asset. For instance, a put has a negative delta because as the underlying asset moves higher, the value of the put moves lower.Open interest: The total number of options contracts that have beenopened and not yet closed out.Positive delta: A delta that moves in the same direction as the underlying asset. Calls, for example, have positive deltas because they appreciateas the underlying asset moves higher.Thin spreads: Large gaps between the bids and offers caused by infrequent and illiquid trading. Thin spreads tend to move a great deal and willoften move against the trader once an order is submitted.Time-based adjustment: A type of modification to an options contractthat occurs at regular intervals (five days, two weeks, one month, etc.).Strategists sometimes use time-based adjustments to keep positionsdelta neutral.Variable delta: A delta that changes as the price of the underlying assetmoves higher or lower. Options have variable deltas.
CHAPTER 12
Choosingthe RightBroker
SUMMARYChoosing the right broker can be a difficult task, but it can also prove to beone of the most important trading decisions that you can make. Newtraders will often choose a broker based on the fees charged (i.e., thecheaper, the better). Yet, while keeping trading costs low is an importantfactor to consider, other aspects of the broker’s responsibilities and accessible tools—such as the quality of executions, online tools, and research—can prove equally important over the long run.In this chapter, we hope to help you determine what defines the rightbroker for you. First, it’s important to understand how brokers operate,their roles and responsibilities, and what separates the quality brokersfrom the inferior firms. In addition, there are several different types of brokers. Some offer rock-bottom commissions, but nothing else. Others specialize in a specific investment (stocks, bonds, mutual funds, etc.), andsome offer one-stop shopping to solve a variety of financial needs. Choosing from the wide array of brokers available today often requires a look atyour needs as a trader in order to determine which one is right for you.
QUESTIONS AND EXERCISES1. Define the word broker.________________________________________________________________________________________________________________________149
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2. What is the primary difference between a self-directed broker and afull-service broker?________________________________________________________________________________________________________________________3. When you buy or sell a security through a brokerage firm, you pay______________.A. A commission.B. Interest.C. Nothing.D. None of the above.4. What is an advantage of using an online broker?A. In most cases, you can place trades through a live broker if youneed to.B. Commission costs are cheaper.C. Online brokers often provide a wide range of research, investment tools, and information.D. All of the above.5. A fill is a Wall Street term meaning ______________.A. What traders do on their lunch break.B. The execution (price) of a trade.C. When too many orders are submitted at once.D. The price charged in addition to the commission.6. Many options traders focus on commissions, but ______________ canbe just as important.A. Interest charges.B. Quality of executions.C. Location.D. Freebies.7. Payment for order flow ______________.A. Always leads to the best execution.B. Is often a conflict of interest for the brokerage firm.C. Can lead to poor fills.
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D. A and B.E. B and C.8. The duty of best execution ______________.A. Requires brokerage firms to work for their clients and shop forthe best available prices.B. Is the responsibility of the trader, not the broker.C. Is a rule imposed by the Options Clearing Corporation.D. All of the above.9. If a broker encourages a client to do many trades in order to generatemore commissions, the broker is ______________.A. Churning the account.B. Failing to live up to the duty of best execution.C. Involved in payment for order flow.D. None of the above.10. Front running is ______________.A. A violation of current regulations.B. The practice of trading ahead of customer’s orders.C. The misuse of privileged information.D. All of the above.11. In order to open an options trading account with most brokeragefirms, new customers must ______________.A. Demonstrate a sufficient amount of investment experience.B. Complete the options approval form.C. Have a certain net worth.D. All of the above.12.
SEC stands for the ______________.
