.
B. Decrease.
C. Not affect.
D. None of the above.
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17. ______________ is the ability to use less capital for a larger potential
return but can result in increased risk.
A. Volatility.
B. Liquidity.
C. Flexibility.
D. Leverage.
MEDIA ASSIGNMENT
The next media assignment takes a closer look at margin and margin ac-counts. When investors use margin, they deposit a percentage (normally50 percent) of the cost of the investment security and borrow the rest. Thebrokerage charges the investor interest on the money borrowed. The ad-vantage to buying stocks on margin, however, is that it enables the traderto control a greater amount of an investment with less capital. Therefore,margin equals leverage.
To  learn  more  about  margin  accounts  and  current  trends  related  tomargin,  let’s  visit  the  web  site  of  the  National  Association  of  SecuritiesDealers (NASD). The home page is www.nasd.com. From there, click the“Investor Information” tab. Then choose “Markets & Trading” at the top ofthe page. Finally, click “Margin Information.”
Once inside the Margin Information section of the National Associa-tion of Securities Dealers web site, readers will ﬁnd a wealth of informa-tion  related  to  this  topic.  A  section  called  Understanding  Margin  Accountswalks the reader through real world examples and situations dealing withcustomer margin accounts. The Purchasing on Margin section discusses thepotential risks of using margin. Current and historic levels of margin debtcan be found in the Margin Statistics area of the site. The information at theNASD site offers traders the opportunity to gain a comprehensive under-standing of margin including its potential beneﬁts and pitfalls.
VOCABULARY LIST
Cash account
Cash trade
Federal Reserve
Leverage
Liquidation
Margin
Margin call
Margin debt
Margin requirement
Margin trade
Marginable security
Naked writing
Margin account
Risk
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1. What are the two key elements that characterize attractive trades?
Answer: Limited risk and unlimited reward.Discussion: Worthwhile options trades put a limit on possible losses,but also offer the potential for large rewards. Trades that possess theopposite  characteristics  (i.e.,  unlimited  risks  and  limited  rewards)are generally discouraged.
2. What are the two most important factors in determining the cost of
an investment?Answer: The  size  of  the  transaction  (number  of  shares,  futures,  oroptions) and the risk calculated on the trade.Discussion: The cost of a trade has two components. First, what isthe cash outlay in terms of the number of shares/contracts times themarket prices? Second, what is the possible loss or risk of the trade?Sometimes these two costs can differ signiﬁcantly.
3. A/an ______________ requires you to put up 100 percent of the money
to execute the trade.Answer: B—Cash trade.Discussion: In a cash trade, the investor is required to pay 100 per-cent of the cost of the trade. Since options cannot be purchased onmargin, buying puts and calls is an example of a cash trade.
4. A/an ______________ allows you to put up a percentage of the calcu-
lated amount in cash and the rest is “on account.”Answer: A—Margin trade.Discussion: In a margin account, traders can buy stocks for less thanthe 100 percent required to cover the cost of the trade. For instance,stock traders using margin accounts can buy stocks for 50 percent ofthe  actual  cost  of  the  trade.  Margin  requirements  can  change  overtime, however.
5. ______________  is  deﬁned  as  the  amount  of  cash  required  to  be  ondeposit with your clearing ﬁrm to secure the integrity of the trade.Answer: D—Margin.Discussion: Margin is the amount of money you are required to postto secure a position and the amount a company will lend you againstthe security of the investment you seek to buy.
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6. A/an  ______________  allows  traders  and  investors  to  leverage  their
assets to produce a higher return.Answer: B—Margin account.Discussion: To buy and sell securities using margin, the client mustﬁrst open a margin account with a brokerage ﬁrm.
7. Margin accounts allow traders to extract up to ______________ of the
cash value of their securities.Answer: B—50 percent.Discussion: Currently,  the  margin  requirements  are  50  percent.However,  margin  requirements  can  change  over  time,  so  investorsshould  check  with  their  brokerage  ﬁrms  periodically  before  initiat-ing margin trades.
8. Using a margin account, if you buy 500 shares of XYZ at $100, how
much will this trade cost you, not including commissions?Answer: C—$25,000.Discussion: Buying  500  shares  of  XYZ  at  $100  a  share  would cost  $50,000.  Since  the  margin  requirement  is  50  percent,  or  half,the  trader  pays  $25,000  for  500  shares  if  the  stock  is  purchased on margin.
