 in  thiscontroversial practice.Privileged information: Information that is not available to the public.See also Inside information and Insider trading.Retail investor: Individual investor making decisions for a personal port-folio. In contrast to institutional investors who make decisions on behalf ofﬁnancial institutions, retail investors represent individual trading accounts.Securities and Exchange Commission (SEC): A commission createdby Congress to regulate the securities markets and protect investors. It iscomposed of ﬁve commissioners appointed by the President of the UnitedStates and approved by the Senate. The SEC enforces, among other acts,the Securities Act of 1933, the Securities Exchange Act of 1934, the TrustIndenture  Act  of  1939,  the  Investment  Company  Act  of  1940,  and  the Investment Advisers Act of 1940.Self-directed  broker: A  ﬁrm  that  caters  to  brokerage  customers  whomake their own decisions and seek lower commissions.Series  7: An  examination  for  a  license  that  allows  individual  stockbro-kers to serve brokerage customers.Ticket: The details of a trade—number of shares, type of order, prices—that must be submitted for a trade to be executed. In the past, this infor-mation was handwritten on a piece of paper called a ticket.
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CHAPTER 13
ProcessingYourTrade
SUMMARY
Trades  are  executed  on  exchanges.  This  chapter  explores  the  processthat a trade goes through from beginning to end. Stocks, futures, and op-tions trades are investigated in depth so that the reader can understandthe extraordinary process a trade goes through to be executed. Addition-ally, it is essential to master the art of placing orders. This chapter also in-vestigates  the  order  process  itself,  including  guiding  the  reader  throughthis precise process.
There are many variables and terms that are used in the trading ﬁeld.In addition, each broker has his or her own way of doing things. Nonethe-less, by learning the basic concepts and being clear when placing an order,even a new trader can place a complicated trade correctly. Though mosttraders stick to using market and limit orders, it’s a good idea to get a basicunderstanding of the various order-placing terms so that you are aware ofwhat is available for you as a trader.
QUESTIONS AND EXERCISES
1. What are the three primary U.S. stock exchanges?
1. _________________________________________________________
2. _________________________________________________________
3. _________________________________________________________
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2. U.S. exchanges are regulated by the ______________.
A. U.S. Congress.
B. National Stock Exchange Commission.
C. Securities and Exchange Commission.
D. Securities Exchange Act.
3. The  ______________  regulates  the  nation’s  commodity  futures 
exchanges.
A. Commodity Futures Trading Commission.
B. Securities and Exchange Commission.
C. National Commodity Exchange Commission.
D. U.S. Congress.
4. Describe the process your order goes through to get ﬁlled at a stock
exchange.
____________________________________________________________
____________________________________________________________
5. A ______________ is there to create liquidity and narrow the spread.
A. Specialist.
B. Floor broker.
C. Market maker.
D. Exchange ofﬁcer.
6. Orders are ﬁlled by a system of ______________ at a commodities
exchange.
A. Electronic review.
B. Specialists making transaction matches.
C. Market makers creating a market.
D. Open outcry.
7. Floor traders make most of their money on ______________.
A. The bid-ask spread.
B. Commissions.
C. Leasing their seats.
D. All of the above.
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8. The ______________ is the highest-volume stock options exchange.
A. New York Stock Exchange (NYSE).
B. Chicago Board Options Exchange (CBOE).
C. American Stock Exchange (AMEX).
D. Paciﬁc Exchange (San Francisco).
9. A/an ______________ is an individual who is licensed to buy and sellmarketplace  securities  and/or  derivatives  directly  to  traders  andinvestors.
A. Market maker.
B. Speculator.
C. Arbitrageur.
D. Broker.
10. True or False: Someone who is licensed to take an order must have
the knowledge to invest your money wisely.
11. Your broker—as your intermediary—will get paid a/an ______________
for each transaction.
A. Round turn.
B. Arbitrage.
C. Commission.
D. Dividend.
12. True or False: Never make an investment while on the phone with asales call. End the call, and then think about what was told to you anddo your own analysis of risk and reward.
13. A/an ______________ is the price that you are given on an executed
trade.
A. Buy.
B. Bid.
C. Ask.
D. Fill.
14. Make a list of important items that need to be speciﬁed when placing
an order.
1. _________________________________________________________
2. _________________________________________________________
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3. _________________________________________________________
4. _________________________________________________________
5. _________________________________________________________
6. _________________________________________________________
7. _________________________________________________________
15.
If  you  place  a  ______________,  you  will  get  an  immediate  ﬁll  at  thecurrent price.