MEDIA ASSIGNMENTIn order to learn more about brokers, let’s get online and find some information. There is plenty of free information out there. One starting place isthe brokerage review section at Optionetics.com. To access the site, visit
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www.optionetics.com and look for the tab that says “Broker Review.”From there, you can compare brokers based on commission charges, online trading capabilities, and options usefulness. The brokerage reviewsection provides profiles for a dozen or so leading brokerage firms: thefirms’ online trading capabilities, the commissions, any research toolsavailable, and important tidbits such as telephone numbers, locations, andeach firm’s web site address.After looking through the broker review section, visit the web sites ofsome brokerage firms that interest you. Most brokerage sites offer information about trading demos, charting capabilities, research tools, specialoffers, and other information specific to that brokerage firm. Once youopen a brokerage account, you could be with that firm for many years,even decades. So, take some time in the beginning to find the one that isright for you.Finally, keep an eye out for information about brokerage firms in various news sources. A number of financial publications and web sites alsoconduct annual rankings of brokerage firms. Barron’s provides a regular review of various brokerage firms (see, for instance, the article “Trading Up,”by Theresa Carey, March 8, 2004). In the spring of 2004, the weekly publication picked OptionsXpress as its top online broker. However, the rankingschange from year-to-year. To stay current, look for the latest articles and doa web search using keywords like “best brokers” or “top brokerage firms.”
VOCABULARY LISTBroker
Full-service broker
Broker-assisted trade
Hedge fund
Broker/dealer
Inside information
Churning
Insider trading
Clearinghouse
Institutional investor
Commission
Listed/listing
Discount broker
Live broker
Duty of best execution
National Association of SecuritiesDealers (NASD)
ExecutionFillFront running
Online brokerOptions approval form
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Options Clearing Corporation(OCC)
Securities and ExchangeCommission (SEC)
Order
Self-directed broker
Payment for order flow
Series 7
Privileged information
Ticket
Retail investor
SOLUTIONS1. Define the word broker.Answer: A broker is an individual or entity that is licensed to buyand sell marketplace securities and/or derivatives to traders andinvestors.Discussion: Broker is a term used rather loosely to describe either afirm or an individual that is authorized to trade investment securities.If your next-door neighbor tells you that he or she works as a broker,he or she probably has passed the Series 7 licensing exam, whichgives him or her the authority to take orders for stocks, bonds, andmutual funds. However, brokers must also work with firms that areregulated by the Securities and Exchange Commission and theNational Association of Securities Dealers.2. What is the primary difference between a self-directed broker and afull-service broker?Answer: Full-service brokers offer advice in addition to executingorders. Self-directed brokerage firms are for investors or traders whomake their own decisions.Discussion: A full-service firm can provide you with investment tools,information and advice that is not available at self-directed firms.However, these services come at a cost. In most cases, the cost is inthe form of higher commissions. Therefore, do-it-yourself investorswho are seeking lower commissions often use self-directed firms.3. When you buy or sell a security through a brokerage firm, you pay______________.Answer: A—A commission.Discussion: The primary source of revenue for many brokeragefirms is the commissions from trading. Individual brokers often make
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a living from commissions. When a client buys an investment security, he or she is charged a commission. When the client sells thatsecurity, he or she is also charged a commission.4. What is an advantage of using an online broker?Answer: D—All of the above (in most cases, you can place tradesthrough a live broker if you need to; commission costs are cheaper;online brokers often provide a wide range of research, investmenttools, and information).Discussion: Most online brokers allow you to trade online or througha live broker. Generally, there is a higher commission imposed forbroker-assisted trades. Nevertheless, commissions at online firms aregenerally cheaper than with full-service brokers. In addition, in orderto compete with one another, many online brokerage firms provide awide range of research, investment tools, and information.5. A fill is a Wall Street term meaning ______________.Answer: B—The execution (price) of a trade.Discussion: On Wall Street, the term fill refers to the execution of atrade. For instance, “That was a good fill on my order for IBM calls”or “I was filled on my IBM order at $50 a share.”6. Many options traders focus on commissions, but ______________ canbe just as important.Answer: B—Quality of executions.Discussion: Poor executions can often cost a trader more moneythan higher commissions. Ideally, a trader looks for a broker who willoffer both great executions and rock-bottom commissions. In the realworld, however, there is often a trade-off between the two.7. Payment for order flow ______________.Answer: E—B and C (is often a conflict of interest for the brokeragefirm and can lead to poor fills).Discussion: Payment for order flow describes the practice of sending orders to specific exchanges and receiving a cash payment forthese orders. Brokerage firms that engage in this practice often face aconflict of interest because, since they receive a payment for routingan order to a specific exchange, they might not be sending the orderto the exchange that is showing the best prices. For that reason,clients sometimes don’t get the best executions when brokeragefirms receive payments for orders.
