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Subject: The Investment FAQ (part 5 of 20)

This article was archived around: 21 May 2006 04:23:39 GMT

All FAQs in Directory: investment-faq/general
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Archive-name: investment-faq/general/part5 Version: $Id: part05,v 1.61 2003/03/17 02:44:30 lott Exp lott $ Compiler: Christopher Lott
The Investment FAQ is a collection of frequently asked questions and answers about investments and personal finance. This is a plain-text version of The Investment FAQ, part 5 of 20. The web site always has the latest version, including in-line links. Please browse http://invest-faq.com/ Terms of Use The following terms and conditions apply to the plain-text version of The Investment FAQ that is posted regularly to various newsgroups. Different terms and conditions apply to documents on The Investment FAQ web site. The Investment FAQ is copyright 2003 by Christopher Lott, and is protected by copyright as a collective work and/or compilation, pursuant to U.S. copyright laws, international conventions, and other copyright laws. The contents of The Investment FAQ are intended for personal use, not for sale or other commercial redistribution. The plain-text version of The Investment FAQ may be copied, stored, made available on web sites, or distributed on electronic media provided the following conditions are met: + The URL of The Investment FAQ home page is displayed prominently. + No fees or compensation are charged for this information, excluding charges for the media used to distribute it. + No advertisements appear on the same web page as this material. + Proper attribution is given to the authors of individual articles. + This copyright notice is included intact. Disclaimers Neither the compiler of nor contributors to The Investment FAQ make any express or implied warranties (including, without limitation, any warranty of merchantability or fitness for a particular purpose or use) regarding the information supplied. The Investment FAQ is provided to the user "as is". Neither the compiler nor contributors warrant that The Investment FAQ will be error free. Neither the compiler nor contributors will be liable to any user or anyone else for any inaccuracy, error or omission, regardless of cause, in The Investment FAQ or for any damages (whether direct or indirect, consequential, punitive or exemplary) resulting therefrom. Rules, regulations, laws, conditions, rates, and such information discussed in this FAQ all change quite rapidly. Information given here was current at the time of writing but is almost guaranteed to be out of date by the time you read it. Mention of a product does not constitute an endorsement. Answers to questions sometimes rely on information given in other answers. Readers outside the USA can reach US-800 telephone numbers, for a charge, using a service such as MCI's Call USA. All prices are listed in US dollars unless otherwise specified. Please send comments and new submissions to the compiler. --------------------Check http://invest-faq.com/ for updates------------------ Subject: Derivatives - Black-Scholes Option Pricing Model Last-Revised: 5 Jan 2001 Contributed-By: Kevin Rubash (arr at bradley.edu) The Black and Scholes Option Pricing Model is an approach for calculating the value of a stock option. This article presents some detail about the pricing model. The Black and Scholes Option Pricing Model didn't appear overnight, in fact, Fisher Black started out working to create a valuation model for stock warrants. This work involved calculating a derivative to measure how the discount rate of a warrant varies with time and stock price. The result of this calculation held a striking resemblance to a well-known heat transfer equation. Soon after this discovery, Myron Scholes joined Black and the result of their work is a startlingly accurate option pricing model. Black and Scholes can't take all credit for their work, in fact their model is actually an improved version of a previous model developed by A. James Boness in his Ph.D. dissertation at the University of Chicago. Black and Scholes' improvements on the Boness model come in the form of a proof that the risk-free interest rate is the correct discount factor, and with the absence of assumptions regarding investor's risk preferences. The model is expressed as the following formula. C = S * N(d1) - K * (e ^ -rt) * N (d2) ln (S / K) + (r + (sigma) ^ 2 / 2) * t d1 = -------------------------------------- sigma * sqrt(t) d2 = d1 - sigma * sqrt(t) Where: C = theoretical call premium S = current stock price N = cumulative standard normal distribution t = time until option expiration r = risk-free interest rate K = option strike price e = the constant 2.7183.. sigma = standard deviation of stock returns (usually written as lower-case 's') ln() = natural logarithm of the argument sqrt() = square root of the argument ^ means exponentiation (i.e., 2 ^ 3 = 8) (boy, HTML just isn't much good for formulas!) In order to understand the model itself, we divide it into two parts. The first part, SN(d1), derives the expected benefit from acquiring a stock outright. This is found by multiplying stock price [S] by the change in the call premium with respect to a change in the underlying stock price [N(d1)]. The second part of the model, K(e^-rt)N(d2), gives the present value of paying the exercise price on the expiration day. The fair market value of the call option is then calculated by taking the difference between these two parts. The Black and Scholes Model makes the following assumptions. 1. The stock pays no dividends during the option's life Most companies pay dividends to their share holders, so this might seem a serious limitation to the model considering the observation that higher dividend yields elicit lower call premiums. A common way of adjusting the model for this situation is to subtract the discounted value of a future dividend from the stock price. 