A. Limit order.
B. Market order.
C. Day order.
D. Stop order.
16.
If you place a ______________, you will have to wait until the priceyou want gets hit before the broker can execute your trade.
A. Limit order.
B. Market order.
C. Day order.
D. Stop order.
17. You  want  to  place  the  following  market  order:  Short  100  Shares  ofIBM @ $87 and Long 2 September IBM 90 ATM Calls. What would youtell your broker?
____________________________________________________________
____________________________________________________________
18. The  more  volatile  the  market  is,  the  ______________  the  bid-ask
spread will be.
A. Narrower.
B. Wider.
C. More consistent.
D. More ﬂuctuating.
19. Floor prices primarily depend on ______________.
A. Your broker’s execution and the exchange.
B. The bid-ask spread and volatility.
C. The bid-ask spread and liquidity.
D. Liquidity and volatility.
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MEDIA ASSIGNMENT
In this chapter’s media assignment, readers are encouraged to learn moreabout  how  options  trades  are  processed  by  visiting  the  web  sites  of  thekey U.S. options exchanges. Today, there are six options exchanges in theUnited  States.  The  two  largest,  the  Chicago  Board  Options  Exchange(CBOE) and the International Securities Exchange (ISE), handle the lion’sshare of the volume. However, all six exchanges have web sites availableto investors. The web sites and addresses are as follows:
Chicago Board Options Exchange 
www.cboe.com
The International Securities Exchange
www.iseoptions.com
The Boston Options Exchange
www.bostonoptions.com
The Philadelphia Stock Exchange 
www.phlx.com
The American Stock Exchange
www.amex.com
The Paciﬁc Stock Exchange
www.paciﬁcex.com
Take a few minutes at each web site and look around. On the ﬁrst stop atthe  Chicago  Board  Options  Exchange  web  site,  pay  special  attention  tothe “About CBOE” area of the site. Within this section, readers will ﬁnd ahistory  of  the  Chicago  Board  Options  Exchange.  Looking  through  thethirty-year history of the ﬁrst organized options exchange gives great in-sight  about  the  development  and  evolution  of  options  trading  in  theUnited States.
On your next stop, the International Securities Exchange web site in-cludes  detailed  descriptions  of  the  technology  that  drives  this  relativelynew options exchange. It also explains its current structure and member-ship  information.  Similarly,  the  Boston  Options  Exchange,  which  is  thenewest exchange, provides detailed descriptions about how this moderntrading mechanism works day-in and day-out.
The remaining three options exchanges also have web sites. These ex-changes trade both stocks and options. Therefore, readers can ﬁnd informa-tion about the stocks and options traded on their web sites. For example,the “At the AMEX” section of the American Stock Exchange’s web site in-cludes information about the structure of the exchange as well as the tradeexecution process. Taken together, readers can ﬁnd a wealth of informationabout how the options market works at the six web sites of the U.S. optionsexchanges,  which  will  also  help  develop  a  good  understanding  about  theoptions trading process.
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VOCABULARY LIST
Exchange
Limit order
Market maker
Market order
SOLUTIONS
Options Clearing Corporation(OCC)
Options Industry Council (OIC)
Specialist
1. What are the three primary U.S. stock exchanges?
Answer: New  York  Stock  Exchange  (NYSE),  American  Stock Exchange (AMEX), Nasdaq.Discussion: These  are  the  main  exchanges  and  the  ones  that  wehear about the most on television and read about in the newspaper.However, there are many other exchanges that play a role in provid-ing liquidity and opportunity for stock, options, and futures traders.
2. U.S. exchanges are regulated by the ______________.Answer: C—Securities and Exchange Commission.Discussion: The SEC has a major role in policing and setting up theappropriate  rules  and  regulations  for  the  marketplace.  There  havebeen  several  acts  passed  by  Congress  that  the  SEC  has  to  enforce.There have been many high-proﬁle cases the past ﬁve years that theSEC has had to oversee.
3. The ____________ regulates the nation’s commodity futures exchanges.
Answer: A—Commodity Futures Trading Commission.Discussion: Similar to the SEC, the CFTC regulates activity in thecommodity  exchanges.  This  commission  was  set  up  by  the  Com-modity Futures Trading Commission Act of 1974 and is made up ofﬁve  commissioners  appointed  by  the  U.S.  President  and  approvedby the Senate.