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8. The duty of best execution ______________.Answer: A—Requires brokerage firms to work for their clients andshop for the best available prices.Discussion: Brokerage firms have a duty of best execution, whichrequires them to try to get the best prices on all customer orders. Inthe options market, where options are listed on multiple exchanges,this often involves sending the order to the exchange showing thebest prices.9. If a broker encourages a client to do many trades in order to generatemore commissions, the broker is ______________.Answer: A—Churning the account.Discussion: When a broker encourages a client to make frequent andsometimes unwarranted transactions within the client’s account, thebroker may be guilty of churning the account. This practice is prohibited and, if found guilty, the broker could face disciplinary action.10. Front running is ______________.Answer: D—All of the above (a violation of current regulations, thepractice of trading ahead of customers’ orders, the misuse of privileged information).Discussion: Front running, the practice of trading ahead of a customer’s orders, is generally not an important issue with small orders.However, front running ahead of large orders can be significant. Forinstance, if a trader at a brokerage firm knows that a large institutional client is going to buy a million shares of XYZ, that trader mightbuy XYZ ahead of the order because the stock price will probably goup once the order is executed. However, this type of front running isa violation of current regulations and also represents the misuse ofprivileged information.11. In order to open an options trading account with most brokeragefirms, new customers must ______________.Answer: D—All of the above (demonstrate a sufficient amount ofinvestment experience, complete the options approval form, andhave a certain net worth).Discussion: In order to begin trading options, a new customermust open an account and submit an options approval form.Among other things, brokerage firms look at clients’ experiencelevel and net worth before allowing them to trade options or certainhigh-risk strategies.
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12. SEC stands for the ______________.Answer: Securities and Exchange Commission.Discussion: The Securities and Exchange Commission was createdby Congress to regulate the securities markets and protect investors.It consists of five commissioners appointed by the President of theUnited States and approved by the Senate. Most traders simply referto the commission as the SEC.
MEDIA ASSIGNMENTAfter completing the media assignment in this chapter, readers shouldhave a large amount of information regarding online brokers. The BrokerReview section at www.optionetics.com provides information on the toponline brokerage firms. In addition, after visiting various web sites of theindividual brokers, readers should look for the annual rankings of brokerage firms in Barron’s as well as other financial publications. From there,readers should be able to identify the two or three firms that best meettheir needs, open options trading accounts, and begin trading.
VOCABULARY DEFINITIONSBroker: A person or firm that buys and sells securities for customers. Most brokers charge commissions for executing transactionsfor customers.Broker-assisted trade: A trade that is handled by a live broker. Many online brokerage firms allow customers not only to trade over the Internet,but also to talk to a live broker for assistance.Broker/dealer: Another term used for brokerage firms or brokers.Churning: Excessive trading in a customer’s account by a broker who seeksto increase commissions. The practice is a violation of NASD regulations.Clearinghouse: An institution established separately from the stockexchanges that ensures that the payment and delivery of stocks or optionsis handled accurately and efficiently.Commission: A charge for executing a trade. Most brokerage firmscharge commissions on stock and options transactions.Discount broker: A brokerage firm that offers lower commission ratesthan a full-service broker, but does not offer services such as advice,research, and portfolio planning.