2. European exercise terms are used European exercise terms dictate that the option can only be exercised on the expiration date. American exercise term allow the option to be exercised at any time during the life of the option, making american options more valuable due to their greater flexibility. This limitation is not a major concern because very few calls are ever exercised before the last few days of their life. This is true because when you exercise a call early, you forfeit the remaining time value on the call and collect the intrinsic value. Towards the end of the life of a call, the remaining time value is very small, but the intrinsic value is the same. 3. Markets are efficient This assumption suggests that people cannot consistently predict the direction of the market or an individual stock. The market operates continuously with share prices following a continuous Itt process. To understand what a continuous Itt process is, you must first know that a Markov process is "one where the observation in time period t depends only on the preceding observation." An Itt process is simply a Markov process in continuous time. If you were to draw a continuous process you would do so without picking the pen up from the piece of paper. 4. No commissions are charged Usually market participants do have to pay a commission to buy or sell options. Even floor traders pay some kind of fee, but it is usually very small. The fees that individual investors pay is more substantial and can often distort the output of the model. 5. Interest rates remain constant and known The Black and Scholes model uses the risk-free rate to represent this constant and known rate. In reality there is no such thing as the risk-free rate, but the discount rate on U.S. Government Treasury Bills with 30 days left until maturity is usually used to represent it. During periods of rapidly changing interest rates, these 30 day rates are often subject to change, thereby violating one of the assumptions of the model. 6. Returns are lognormally distributed This assumption suggests, returns on the underlying stock are normally distributed, which is reasonable for most assets that offer options. For more detail, visit Kevin Rubash's web page: http://bradley.bradley.edu/~arr/bsm/model.html --------------------Check http://invest-faq.com/ for updates------------------ Subject: Derivatives - Futures Last-Revised: 30 Jan 2001 Contributed-By: Chris Lott ( contact me ) A futures contract is an agreement to buy (or sell) some commodity at a fixed price on a fixed date. In other words, it is a contract between two parties; the holder of the future has not only the right but also the obligation to buy (or sell) the specified commodity. This differs sharply from stock options, which carry the right but not the obligation to buy or sell a stock. These days, all details of a futures contract are standardized, except for the price of course. These details are the commodity, the quantity, the quality, the delivery date, and whether the contract can be settled in goods or in cash. Futures contracts are traded on futures exchanges, of which the U.S. has eight. Futures are commonly available in the following flavors (defined by the underlying "cash" product): * Agricultural commodity futures A commodity future, for example an orange-juice future contract, gives you the right to take delivery of some huge amount of orange juice at a fixed price on some date. Alternately, if you wrote (i.e., sold) the contract, you have the obligation to deliver that OJ to someone. * Foreign currency futures For example, on the Euro. * Stock index futures Since you can't really buy an index, these are settled in cash. * Interest rate futures (including deposit futures, bill futures and government bond futures) Again, since you cannot easily buy an interest rate, these are usually settled in cash as well. Futures are explicitly designed to allow the transfer of risk from those who want less risk to those who are willing to take on some risk in exchange for compensation. A futures instrument accomplishes the transfer of risk by offering several features: * Liquidity * Leverage (a small amount of money controls a much larger amount) * A high degree of correlation between changes in the futures price and changes in price of the underlying commodity. In the case of the commodity future, if I sell you a commodity future then I am promising to deliver a fixed amount of the commodity to you at a given price (fixed now) at a given date in the future. Note that if the price of the future becomes very high relative to the price of the commodity today, I can borrow money to buy the commodity now and sell a futures contract (on margin). If the difference in price between the two is great enough then I will be able to repay the interest and principal on the loan and still have some riskless profit; i.e., a pure arbitrage. Conversely, if the price of the future falls too far below that of the commodity, then I can short-sell the commodity and purchase the future. I can (predumably) borrow the commodity until the futures delivery date and then cover my short when I take delivery of some of the commodity at the futures delivery date. I say presumably borrow the commodity since this is the way bond futures are designed to work; I am not certain that comodities can be borrowed. Note that there are also options on futures! See the article on the basics of stock options for more information on options. Here are a few resources on futures. * The Futures FAQ has quite a bit of information. http://www.ilhawaii.net/~heinsite/FAQs/futuresfaq.html * The Futures Industry Association and the Futures Industry Institute offer many educational materials. http://www.fiafii.org * The Orion Futures Group offers a "Futures 101" primer. http://www.orionfutures.com/fut101.htm --------------------Check http://invest-faq.com/ for updates------------------ Subject: Derivatives - Futures and Fair Value Last-Revised: 11 Apr 2000 Contributed-By: Chris Lott ( contact me ) In the case of futures on equity indexes such as the S&P 500 contract, it is possible to make a careful computation of how much a futures contract should cost (in theory) based on the current market prices of the stocks in the index, current interest rates, how long until the contract expires, etc. This computation yields a theoretical result that is called the fair value of the contract. If the contract trades at prices that are far from the fair value, you can be fairly certain that traders will buy or sell contracts appropriately to exploit the differentce (also called arbitrage). Much of this trading is initiated by program traders; it gets restricted (curbed) when the markets have risen or fallen far during the course of a day. Here are some resources about fair value of equity index futures. * An example from the Chicago Mercantile Exchange about calculating fair value: