 2003, more than 900 million contracts traded, nearly four times greater than 10 years before. Therefore, despite the three-year downturn in the U.S. stock mar- ket, options trading continued to grow. On February 6, 2004, the Boston Options Exchange (BOX) made its debut as the sixth options exchange and began trading a handful of op- tions contracts. The exchange was the second all-electronic exchange and is already another key player in the burgeoning options market. EVOLUTION OF THE CHICAGO BOARD OPTIONS EXCHANGE The CBOE has had quite an impact on the financial world over the past 31 years. Formed on April 26, 1973, the CBOE changed this country’s and the world’s approach to the markets forever. This new organization introduced the trading universe to standardized options contracts. The 352 THE OPTIONS COURSE ccc_fontanills_ch13_347-370.qxd 12/17/04 4:23 PM Page 352 contract represented 100 shares of stocks with expiration dates attached using various months as their basis. Today the CBOE is the largest options exchange in the United States, trading more than half of all U.S. options and accounting for over 90 per- cent of all index trading. To get to this point, the CBOE has been through many changes and has had a very interesting historical time line. When the Chicago Board of Trade first opened the CBOE, it traded only call options on 16 equities. After four years of operation, put options were finally offered. This caused quite an explosion in option trading ac- tivity in 1977 and moved the SEC to bring to a halt any further options ex- pansion until a formal review could take place. The review, which was designed to protect the customer, lasted until March of 1980. From there the CBOE quickly added option coverage to include 120 equities. Later in that same year (1980) the CBOE and the Midwest Stock Exchange merged their options operations. In March 1983, one of the biggest developments in the CBOE’s history took place. This involved introducing the trading public to options on broad-based stock indexes. The impact was enormous, with the first such index traded being the Standard & Poor’s 100 Index (OEX). This proved to be a very active index, trading an average of more than 130,000 contracts per day in 1983. This surge in trading volume prompted the CBOE to move into its own facilities in 1984, leaving the CBOT behind. The move allowed the CBOE to implement key trading floor technologies enhancing customer service. The major innovation was what was known as the Retail Auto- matic Execution System that facilitated the filling of customer orders at the current bid or ask and reported back all within a matter of seconds. The CBOE launched the Options Institute in 1985 to educate its major customers such as retail account executives and institutional money man- agers. In 1989 options on Treasury securities were introduced. The option values were pegged to changes in the U.S. Treasury yield curve. In 1990, the needs of the conservative options investor were ad- dressed by introducing long-term equity anticipation securities (LEAPS) to the trading public. LEAPS allow investors to create positions that have up to three years until expiration, which makes them particularly attrac- tive to the traditional buy-and-hold investor. In 1992 the CBOE expanded its coverage to include various sectors and foreign markets. This new de- velopment helped customers to better hedge their exposure to these areas as well as allowing investors to participate in different market spaces and the continued globalization of the markets. The growth continued in 1997, adding another cash-settled index based on the Dow Jones Industrial Average, which quickly became the CBOE’s most popular new product. At the same time options on the Processing Your Trade 353 ccc_fontanills_ch13_347-370.qxd 12/17/04 4:23 PM Page 353 [...]... volatility and liquidity In addition, the longer the time your options have until expiration, the wider the spread Floor traders will widen the spread when there is a greater chance of their being wrong due to time, volatility, and volume  370 THE OPTIONS COURSE CONCLUSION The progression of an order through the trading system is a fascinating process It has come a long way from the days in the late 170 0s... option and you either want the stock (if you are long the call) or you want to sell stock you own (if you are long the put), you would exercise your option You would choose to exercise the option as opposed to either buying the stock and selling the call or selling the stock and selling the put if there was no time value in the option (typically if the option is deep in -the- money) You will then get the. .. see if you get the trade filled If you do not get your credit price or at even, try the trade at some other time Do not chase the trade The more volatile the market is, the wider the bid-ask spread will be If the market is pretty quiet that day, the bid-ask spread will be smaller The bid-ask will be smaller for the at -the- money (ATM) options and for the body of the trade and greater for the wings Floor... trading on the exchange floor For this they want something in return the right to make money on the spread The money to be made on the spread comes from the difference between the bid and offer price In the gold example, the reward is $1.00 ($300.50 – $299.50 = $1.00) In addition, being right where the action is allows them to see the order flow Order flow is the buying and selling happening around them They... make their money on the bid/ask spread They are the ones who spend (in many cases) thousands of dollars each month for the privilege of being on the floor of the exchange (or hundreds of thousands to buy a seat) They can either lease the seats—gaining the right to trade as an exchange member—or purchase the seats In addition, they spend each and every day creating liquidity for the investor who is not trading. ..354 THE OPTIONS COURSE Dow Jones Transportation Average and Dow Jones Utility Average were introduced Of course, there are indeed other option exchanges that do exist in the United States such as the American Stock Exchange, the Philadelphia Stock Exchange, and the Pacific Exchange However, by far the CBOE is the options- trading king when one just looks at sheer volume Going forward, the CBOE will... number of high- tech firms Brokers can trade directly from their offices using telephones and continuously revised computerized prices Since they completely bypass the floor traders, they get to keep more of their commissions There are no specialists, either—but there are market makers Their role is to bid and offer certain shares they specialize in, thereby creating liquidity They make their money on the spread the. .. you are trading options By placing a market order, you are assured of getting the trade executed immediately, but at whatever price the floor chooses to charge you! You are, in effect, handing them a blank check In reality, if you are trading a stock or option with much activity, the price that the broker gives you on the phone and the price the stock is trading at by the time the order reaches the floor... recorded on trading cards that are turned in to the pit recorder, who time-stamps and keys the transaction into a computer Some exchanges prefer the use of handheld computers that instantly record the transactions 356 THE OPTIONS COURSE Orders are filled using an open-outcry system in which the buyers (who make bids) and the sellers (who make offers, otherwise known as the ask) come together to execute... was developed in the 1980s and was made mandatory after the 19 87 stock market crash During the crash, market makers were ignoring their posted prices and therefore clients weren’t able to execute their orders This system made it mandatory for market makers to execute orders at the market maker’s displayed price It is for trading with the market makers only and cannot execute to ECNs The small order . understand the risks of trading options. After that, most firms will allow you to fund the account and to begin implementing those options trading strategies that interest you. 344 THE OPTIONS COURSE TABLE. 1 976 , the Pacific Stock Exchange (PCX) entered the options- trading scene. All three became members of the OCC, and all three still trade options today. In addition, in 1 977 , the SEC permitted the. in trading options, and annual options trading vol- umes continue to set records. Indeed, over the course of 30 years, from the early 1 970 s until now, a great deal has changed in the world of options trading.