9. A ______________ from your broker requires you to place additionalfunds in your account. If you do not place these additional funds inyour account, your positions will be liquidated.Answer: D—Margin call.Discussion: A margin call occurs if the equity value in a margin ac-count drops below a certain level. The deposit into the account mustoccur  within  one  business  day.  If  not,  securities  in  the  account  willprobably be sold to cover the 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.Answer: False.Discussion: If your futures side starts losing money, you may get amargin call.
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11.
12.
If  the  ______________  of  your  trade  increases,  then  the  margin  willalso increase.Answer: D—Perceived risk.Discussion: Higher  risk  strategies,  like  naked  call  selling,  havehigher margin requirements. The exact dollar amount will vary fromone brokerage ﬁrm to the next.
If you do not have additional funds to place in your account to covera margin call, your position will be ______________.Answer: B—Liquidated.Discussion: In order to cover a margin call, an investor must eitheradd  more  cash  to  the  account  or  liquidate  some  of  the  holdingswithin the account. The amount that is liquidated will depend on theamount needed to cover the margin call.
13. Based on the rules of the Securities and Exchange Commission andthe  clearing  ﬁrms,  margin  for  stocks  equals  ______________  of  theamount of the trade.Answer: C—50 percent.Discussion: Current  margin  requirements  are  50  percent,  but  areoccasionally subject to change.
14. For stock options, each point of the premium equals ______________.
Answer: B—$100.Discussion: The  multiplier  for  stock  options  is  100.  So  an  optionscontract trading for a premium of 1 is worth $100 a contract.
15. Selling ______________ options, or placing an unprotected trade, has
the highest risk and the highest margin requirements.Answer: A—Naked.Discussion: Naked options writing carries extremely high risk. As aresult, brokerage ﬁrms impose high margin requirements for this typeof trading activity.
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16. Combining  the  buying  and  selling  of  options,  stocks,  and/or  fu-tures  creates  a  more  complex  calculation;  however,  this  will______________ your margin requirements.Answer: B—Decrease.Discussion: In general, more complex strategies that involve buyingand selling options as well as the underlying instrument can reducethe overall risk of the trade. Consequently, the margin requirementsshould be less. However, the margin requirements for complex tradeswill often vary among brokerage ﬁrms.
17. ______________ is the ability to use less capital for a larger potential
return but can result in increased risk.Answer: D—Leverage.Discussion: In the ﬁnancial markets, leverage is using small amountsof money to control a much larger position. Stock options are an ex-ample of leverage because by paying a small premium investors cancontrol a large number of shares.
MEDIA ASSIGNMENT
Margin is a double-edged sword. While it can be used as leverage to gener-ate  higher  returns,  the  effect  of  added  leverage  can  also  lead  to  greaterlosses. Hence, the decision to use margin is ultimately left to the whim ofthe individual trader. Basically, margin results in a higher risk-reward situ-ation.  The  decision  to  use  margin  is  an  important  one  and  therefore  de-serves careful consideration. 
In order to better understand the possible beneﬁts and potential pit-falls of using margin, readers are encouraged to visit the “Margin Infor-mation”  section  of  the  NASD  web  site.  It  probably  offers  the  mostcomprehensive  look  at  margin  available  anywhere.  Real  world  exam-ples  and  situations  help  to  understand  exactly  how  margin  accountswork. In addition, readers will ﬁnd the latest margin statistics, informa-tion on purchasing on margin, as well as potential risks associated withmargin trading.
As  you  can  see,  leverage  will  have  a  signiﬁcant  effect  on  the  risk-reward  outlook  when  50  percent  margin  is  used  to  buy  shares.  For instance, a 25 percent decline in the stock price results in a 50 percentloss  in  the  margin  account.  However,  a  10  percent  gain  in  the  stock
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translates into a 20 percent gain using 50 percent margin. So, the risksare greater and the rewards potential is also higher when investors usemargin to buy stocks.