http://www.cme.com/market/equity/fairvalu.html * A long discussion (case study) about fair value, also from the Chicago Mercantile Exchange: http://www.cme.com/market/fairvalu.html * A few words from one of the program traders. http://www.programtrading.com/fvalue.htm --------------------Check http://invest-faq.com/ for updates------------------ Subject: Derivatives - Stock Option Basics Last-Revised: 26 May 1999 Contributed-By: Art Kamlet (artkamlet at aol.com), Bob Morris, Chris Lott ( contact me ), Larry Kim (lek at cypress.com) An option is a contract between a buyer and a seller. The option is connected to something, such as a listed stock, an exchange index, futures contracts, or real estate. For simplicity, this article will discuss only options connected to listed stocks. Just to be complete, note that there are two basic types of options, the American and European. An American (or American-style) option is an option contract that can be exercised at any time between the date of purchase and the expiration date. Most exchange-traded options are American-Style. All stock options are American style. A European (or European-style) option is an option contract that can only be exercised on the expiration date. Futures contracts (i.e., options on commodities; see the article elsewhere in this FAQ) are generally European-style options. Every stock option is designated by: * Name of the associated stock * Strike price * Expiration date * The premium paid for the option, plus brokers commission. The two most popular types of options are Calls and Puts. We'll cover calls first. In a nutshell, owning a call gives you the right (but not the obligation) to purchase a stock at the strike price any time before the option expires. An option is worthless and useless after it expires. People also sell options without having owned them before. This is called "writing" options and explains (somewhat) the source of options, since neither the company (behind the stock that's behind the option) nor the options exchange issues options. If you have written a call (you are short a call), you have the obligation to sell shares at the strike price any time before the expiration date if you get called . Example: The Wall Street Journal might list an IBM Oct 90 Call at $2.00. Translation: this is a call option. The company associated with it is IBM. (See also the price of IBM stock on the NYSE.) The strike price is 90. In other words, if you own this option, you can buy IBM at US$90.00, even if it is then trading on the NYSE at $100.00. If you want to buy the option, it will cost you $2.00 (times the number of shares) plus brokers commissions. If you want to sell the option (either because you bought it earlier, or would like to write the option), you will get $2.00 (times the number of shares) less commissions. The option in this example expires on the Saturday following the third Friday of October in the year it was purchased. In general, options are written on blocks of 100s of shares. So when you buy "1" IBM Oct 90 Call at $2.00 you actually are buying a contract to buy 100 shares of IBM at $90 per share ($9,000) on or before the expiration date in October. So you have to multiply the price of the option by 100 in nearly all cases. You will pay $200 plus commission to buy this call. If you wish to exercise your option you call your broker and say you want to exercise your option. Your broker will make the necessary requests so that a person who wrote a call option will sell you 100 shares of IBM for $9,000 plus commission. What actually happens is the Chicago Board Options Exchange matches to a broker, and the broker assigns to a specific account. If you instead wish to sell (sell=write) that call option, you instruct your broker that you wish to write 1 Call IBM Oct 90s, and the very next day your account will be credited with $200 less commission. If IBM does not reach $90 before the call expires, you (the option writer) get to keep that $200 (less commission). If the stock does reach above $90, you will probably be "called." If you are called you must deliver the stock. Your broker will sell IBM stock for $9000 (and charge commission). If you owned the stock, that's OK; your shares will simply be sold. If you did not own the stock your broker will buy the stock at market price and immediately sell it at $9000. You pay commissions each way. If you write a Call option and own the stock that's called "Covered Call Writing." If you don't own the stock it's called "Naked Call Writing." It is quite risky to write naked calls, since the price of the stock could zoom up and you would have to buy it at the market price. In fact, some firms will disallow naked calls altogether for some or all customers. That is, they may require a certain level of experience (or a big pile of cash). When the strike price of a call is above the current market price of the associated stock, the call is "out of the money," and when the strike price of a call is below the current market price of the associated stock, the call is "in the money." Note that not all options are available at all prices: certain out-of-the-money options might not be able to be bought or sold. The other common option is the PUT. Puts are almost the mirror-image of calls. Owning a put gives you the right (but not the obligation) to sell a stock at the strike price any time before the option expires. If you have written a put (you are short a put), you have the obligation to buy shares at the strike price any time before the expiration date if you get get assigned . Covered puts are a simple means of locking in profits on the covered security, although there are also some tax implications for this hedging move. Check with a qualified expert. A put is "in the money" when the strike price is above the current market price of the stock, and "out of the money" when the strike price is below the current market price. How do people trade these things? Options traders rarely exercise the option and buy (or sell) the underlying security. Instead, they buy back the option (if they originally wrote a put) or sell the option (if the originally bought a call). This saves commissions and all that. For example, you would buy a Feb 70 call today for $7 and, hopefully, sell it tommorow for $8, rather than actually calling the option (giving you the right to buy stock), buying the underlying stock, then turning around and selling the stock again. Paying commissions