4. Describe the process your order goes through to get ﬁlled at a stock
exchange.Answer: You call your broker, who passes your order along via Des-ignated Order Turnaround (DOT) or by wire to a ﬂoor broker. DOT isan electronic system on the New York Stock Exchange that is used tosend  small  orders  directly  to  the  specialists’  posts  on  the  tradingﬂoor.  DOT  bypasses  ﬂoor  brokers  and  speeds  up  the  execution  of
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small orders. If your order is sent by wire to a ﬂoor broker, he or shewill immediately try to ﬁll your order or take it directly to a specialist.If the specialist matches your order, you will receive a call from yourbroker with conﬁrmation that your order has been executed.Discussion: The amazing thing about the order process is the speedwith which it happens. If a market order is placed, it takes just a fewseconds  to  get  conﬁrmation  of  the  ﬁll.  Technology  has  made  theprocess extremely fast and efﬁcient.
5. A ______________ is there to create liquidity and narrow the spread.
Answer: C—Market maker.Discussion: A  market  maker  plays  an  important  role  in  the  orderplacing process. Market makers take the opposite side of a trade whenthere isn’t anyone else to take it. This means that traders can get ﬁlledon a stock at any time if they are willing to pay the going price.
6. Orders are ﬁlled by a system of ______________ at a commodities
exchange.Answer: D—Open outcry.Discussion: We all have seen movies where ﬂoor traders are scream-ing and yelling and making hand signals. While this might seem veryunorganized,  the  open  outcry  method  has  worked  for  decades  andcontinues to be the system used at the commodities exchanges.
7. Floor traders make most of their money on ______________.
Answer: A—The bid-ask spread.Discussion: New traders often ask why they can’t buy at the bid andsell at the ask. This is because the ﬂoor traders need to make some-thing for the services they offer. Just like a retail store, they are notgoing to sell something unless they can make a proﬁt.
8. The ______________ is the highest-volume stock options exchange.
Answer: B—Chicago Board Options Exchange (CBOE).Discussion: The  CBOE  was  the  ﬁrst  options  exchange  to  be  estab-lished (1973). Since that time, options volume has grown at an incred-ible  rate.  Although  other  options  exchanges  have  been  created,  theCBOE remains the most popular.
9. A/an  ______________  is  an  individual  who  is  licensed  to  buy  andsell  marketplace  securities  and/or  derivatives  directly  to  tradersand investors.Answer: D—Broker.
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Discussion: A  broker  is  the  liaison  between  a  trader  and  the  ex-changes. With the advent of online trading, hundreds of new compa-nies  have  been  established  that  offer  brokerage  services.  The  hugeincrease in the number of choices often makes it difﬁcult to narrowdown the universe of brokers to the few that you want to use.
10. True or False: Someone who is licensed to take an order must have
the knowledge to invest your money wisely.Answer: False.Discussion: In any profession, just because you have a license to per-form  certain  functions  doesn’t  mean  you  are  knowledgeable  enoughto make wise choices. This is why it is important to ask the appropri-ate  questions  when  interviewing  a  new  broker.  The  Optionetics  sitehas an entire section dedicated to helping traders choose a broker, souse this to your advantage.
11. Your broker—as your intermediary—will get paid a/an ______________
for each transaction.Answer: C—Commission.Discussion: Commissions have come down substantially with the ad-vent of the Internet. Even so, there still are various types of brokers,and their commissions vary widely depending on what services theyoffer.  Online  brokers  charge  small  commissions  if  they  do  nothingother  than  route  the  trade.  Full-service  brokers  charge  considerablymore per transaction because of the various services they offer.
12. True or False: Never make an investment while on the phone with asales call. End the call, and then think about what was told to you anddo your own analysis of risk and reward.Answer: True.Discussion: Individuals get sales calls all the time with the caller try-ing to sell various investments. However, it is important to do the ap-propriate research before investing in any stock or commodity. Don’tbe lured in by promises of riches and wealth. Though some of theseinvestments might be worth a look, take the time to study the invest-ment vehicle before committing your hard-earned cash.
13. A/an ____________ is the price that you are given on an executed trade.
Answer: D—Fill.Discussion: After a trade has been entered, your broker will give you aﬁll price. The ﬁll price could be the price at which a security was boughtor sold. This initial price is the basis for ﬁguring your proﬁts and losses.
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14. Make a list of important items that need to be speciﬁed when placing
an order.Answer:
1. What kind of order you wish to place.
2. The  exchange—where  the  order  is  to  be  placed  (for  futures  and
options).
3. Quantity—number of contracts.
4. Buy/sell—puts or calls (also include the strike price and expiration).
5. Contract—name of the contract.
6. Month—delivery month of the contract.
7. Price—instructions regarding price execution.Discussion: Though  a  trader  doesn’t  need  to  follow  this  exact  for-mat, it is a good idea to develop a system that works well for you andyour broker. Generally, all of these components will need to be partof the order when placed on the phone. Even when using the Inter-net, it is a good idea to have this information written down to makesure no errors are made.