VOCABULARY DEFINITIONS
Cash account: A type of brokerage account that requires investors to payfor trades in their entirety, which is in contrast to a margin account thatallows customers to use collateral to buy securities.Cash  trade: A  trade  that  must  be  paid  for  in  its  entirety  once  it  is initiated.Federal Reserve: The U.S. central bank that is responsible for monetarypolicy. The Federal Reserve will change interest rates and the money sup-ply in an effort to keep the economy expanding at a reasonable pace.Leverage: Using  a  small  amount  of  capital  to  control  a  much  largeramount  of  capital.  Options  are  an  example  of  a  trading  instrument  thatoffers a high leverage trading approach.Liquidation: When the assets within a portfolio are sold or cashed out.Margin: A deposit made by a trader with a clearinghouse to ensure thathe/she will fulﬁll any ﬁnancial obligations resulting from his or her trades.Margin is the amount of money a company will lend you against the secu-rity of the investment you buy.Margin  account: An  account  in  which  stocks  can  be  purchased  for  acombination of cash and a loan. The loan in the margin account is collat-eralized by the stock, and if the value of the stock drops sufﬁciently, theowner  will  be  asked  to  either  put  in  more  cash  or  sell  a  portion  of  thestock.Margin call: The brokerage’s demand that a customer deposit a speciﬁedamount of money or securities when a purchase is made in a margin ac-count; the amount is expressed as a percentage of the market value of thesecurities at the time of purchase. The deposit must be made within onepayment period.Margin  debt: The total amount of money that has been borrowed frombrokers to pay for margin trades.Margin requirement: The amount of cash an uncovered (naked) optionwriter is required to deposit and maintain to cover the daily position valu-ation and reasonably foreseeable intraday price changes.
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Margin  trade: A  trade  that  is  executed  in  a  margin  account  using  lessthan 100 percent cash to pay for the transaction.Marginable security: An investment that can be used as collateral in amargin account. A brokerage ﬁrm can tell you whether your investmentis  marginable.  Most  exchange-traded  stocks  are,  but  options  contractsare not.Naked writing: Selling options with no hedge or offsetting position.Risk: The potential loss associated with a trade or investment.
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CHAPTER 15
A Short Coursein EconomicAnalyses
SUMMARY
Economists  don’t  often  make  good  traders,  but  having  a  basic  under-standing of economic trends can help make sense of the day-to-day hap-penings  in  the  futures,  bond,  and  stock  markets.  For  instance,  aneconomic  report  can  cause  bond  prices  to  tumble,  interest  rates  toshoot higher, and stock index futures to fall. When the moves are sud-den and short-term in nature, they can cause volatility in the stock mar-ket  to  spike  higher.  However,  long  periods  of  stable  or  falling  interestrates can keep volatility at bay and create a favorable environment forhigher stock prices.
This  chapter  explores  the  relationships  between  interest  rates,  bondprices, and stocks. An important factor to keep in mind is that when inter-est  rates  move  higher,  bond  prices  tumble.  And  when  rates  fall,  bondsrally. In addition, sudden jumps in interest rates can cause money to shiftout of stocks and into interest-bearing investments—which can also makeprices fall in the stock market. However, when interest rates are low, in-vestors are more inclined to look for proﬁts in the stock market, and thattrend can help lift share prices over the long term. In sum, for those read-ers  interested  in  trading  stock  index  options,  index  futures,  and  evenshares of large companies, this chapter is designed to help you by provid-ing a short course in economic analysis.
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QUESTIONS AND EXERCISES
1. The  ______________  has  a  corresponding  futures  contract  that  istraded at the Chicago Board of Trade (CBOT) and reﬂects one veryimportant aspect of many people’s lives: mortgage interest rates.
A. S&P 500.
B. OEX.
C. Ten-year note.
D. Crude oil.
2.
In  a  typical  situation,  if  interest  rates  go  up,  bond  prices______________.
A. Go up.
B. Go down.
C. Stay the same.
D. Go either way—you can never really tell.
3. Bond prices and the stock market should ______________.
A. Go in the same direction.
B. Have an inverse relationship.
C. Go in opposite directions.
D. Have no relationship whatsoever.
4.
interest  rates  go  sideways,  stock  prices  will  probably
If ______________.
A. Rise.
B. Fall.
C. Go sideways.
D. Rise at ﬁrst and then fall steadily.
5. There are periods when a/an ______________ occurs and stock prices
rise regardless of whether interest rates go up or down.
A.
Inverse relationship.
B. Contrarian effect.
C. Divergence.
D. Momentum push.
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6.
If you see interest rates ______________ quickly, you don’t want to bea buyer of stocks.