on those two stock trades gets expensive. Although options offically expire on the Saturday immediately following the third Friday of the expiration month, for most mortals, that means the option expires the third Friday, since your friendly neighborhood broker or internet trading company won't talk to you on Saturday. The broker-broker settlements are done effective Saturday. Another way to look at the one day difference is this: unlike shares of stock which have a 3-day settlement interval, options settle the next day. In order to settle on the expiration date (Saturday), you have to exercise or trade the option by Friday. While most trades consider only weekdays as business days, the Saturday following the third Friday is a business day for expiring options. The expiration of options contributes to the once-per-quarter "triple-witching day," the day on which three derivative instruments all expire on the same day. Stock index futures, stock index options and options on individual stocks all expire on this day, and because of this, trading volume is usually especially high on the stock exchanges that day. In 1987, the expiration of key index contracts was changed from the close of trading on that day to the open of trading on that day, which helped reduce the volatility of the markets somewhat by giving specialists more time to match orders. You will frequently hear about both volume and open interest in reference to options (really any derivative contract). Volume is quite simply the number of contracts traded on a given day. The open interest is slightly more complicated. The open interest figure for a given option is the number of contracts outstanding at a given time. The open interest increases (you might say that an open interest is created) when trader A opens a new position by buying an option from trader B who did not previously hold a position in that option (B wrote the option, or in the lingo, was "short" the option). When trader A closes out the position by selling the option, the open interest either remain the same or go down. If A sells to someone who did not have a position before, or was already long, the open interest does not change. If A sells to someone who had a short position, the open interest decreases by one. For anyone who is curious, the financial theoreticians have defined the following relationship for the price of puts and calls. The Put-Call parity theorem says: P = C - S + E + D where P = price of put C = price of call S = stock price E = present value of exercise price D = present value of dividends The ordinary investor will occasionally see a violation of put-call parity. This is not an instant buying opportunity, it's a reason to check your quotes for timeliness, because at least one of them is out of date. My personal advice for new options people is to begin by writing covered call options for stocks currently trading below the strike price of the option; in jargon, to begin by writing out-of-the-money covered calls. The following web resources may also help. * For the last word on options, contact The Options Clearing Corporation (CCC) at 1-800-OPTIONS and request their free booklet "Characteristics and Risks of Listed Options." This 94-page publications will give you all the details about options on equity securities, index options, debt options, foreign currency options, principal risks of options positions, and much more. The booklet is published jointly by the American Stock Exchange, The Chicago Board Options Exchange, The Pacific Exchange, and The Philadelphia Stock Exchange. It's available on the web at: http://www.optionsclearing.com/publications/riskstoc.htm * The Chicago Board Options Exchange (CBOE) maintains a web site with extensive information about equity and index options. Visit them at: http://www.cboe.com * The Orion Futures Group offers an "Options 101" primer. http://www.orionfutures.com/opts.htm --------------------Check http://invest-faq.com/ for updates------------------ Subject: Derivatives - Stock Option Covered Calls Last-Revised: 17 July 2000 Contributed-By: Chris Lott ( contact me ), Art Kamlet (artkamlet at aol.com), John Marucco A covered call is a stock call option that is written (i.e., created and sold) by a person who also owns a sufficient number of shares of the stock to cover the option if necessary. In most cases this means that the call writer owns at least 100 shares of the stock for every call written on that stock. The call option, as explained in the article on option basics , grants the holder the right to buy a security at a specific price. The writer of the call option receives a premium and agrees to deliver shares (possibly from his or her holdings, but this is not required) if the option is called. Because the call writer can deliver the shares from his or her holdings, the writer is covered: there is no risk to the call writer of being forced to buy and subsequently deliver shares of the stock at a huge premium due to some fantastic takeover offer (or whatever event that drives up the price). Note the difference between selling something in an opening transaction and selling something in a closing transaction. When you sell a call you already own, you are selling to close a position. When you sell a call you do not own (whether it is covered by a stock position or not), you are selling to open the option position; i.e., you are writing the call. You might compare this with selling stock short, where you are selling to open a position. A call writer is covered in the broker's opinion if the broker has on deposit in the call writer's option account the number of shares needed to cover the call. The call writer might have shares in his or her safe deposit box, or in another broker's account, or in that same broker's cash account -- this makes the investor covered, but not as far as the broker is concerned. So the call writer might consider himself covered, but what will happen if the call is exercised and the shares are not in the appropriate account? Quite simply, the broker will think the call is naked, and will immediately purchase shares to cover. That costs the call writer commissions -- and the writer will still own the shares that were supposed to cover the call! A call is also considered covered if the call writer has an escrow receipt for the stock, owns a call on the same stock with a lower strike price (a spread), or has cash equal to the market value of the stock. But