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Duty of best execution: Brokerage firms have the obligation to look forthe best prices for their customers. This often involves executing tradespromptly or sending the order to the exchange that is currently showingthe best quotes.Execution: The process of completing an order to buy or sell a security.Once a trade is executed, it is reported in a confirmation report.Fill: The execution of an order; also, the price at which an order isexecuted.Front running: Broker practice of placing an order ahead of a customer’sorder. This practice can represent a conflict of interest and is prohibited.Full-service broker: A type of stockbroker who provides more thanstock quotes and order execution, including (and not limited to) portfolioplanning and management, investment ideas, and researching specific investments. Since these brokers provide more than order taking and stockquotes, their commissions are higher.Hedge fund: A private investment partnership that can use leverage and derivatives, take both long and short positions, and invest in many markets.Hedge funds can succeed in any market environment, even one with sharplydeclining prices, because they can take advantage of many speculativestrategies, including program trading, swaps, arbitrage, and selling short.Inside information: Relevant information about a company that has notyet been made public. It is illegal for holders of this information to maketrades based on it, however received.Insider trading: Making investment decisions based on information thatis not yet public. Although trading based on this type of inside informationdoes occur, it is against regulations.Institutional investor: A customer at a brokerage firm or an investorthat makes investment decisions for a large financial institution or hedgefund. Examples include portfolio managers, some professional financialadvisers, mutual fund managers, and hedge fund traders.Listed/Listing: Refers to the exchange where an investment trades. Aninvestment is “listed” if it is traded on an exchange. For instance, companies pay fees to be traded on an exchange and must abide by the rules andregulations set out by the exchange to maintain listing privileges.Live broker: A human being who answers calls and takes orders.National Association of Securities Dealers (NASD): The Americanself-regulatory organization of the securities industry responsible for theregulation of Nasdaq and the over-the-counter markets.Online broker: A brokerage firm that allows clients to trade over theInternet using Web-based trading platforms.
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Options approval form: A document that must be completed bytraders before trading options is allowed by a brokerage firm. Brokeragefirms use the form in order to determine if options trading is suitable forthe investor.Options Clearing Corporation (OCC): The clearing entity for all U.S.options exchanges. The OCC is the guarantor and is responsible for ensuring that contracts are fulfilled.Order: A customer request to buy or sell an investment security.Payment for order flow: The practice of routing orders to specific exchanges in return for payments. Various brokerage firms engage 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 portfolio. 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 theInvestment 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 stockbrokers 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 information was handwritten on a piece of paper called a ticket.
CHAPTER 13
ProcessingYourTrade
SUMMARYTrades are executed on exchanges. This chapter explores the processthat a trade goes through from beginning to end. Stocks, futures, and options trades are investigated in depth so that the reader can understandthe extraordinary process a trade goes through to be executed. Additionally, it is essential to master the art of placing orders. This chapter also investigates 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. Nonetheless, 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 EXERCISES1. What are the three primary U.S. stock exchanges?1. _________________________________________________________2. _________________________________________________________3. _________________________________________________________159
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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 futuresexchanges.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 stockexchange.________________________________________________________________________________________________________________________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 commoditiesexchange.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 havethe 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 executedtrade.A. Buy.B. Bid.C. Ask.D. Fill.14. Make a list of important items that need to be specified when placingan 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-askspread 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 ASSIGNMENTIn 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 insight about the development and evolution of options trading in theUnited States.On your next stop, the International Securities Exchange web site includes detailed descriptions of the technology that drives this relativelynew options exchange. It also explains its current structure and membership 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 exchanges trade both stocks and options. Therefore, readers can find information 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 includes 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 LISTExchangeLimit orderMarket makerMarket order
Options Clearing Corporation(OCC)Options Industry Council (OIC)Specialist
SOLUTIONS1. What are the three primary U.S. stock exchanges?Answer: New York Stock Exchange (NYSE), American StockExchange (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 providing 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 Commodity 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 stockexchange.Answer: You call your broker, who passes your order along via Designated 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 commoditiesexchange.Answer: D—Open outcry.Discussion: We all have seen movies where floor traders are screaming 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 something 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 established (1973). Since that time, options volume has grown at an incredible 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 exchanges. With the advent of online trading, hundreds of new companies 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 havethe knowledge to invest your money wisely.Answer: False.Discussion: In any profession, just because you have a license to perform certain functions doesn’t mean you are knowledgeable enoughto make wise choices. This is why it is important to ask the appropriate 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 advent 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 trying to sell various investments. However, it is important to do the appropriate 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 investment 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 placingan order.Answer:1. What kind of order you wish to place.2. The exchange—where the order is to be placed (for futures andoptions).3. Quantity—number of contracts.4. Buy/sell—puts or calls (also include the strike price and expiration).5. Contract—name of the contract