15.
16.
If  you  place  a  ______________,  you  will  get  an  immediate  ﬁll  at  thecurrent price.Answer: B—Market order.Discussion: Market orders are the best-known type of order and areused  frequently  when  trading  stock.  However,  an  options  tradershould use limit orders to avoid getting ﬁlled at a price much differentthan  expected.  Market  orders  should  be  used  only  when  a  traderneeds an immediate ﬁll and is trading a highly liquid security.
If you place a ______________, you will have to wait until the priceyou want gets hit before the broker can execute your trade.Answer: A—Limit order.Discussion: Limit  orders  might  take  a  longer  time  to  ﬁll,  but  theyprotect  traders  from  getting  a  price  they  didn’t  want.  Limit  orderswork  well  when  trading  options  because  liquidity  on  some  optionsmight not be high enough to use market orders.
17. You  want  to  place  the  following  market  order:  Short  100  Shares  ofIBM @ $87 and Long 2 September IBM 90 ATM Calls. What would youtell your broker?Answer: “I want to buy two September/Labor Day IBM at-the-moneycalls and sell 100 shares of IBM at the market.”
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Discussion: The term Labor Day is used to clarify that the month isSeptember  and  not  December.  This  isn’t  necessary,  but  it  helps  en-sure that the broker understands the complete trade. The clearer youare, the better the chance that the trade will be ﬁlled correctly.
18. The  more  volatile  the  market  is,  the  ______________  the  bid-ask
spread will be.Answer: B—Wider.Discussion: High volatility creates high risk for ﬂoor traders. Hence,the higher the risk to the ﬂoor trader, the higher the bid-ask spreadwill be. This is most notable when trading options because volume ismuch lighter for options than for most stocks.
19. Floor prices primarily depend on ______________.
Answer: D—Liquidity and volatility.Discussion: Supply and demand play a major role in the prices forstocks and options. When there isn’t much demand for a stock or op-tion, the bid-ask spread will normally be wider. When volatility is highfor a security, the bid-ask spread will be wider as well. This is why itis important to trade securities with liquidity.
MEDIA ASSIGNMENT
Today, six U.S. options exchanges compete for your trades. Some, like theChicago  Board  Options  Exchange  and  the  American  Stock  Exchange,have been around for quite some time. Others, such as the Boston OptionsExchange  and  the  International  Securities  Exchange,  are  relatively  newplayers  on  the  scene.  The  two  largest,  which  handle  the  majority  of  op-tions volume today, are the Chicago Board Options Exchange and the In-ternational Securities Exchange.
All  six  options  exchanges  have  excellent  web  sites.  In  this  chapter,readers are encouraged to visit each one and pay special attention to thehistory of each exchange as well as the areas of the site that explain howeach is designed or structured. Doing so provides better insight into theworkings and ﬂavor of each exchange, which will also help you to betterunderstand how options trades are processed.
VOCABULARY DEFINITIONS
Exchange: Place where a stock or an option, a future, or other deriva-tive  is  bought  and  sold.  The  best-known  exchange  is  the  New  YorkStock Exchange.
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Limit order: An order to buy a stock at or below a speciﬁed price or tosell  a  stock  at  or  above  a  speciﬁed  price.  For  instance,  you  could  tell  abroker, “Buy me 100 shares of XYZ Corporation at $8 or less” or “Sell 100shares of XYZ at $10 or better.”Market maker: A dealer willing to accept the risk of holding a particularsecurity in his or her own account to facilitate trading in that security. Onthe  over-the-counter  markets,  there  are  individuals  and  companies  thatmaintain bids and offers for stocks. They must be prepared to buy or sellstocks from investors at any time.Market order: An order to buy or sell securities at the price given at thetime the order reaches the market. This can be different from the price onthe broker’s screen, depending on how fast the market is moving. A mar-ket order is to be executed immediately at the best available price, and isthe only order that guarantees execution.Options Clearing Corporation (OCC): Established in 1973, the organi-zation processes and guarantees the standardized options contracts thattrade on the U.S. options exchanges. It is the world’s largest equity deriva-tives clearing organization.Options Industry Council (OIC): A nonproﬁt association created to in-form and educate investors about the beneﬁts of listed options contracts.Formed in 1992, the OIC is sponsored by the major options exchanges andthe Options Clearing Corporation (OCC).Specialist: A  stock  exchange  member  who  stands  ready  to  quote  andtrade certain securities either for his or her own account or for customeraccounts. The specialist’s role is to maintain a fair and orderly market inthe stocks for which he or she is responsible. A trader on the market ﬂooris assigned to ﬁll bids/orders in a speciﬁc stock out of his or her own ac-count when the order has no competing bid/order to ensure a fair and or-derly market.