a person who writes a covered call and doesn't have the sahres in the brokerage account might be well advised to check with his or her broker to make sure the broker knows all the details about how the call is covered. While the covered-call writer has no risk of losing huge amounts of money, there is an attendant risk of missing out on large gains. This is pretty simple: if a stock has a large run-up in price, and calls are nearing expiration with a strike price that is even slightly in the money, those calls will be exercised before they expire. I.e., the covered call writer will be forced to deliver shares (known as having the shares "called away"). If the call writer does not want the shares to get called away, he or she can buy back the option if it hasn't been exercised yet. And then the call writer can roll up (higher strike price) or roll over (same strike price, later expiration date), or roll up and over. Of course the shares could be bought on the open market and delivered, but that would get expensive. If you write a covered call and are concerned about indicating specific shares to be delivered in case you are called, it may be possible to have your broker write a note on the call to specify a vs date. The call confirmation might read: "Covered vs. Purchase 4/12/97." In other words the decision on which shares you are covering is made at the time you write the call. This should be more than enough to prove your intent. What your individual broker or brokerage service will do for you is a business matter between them and you. My personal advice for new options people is to begin by writing covered call options for stocks currently trading below the strike price of the option; in jargon, to begin by writing out-of-the-money covered calls. For comprehensive information about covered calls, try this site: http://www.coveredcalls.com --------------------Check http://invest-faq.com/ for updates------------------ Subject: Derivatives - Stock Option Covered Puts Last-Revised: 30 May 2002 Contributed-By: Art Kamlet (artkamlet at aol.com), Chris Lott ( contact me ) A covered put is a stock put option that is written (i.e., created and sold) by a person who also is short (i.e., has borrowed and sold) a sufficient number of shares of the stock to cover the option if necessary. In most cases this means that the put writer is short at least 100 shares of the stock for every put written on that stock. The put option, as explained in the article on option basics , grants the holder the right to sell a security at a specific price. The writer of the put option receives a premium and agrees to buy shares if the option is exercised. For an explanation of what it mans to borrow and sell shares, please see the FAQ article on selling short . Note the difference between selling something in an opening transaction and selling something in a closing transaction. When you sell a put you already own, you are selling to close a position. When you sell a put you do not own, you are selling to open a position. So when you sell a put in an opening transaction (you give an instruction to your broker "Sell 1 put to open"), that is known as writing the put. You might compare this with selling stock short, where you are selling to open a position. If you write a naked put, and the stock price goes way way down, you have incurred a significant loss because you must buy the stock at the strike price, which (in this example) is well above the current price. If you write a covered put, that is you hold a short postion on the underlying stock, then past the strike price the put is covered. For every dollar the stock price goes down, the cost to you of getting put (i.e., of buying the shares because the option gets exercised) is exactly offset by the decrease in the stock you hold short. In other words, for the covered put writer, the shares s/he is put balance the shares s/he will have to deliver to close out the short position in those shares, so it balances out pretty well. The put is covered. Like the covered call, the covered put does not do a thing to protect you against the rise (in this case) in price of the underlying stock you hold short. But if the price of the stock rises, the put itself is safe. So the put writer is covered from loss due to the put. While the covered-put writer has no risk of losing huge amounts of money, there is an attendant risk of missing out on large gains. This is pretty simple: if a stock has a large fall in price, and puts are nearing expiration with a strike price that is even slightly in the money, those puts will be exercised before they expire. I.e., the covered put writer will be forced to buy shares (known as "being put"). --------------------Check http://invest-faq.com/ for updates------------------ Subject: Derivatives - Stock Option Ordering Last-Revised: 25 Jan 96 Contributed-By: Hubert Lee (optionfool at aol.com) When you are dealing in options, order entry is a critical factor in getting good fills. Mis-spoken words during order entry can lead to serious money errors. This article discusses how to place your order properly, and focuses on the simplest type of order, the straight buy or sell. There is a set sequence of wording that Wall Street professionals use among themselves to avoid errors. Orders are always "read" in this fashion. Clerks are trained from day one to listen for and repeat for verification the orders in the same way. If you, the public customer, adopt the same lingo, you'll be way ahead of the game. In addition to preventing errors in your account, you will win the respect of your broker as a savvy, street-wise trader. Here is the "floor-ready" sequence: After identifying yourself and declaring an intent to place an order, clearly say the following: [For a one-sided order (simple buy or sell)] "Buy 10 Calls XYZ February 50's at 1 1/2 to open, for the day" Always start with whether it is a buy or sell. When you do so, the clerk will reach for the appropriate ticket. Next comes the number of contracts. Remember, to determine the money amount of the trade, you multiply this number of contracts by 100 and then by the price of the option. In the above example, 10 x 100 x 1 1/2 = $1,500. Don't ever mention the equivalent number of underlying shares. One client of mine used to always order 1000 contracts when he really meant to buy 10 options (equivalent to 1000 shares of stock). Thirdly, you name the stock. Call it by name first and then state the symbol if you know it. Be aware of similar sounding letters. B, T, D, E etc., can all sound alike in a noisy brokerage office. Over The Counter stocks can have really strange option symbols. The month of expiration comes next. Again, be careful. September and December can sound alike. Floor lingo uses colorful nicknames to differentiate. The "Labor Day" 50s are Sept options while the "Christmas" 50s are the December series. But don't get carried away with trying to use the slang. Don't ever use it to show off to a clerk. Simply use it for accuracy (e.g. "the December as in Christmas 50s"). Then comes the strike price. Read it plainly and clearly. 