A.
Increasing.
B. Decreasing.
C.
Increasing sharply and then falling off.
D. Decreasing slowly and then rising.
7.
If  you  ﬁnd  that  interest  rates  are  ______________,  being  a  buyer of  stocks  is  a  good  idea  because  the  stock  market  will  have  an upward bias.
A.
Increasing.
B. Decreasing.
C. Stable or increasing.
D. Stable or decreasing.
MEDIA ASSIGNMENT
In order to better understand economic events, let’s begin tuning in to thehappenings in the bond market. One of the best ways to do this is to watchﬁnancial  TV  news  before  the  start  of  stock  trading.  The  bond  marketopens and closes one hour before the stock market, so bonds begin trad-ing  at  8:30  A.M. New  York  time.  Furthermore,  since  many  economic  re-ports are released before the start of stock trading, the bond market willoften react to news ﬁrst.
So, at 8:30 A.M. Eastern time (that’s 5:30 A.M. for West Coast traders),turn on CNBC and Bloomberg news and look for their reports that comefrom  the  Chicago  Board  of  Trade  (CBOT).  At  the  time  of  this  writing,CNBC offers live coverage of the start of trading on the CBOT every week-day morning one hour before the start of stock trading. The report sum-marizes  the  important  daily  economic  news,  forthcoming  economicreports, and many other economic events (changes in oil prices, changesin interest rates, activity in the currency markets) that can have an impacton both stocks and bonds.
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VOCABULARY LIST
Bond
Bond trader
Interest-bearing security
Inverse relationship
Chicago Board of Trade (CBOT)
Maturity
Correlation
Economist
Fed funds rate
Interest rate
SOLUTIONS
Treasury bill
Treasury bond
Treasury note
Yield
1. The  ______________  has  a  corresponding  futures  contract  that  istraded at the Chicago Board of Trade (CBOT) and reﬂects one veryimportant aspect of many people’s lives: mortgage interest rates.Answer: C—Ten-year note.Discussion: The  Treasury’s  10-year  note  has  become  a  barometerfor  the  performance  of  the  bond  market.  This  bond  is  activelytraded and has a futures contract trading on the CBOT. As this fu-tures  contract  moves  higher,  it  indicates  that  bond  traders  expectthat interest rates, which move opposite to the note, will fall goingforward.  When  the  10-year  note  futures  contract  falls,  it  is  a  signthat  bond  traders  expect  rates  to  rise.  As  rates  rise  and  fall,  thelong-term  trend  can  impact  many  aspects  of  people’s  lives,  includ-ing mortgage rates.
2.
In  a  typical  situation,  if  interest  rates  go  up,  bond  prices______________.Answer: B—Go down.Discussion: Bond prices move opposite to yields or rates. As bondprices fall, rates start moving higher.
3. Bond prices and the stock market should ______________.
Answer: A—Go in the same direction.Discussion: In general, bond prices will move in the same directionas  stock  prices  because  falling  interest  rates  often  bode  well  for
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185
both stocks and bonds. Rising interest rates are considered a nega-tive  for  stocks  and  bonds,  so  if  rates  experience  a  sudden  movehigher, stocks and bonds tend to fall.
4.
interest  rates  go  sideways,  stock  prices  will  probably
If ______________.Answer: A—Rise.Discussion: Over  the  long  haul,  the  path  of  least  resistance  forstocks is to move higher. So, if interest rates are not a factor, stockswill probably head higher.
5. There are periods when a/an ______________ occurs and stock prices
rise regardless of whether interest rates go up or down.Answer: C—Divergence.Discussion: Company  earnings  can  continue  to  improve,  pushingstock  prices  up,  even  if  interest  rates  move  higher.  In  this  case,  adivergence might occur, with stocks rising and bonds falling.
6.
7.
If you see interest rates ______________ quickly, you don’t want to bea buyer of stocks.Answer: A—Increasing.Discussion: Sudden spikes in interest rates often spook investors inthe stock market. Interest-bearing securities like bonds and savingsaccounts become more competitive compared to stocks. At the sametime, higher rates can make stock prices seem more expensive whenusing various valuation models.