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CHAPTER 14
MarginandRisk
SUMMARY
Every  investment  or  trade  has  a  potential  risk  and  a  possible  reward.Theoretically, the greater an investment’s risk, the greater the potentialreward.  However,  in  the  options  market,  it  is  possible  to  create  tradesthat  have  relatively  high  rewards,  but  limited  risk.  In  addition,  somestrategies have unlimited risks, but only modest rewards. By the conclu-sion  of  this  book,  the  reader  should  understand  this  relationship  andshould be able to utilize strategies that minimize risk while maximizingpotential rewards.
In this chapter, the basic concepts of risk and margin are explored. Aswe have duly noted, risk is inherent in every trade. There are ways to min-imize it, but risk is always a factor to consider. For example, what is therisk  of  holding  cash?  Is  there  a  risk?  Yes,  the  risk  of  holding  paper  cur-rency is that inﬂation will erode its purchasing power. So, regardless of theinvestment or strategy, risk is one of the most important characteristics ofeach investment’s viability.
Meanwhile,  margin,  which  is  the  amount  of  cash  required  to  be on deposit with a trader’s clearing ﬁrm in order to execute a trade, canalso  alter  the  reward/risk  ratio.  In  this  chapter,  the  reader  will  learnwhat  margin  is  and  how  it  works,  as  well  as  its  key  advantages  and disadvantages.
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QUESTIONS AND EXERCISES
1. What are the two key elements that characterize attractive trades?
1. _________________________________________________________
2. _________________________________________________________
2. What are the two most important factors in determining the cost of
an investment?
1. _________________________________________________________
2. _________________________________________________________
3. A/an ______________ requires you to put up 100 percent of the money
to execute the trade.
A. Margin trade.
B. Cash trade.
C. Open trade.
D. None of the above.
4. A/an ______________ allows you to put up a percentage of the calcu-
lated amount in cash and the rest is “on account.”
A. Margin trade.
B. Cash trade.
C. Open trade.
D. None of the above.
5. ______________  is  deﬁned  as  the  amount  of  cash  required  to  be on  deposit  with  your  clearing  ﬁrm  to  secure  the  integrity  of  thetrade.
A. Deposit.
B. Commission.
C. Adjustment.
D. Margin.
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6. A/an  ______________  allows  traders  and  investors  to  leverage  their
assets to produce a higher return.
A. Cash account.
B. Margin account.
C. Absorption account.
D. Adjunct account.
7. Margin accounts allow traders to extract up to ______________ of the
cash value of their securities.
A. 25 percent.
B. 50 percent.
C. 75 percent.
D. 100 percent.
8. Using a margin account, if you buy 500 shares of XYZ at $100, how
much will this trade cost you, not including commissions?
A. $10,000.
B. $20,000.
C. $25,000.
D. $50,000.
9. A ______________ from your broker requires you to place additionalfunds in your account. If you do not place these additional funds inyour account, your position will be liquidated.
A. Margin ratio.
B. Margin account.
C. Margin requirement.
D. Margin call.
10. True or False: If you are trading delta neutral using futures and op-tions, your margin will be close to zero, which means you will neverget a margin call.
11.
If  the  ______________  of  your  trade  increases,  then  the  margin  willalso increase.
A.
Implied risk.
B. Risk premium.
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C. Risk arbitrage.
D. Perceived risk.
12.
If you do not have additional funds to place in your account to covera margin call, your position will be ______________.
A. Placed on hold.
B. Liquidated.
C. Traded by the brokerage ﬁrm.
D. None of the above.
13. Based on the rules of the Securities and Exchange Commission andthe  clearing  ﬁrms,  margin  for  stocks  equals  ______________  of  theamount of the trade.
A. 25 percent.
B. 35 percent.
C. 50 percent.
D. 75 percent.
14. For stock options, each point equals ______________.
A. $10.
B. $100.
C. $500.
D. An amount that depends on the stock.
15. Selling ______________ options, or placing an unprotected trade, has
the highest risk and the highest margin requirements.
A. Naked.
B. Call.
C. Put.
D. Covered.
16. Combining  the  buying  and  selling  of  options,  stocks,  and/or futures  creates  a  more  complex  calculation;  however,  this  will______________ your margin requirements.
A.
Increase