15 and 50 sound alike as does 50 and 60. Name the limit price or whether it is a market order. Qualify it if it is something other than a limit or market order. For example, 1 1/2 Stop. Pet peeve of many clerks: Don't say "or better" when entering a plain limit order. That is assumed in the definition of a limit order. "Or better" is a designation reserved for a specific instance where one names a price higher than the current market bid-ask as the top price to be paid. For instance, an OEX call is 1 1/2 to 1 5/8 while you are watching the President on CNN. He hints at a budget resolution and you jump on the phone. You want to buy the calls but not with a market order. Instead, you give the floor some room with an "1 7/8 or better order". Clerks use this tag as a courtesy to each other to let them know they realize the current market is actually below the limit price. This saves them a confirming phone call. Next is the position of the trade, that is, to Open or to Close. This is the least understood facet. It has nothing to do with the opening bell or closing bell. It tells the firm if you are establishing a new position (opening) or offsetting an existing one (closing). Don't just think that by saying "Buy", your firm knows you are opening a new position. Remember, options can be shorted. One can buy to open or to close. Likewise, one can sell to open or to close. If your order has any restrictions, place them here at the end. Examples are All or None, Fill or Kill, Immediate or Cancel, Minimum of 15 (or whatever you want). Remember, restricted order have no standing. Unrestricted orders have execution priority. Finally, state if the order is a day order or Good Till Canceled. If you don't say, the broker will assume it to be a day order only, but the client should mention it as a courtesy. Very Important: Your clerk will read the order back to you in the same way for verification. LISTEN CAREFULLY. If you don't catch an error at this point, they can stick you with the trade. Proper order entry can mean the difference between a successful execution and a missed fill or a poor price. Doing it the right way can save you precious seconds. Further, it will mean a better relationship with your broker. The representative will act differently when he sees a customer who knows what he is doing. The measure of respect given to someone who knows how to give an order properly is considerable. After all, you've just proven that you "speak" his language. This article is Copyright 1996 by Hubert Lee. For more insights from Hubert Lee, visit his site: http://www.optionfool.com --------------------Check http://invest-faq.com/ for updates------------------ Subject: Derivatives - Stock Option Splits Last-Revised: 23 Apr 1998 Contributed-By: Art Kamlet (artkamlet at aol.com) When a stock splits, call and put options are adjusted accordingly. In almost every case the Options Clearing Corporation (OCC) has provided rules and procedures so options investors are "made whole" when stocks split. This makes sense since the OCC wishes to maintain a relatively stable and dependable market in options, not a market in which options holders are left holding the bag every time that a company decides to split, spin off parts of itself, or go private. A stock split may involve a simple, integral split such as 2:1 or 3:1, it may entail a slightly more complex (non-integral) split such as 3:2, or it may be a reverse split such as 4:1. When it is an integral split, the option splits the same way, and likewise the strike price. All other splits usually result in an "adjustment" to the option. The difference between a split and an adjusted option, depends on whether the stock splits an integral number of times -- say 2 for 1, in which case you get twice as many of those options for half the strike price. But if XYZ company splits 3 for 2, your XYZ 60s will be adjusted so they cover 150 shares at 40. It's worth reading the article in this FAQ on stock splits , which explains that the owner of record on close of business of the record date will get the split shares, and -- and -- that anyone purchasing at the pre-split price between that time and the actual split buys or sells shares with a "due bill" attached. Now what about the options trader during this interval? He or she does have to be slightly cautious, and know if he is buying options on the pre-split or the post-split version; the options symbol is immediately changed once the split is announced. The options trader and the options broker need to be aware of the old and the new symbol for the option, and know which they are about to trade. In almost every case I have ever seen, when you look at the price of the option it is very obvious if you are looking at options for the pre or post-split shares. Now it's time for some examples. * Example: XYZ Splits 2:1 The XYZ March 60 call splits so the holder now holds 2 March 30 calls. * Example: XYZ Splits 3:2 The XYZ March 60 call is adjusted so that the holder now holds one March $40 call covering 150 shares of XYZ. (The call symbol is adjusted as well.) * Example: XYZ declares a 5% stock dividend. Generally a stock dividend of 10% or less is called a stock dividend and does not result in any options adjustments, while larger stock dividends are called stock splits and do result in options splits or readjustments. (The 2:1 split is really a 100% stock dividend, a 3:2 split is a 50% dividend, and so on.) * Example: ABC declares a 1:5 reverse split The ABC March 10 call is adjusted so the holder now holds one ABC March 50 call covering 20 shares. Spin-offs and buy-outs are handled similarly: * Example: WXY spins off 1 share of QXR for every share of WXY held. Immediately after the spinoff, new WXY trades for 60 and QXR trades for $40. The old WXY March 100 call is adjusted so the holder now holds one call for 100 sh WXY @ 60 plus 100 sh WXY at 40. * Example: XYZ is bought out by a company for $75 in cash, to holders of record as of March 3. Holders of XYZ 70 call options will have their option adjusted to require delivery of $75 in cash, payment to be made on the distribution date of the $75 to stockholders. Note: Short holders of the call options find themselves in the same unenviable position that short sellers of the stock do. In this sense, the options clearing corporation's rules place the options holders in a similar risk position, modulo the leverage of options, that is shared by shareholders. The Options Clearing Corporation's Adjustment Panel has authority to deviate from these guidelines and to rule on unusual events. More information concerning options is available from the Options Clearing Corporation (800-OPTIONS) and may be available from your broker in a pamphlet "Characteristics and Risks of Standardized Options." --------------------Check http://invest-faq.com/ for updates------------------ Subject: Derivatives - Stock Option Symbols Last-Revised: 21 Oct 1997 Contributed-By: Chris Lott ( contact me ) The following symbols are used for the expiration month and price of listed stock options. Month Call Put Jan A M Feb B N Mar C O Apr D P May E Q Jun F R Jul G S Aug H T Sep I U Oct J V Nov K W Dec L X Price Code Price A x05 U 7.5 B x10 V 12.5 C x15 W 17.5 D x20 X 22.5 E x25 F x30 G x35 H x40 I x45 J x50 K x55 L x60 M x65 N x70 O x75 P x80 Q x85 R x90 S x95 T x00 The table above does not illustrate the important fact that price code "A", just to pick one example, could mean any of the following strike prices: $5, $105, $205, etc. This is not so much of a problem with stocks, because they usually split to stay in the $0-$100 range most of the time. However, this is particularly confusing in the case of a security like the S&P 100 index, OEX, for which you might find listings of more than 100 different options spread over several hundred dollars of strike price range. The OEX is priced in the hundreds of dollars and sometimes swings wildly. To resolve the multiple-of-$100 ambiguity in the strike price codes, the CBOE uses new "root symbols" such as OEW to cover a specific $100 range on the S&P 100 index. This is very confusing until you see what's going on. --------------------Check http://invest-faq.com/ for updates------------------ Subject: Derivatives - LEAPs Last-Revised: 30 Dec 1996 Contributed-By: Chris Lott ( contact me ) A Long-term Equity AnticiPation Security, or "LEAP", is essentially an option with a much longer term than traditional stock or index options. Like options, a stock-related LEAP may be a call or a put, meaning that the owner has the right to purchase or sell shares of the stock at a given price on or before some set, future date. Unlike options, the given date may be up to 2.5 years away. LEAP symbols are three alphabetic characters; those expiring in 1998 begin with W, 1999 with V. LEAP is a registered trademark of the Chicago Board Options Exchange. Visit their web site for more information: http://www.cboe.com/ --------------------Check http://invest-faq.com/ for updates------------------ Subject: Education Savings Plans - Section 529 Plans Last-Revised: 25 Jan 2003 Contributed-By: Chris Lott ( contact me ) Tax law changes made in 2001 introduced a college savings plan commonly called a "529 plan" (named after their section in the Internal Revenue Code). These plans allow people to save for college expenses. There are actually two types of 529 plans being offered by different states. One kind is a pre-paid tuition plan; the other is a more general savings vehicle. Participants in pre-paid plans are usually strongly encouraged to use their credits at certain state schools, and might not get full benefits if they choose an out-of-state school. Participants in 529 savings plans can use their funds for any accredited institution in any state. Funds in the account, as in an IRA, grow free of taxes. Contribution limits are high; each state sets its own limits. Very few states impose any income limits (meaning that if you make too much money, you cannot contribute to one of these plans). Anyone can contribute: parents, grandparents, etc. Different versions of 529 plans are offered in all 50 states, and there is no restriction on state residency to use a state's plan. So for example, if you live in Maine, you could invest in Hawaii's 529 plan. However, the benefits may differ depending on the state where you live. So if you are the Maine resident who is considering the Hawaii plan, you should certainly ask about the Maine plan's benefits. Many state plans offer significant benefits to state residents. A resident may pay a lower management fee than an out-of-state plan member. A state resident may be able to deduct 529 contributions from his or her state taxable income, which reduces the amount of state income tax due to their state. Note that companies marketing plans from other states may conveniently "gloss over" these benefits. One feature of these plans that makes them most attractive to many people is the amount of control that the donor retains over the funds. Unlike gifts made under a Uniform Gifts to Minors Act or a Coverdell Education Savings Account, where the minor owns the funds, the intended beneficiary of a 529 plan has no right to the money. In fact, many states allow the donor to revoke the donation and get the money back (although subject to various taxes and penalties). A common complaint about 529 plans is the lack of choice in the investments available for participants. State plans are usually managed by some large financial institution. That institution may choose to offer only load funds or other investments that charge fees higher than the fees on comparable investments available outside the 529 plans. Further, many plans restrict how often funds can be moved among the investment choices, usually only once a year. Withdrawals that are used to pay qualified expenses, including tuition, fees, and certain other expenses are free of tax on any earnings. If the money is withdrawn for any other purpose, both state and federal income tax is due on any earnings, and further Uncle Sam demands a 10% penalty on those earnings. (Of course tax law can change at any time; the tax-free withdrawal provision is currently set to expire in 2010.) These plans are suitable for many families but certainly not all. The implications for financial aid computations are not clear and vary with each educational institution. It's probably safe to say that if you have enough income that you will never qualify for financial aid, then a 529 plan is exactly right for you. If you have determined that a 529 plan is right for you, your job is not done yet. Because there are so many plans out there, and so many sales pitches from brokers and other financial institutions, choosing one can be exceedingly difficult. Some items to research about these plans and alternatives include the contribution limits (how much can you stash away), the advantages you may attain, the range of investment choices, and (last but certainly not least) the fees demanded by the account custodian. You can draw parallels to the big debate over load versus non-load mutual funds without really trying. Here are a few web resources on 529 plans: * Joe Hurley runs Saving For College LLC, a comprehensive guide to 529 plans on the web. http://www.savingforcollege.com * The Motley Fool offers a comparison of Section 529 plans against Coverdell Educational Savings Plans. http://www.fool.com/csc/compare.htm --------------------Check http://invest-faq.com/ for updates------------------ Subject: Education Savings Plans - Coverdell Last-Revised: 25 Jan 2003 Contributed-By: Chris Lott ( contact me ) A Coverdell Education Savings Account (ESA), formerly known as an Education IRA, is a vehicle that assists with saving for education expenses. This article describes the provisions of the US tax code for educational IRAs as of mid 2001, including the changes made by the Economic Recovery and Tax Relief Reconciliation Act of 2001. Funds in an ESA can be used to pay for elementary and secondary education expenses, college or university expenses, private school tuition, etc. I am told that the educational institution must be accredited (which in this case means the school can participate in various financial aid programs), but it does not have to be in the United States. In other words, it appears that it's legal to pay tuition at a foreign school using funds from an ESA as long as the school is accredited. An ESA may be established for any person who is under 18 years of age. Contributions to this account are limited to $2,000 in 2002. Once the beneficiary reaches 18, then no further funds may be contributed. Annual contributions must be made by April 15th of the following year (previously they had to be made by December 31st of the same year). Although anyone may contribute to a minor's ESA, contributions are not tax deductible, and further, contributions may only be made by taxpayers who fall under the limits for adjusted gross income. As with many provisions in the tax code, the limits are phased; the ranges are 95-110K for single filers and 150-160K for joint filers. Also, contributions are not permitted if contributions are made to a state tuition program on behalf of the beneficiary. The major benefit of this savings vehicle is that the funds grow free of all taxes. Distributions that are taken for the purpose of paying qualified educational expenses are not subject to tax, thus saving the beneficiary of paying tax on the fund's growth. Distributions that are used for anything other than qualified educational expenses are treated as taxable income and further are subject to a 10% penalty, unless a permitted exception applies. If the beneficiary reaches age 30 and there are still funds in his or her ESA, they must either be distributed (incurring tax and penalties) or rolled over to benefit another family member. On a related note, changes made in 1997 to the tax code also permit withdrawals of funds from both traditional IRAs and Roth IRAs for paying qualified educational expenses. Basically, the change established an exception so you can avoid the 10% penalty on distributions taken before age 59 1/2 if they are for educational expenses. It is possible to roll over funds from an ESA to a (new as of 2002) 529 plan. A roll-over from an ESA plan to a 529 plan is free of tax and penalty as it is completed within 60 days and the account beneficiary is the same. The rules for ESAs changed in mid 2001 in the following ways: * The contribution limit rises from $500 to $2,000 in 2002. * Starting in 2002, funds can be used to pay for elementary and secondary education, not just college/university, including private schools. * Income limits on those who can fund an ESA rise: married filers will be limited starting at $190,000 starting in 2002. --------------------Check http://invest-faq.com/ for updates------------------ Subject: Exchanges - The American Stock Exchange Last-Revised: 19 Jan 2000 Contributed-By: Chris Lott ( contact me ) The American Stock Exchange (AMEX) lists over 700 companies and is the world's second largest auction-marketplace. Like the NYSE (the largest auction marketplace), the AMEX uses an agency auction market system which is designed to allow the public to meet the public as much as possible. In other words, a specialist helps maintain liquidity. Regular listing requirements for the AMEX include pre-tax income of $750,000 in the latest fiscal year or 2 of most recent 3 years, a market value of public float of at least $3,000,000, a minimum price of $3, and a minimum stockholder's equity of $4,000,000. In 1998, a merger between the NASD and the AMEX resulted in the Nasdaq-Amex Market Group. For more information, visit their home page: http://www.amex.com --------------------Check http://invest-faq.com/ for updates------------------ Subject: Exchanges - The Chicago Board Options Exchange Last-Revised: 19 Jan 2000 Contributed-By: Chris Lott ( contact me ) The Chicago Board Options Exchange (CBOE) was created by the Chicago Board of Trade in 1973. The CBOE essentially defined for the first time standard, listed stock options and established fair and orderly markets in stock option trading. As of this writing, the CBOE lists options on over 1,200 widely held stocks. In addition to stock options, the CBOE lists stock index options (e.g., the S&P 100 Index Option, abbreviated OEX), interest rate options, long-term options called LEAPS, and sector index options. Trading happens via a market-maker system. For more information, visit the home page: http://www.cboe.com --------------------Check http://invest-faq.com/ for updates------------------ Compilation Copyright (c) 2003 by Christopher Lott.