If  you  ﬁnd  that  interest  rates  are  ______________,  being  a  buyer of  stocks  is  a  good  idea  because  the  stock  market  will  have  an upward bias.Answer: D—Stable or decreasing.Discussion: Long-term  periods  of  stable  or  falling  interest  rates often  provide  a  favorable  environment  for  higher  stock  prices.Lower  rates  make  money  more  readily  available  for  borrowing, investing,  and  building  successful  businesses.  At  the  same  time, interest-bearing  investments  become  less  attractive  compared  tostocks when rates fall.
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MEDIA ASSIGNMENT
If you have been watching the early morning news reports from the ﬁnan-cial news services like CNBC and Bloomberg TV, you have probably no-ticed that trading in the bond market can become quite chaotic at times.Traders  in  the  bond  pits  are  continually  trying  to  assess  if  interest  ratesare going to move higher or lower, and then buying and selling based onthose expectations. In addition, since so many factors can inﬂuence inter-est  rates  (economic  news,  geopolitical  unrest,  oil  prices,  ﬂuctuations  inthe currency markets, stock prices, etc.), bond traders have a great deal ofinformation to digest.
Yet, while trading in the bond pits can turn frantic, the long-term rela-tionship between stock prices and bonds is fairly clear. Speciﬁcally, peri-ods of long-term bond strength and falling yields are generally bullish forstocks.  Conversely,  when  interest  rates  are  expected  to  move  sharplyhigher,  stocks  have  a  tendency  to  move  lower  and  experience  greatervolatility.  So  changes  in  interest  rates  can  be  important  to  an  optionstrader  because  longer-term  trends  can  have  an  impact  on  both  stockprices and overall levels of market volatility.
VOCABULARY DEFINITIONS
Bond: A debt obligation issued by a government (i.e., Treasury bond) orcorporation  (i.e.,  corporate  bond)  that  promises  to  pay  its  bondholdersperiodic interest at a ﬁxed rate (the coupon) and to repay the principal ofthe  loan  at  maturity  (a  speciﬁed  future  date).  Bonds  are  usually  issuedwith a par or face value of $1,000, representing the principal or amount ofmoney borrowed. The interest payment is stated on the face of the bondat issue.Bond  trader: An  individual  who  works  for  a  ﬁrm  and  buys  and  sellsbonds for clients. Bond traders work via computers or in the trading pitsof the Chicago Board of Trade.Chicago Board of Trade (CBOT): The oldest commodity exchange inthe  United  States,  established  in  1886.  The  exchange  lists  agriculturalcommodity futures such as corn, oats, and soybeans, in addition to morerecent innovations such as ﬁnancial futures.Correlation: The relationship between the prices of two or more invest-ments. For instance, if X moves higher and B moves lower, X and B have anegative correlation. If two assets move in the same direction, they have apositive correlation.
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Economist: Generally,  a  paid  professional,  often  with  a  doctorate  de-gree,  who  makes  forecasts  regarding  the  economy,  interest  rates,  andeconomic activity.Federal funds rate: The short-term interest rate controlled by the Fed-eral Reserve. The Federal Reserve will change this interest rate to stimu-late or cool down the economy.Interest rate: The cost of borrowing money.Interest-bearing security: A type of investment on which earnings bearinterest.  Examples  include  money  markets,  certiﬁcates  of  deposit,  andsavings accounts.Inverse  relationship:  When the prices of two assets move opposite toone another.Maturity: The date on which a bond’s principal is repaid to the investorand interest payments cease. Maturity is the number of years until the prin-cipal amount of a bond is due and payable by the issuer to its bondholders.Treasury bill: Short-term government obligation that matures in 90 daysor less.Treasury bond: Long-term government obligation that has a maturity ofup to 30 years.Treasury note: Government obligation with 5 to 10 years until maturity.Yield: Refers  to  the  annual  interest  on  a  bond  divided  by  the  marketprice of that bond. The current yield is the actual income rate of returnas opposed to the coupon rate or the yield to maturity.
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CHAPTER 16
MasteringtheMarket
SUMMARY
This chapter offers guidelines and suggestions to enhance a trader’s abilityto ﬁnd proﬁtable trades. It introduces several concepts including low risk,time  requirements,  and  risk  tolerance  as  well  as  casting  a  glance  at  riskproﬁles  and  investment  criteria.  In  order  to  become  successful,  tradersneed to ﬁgure out their own risk tolerance. Some of this has to do with theamount  of  capital  available,  and  part  has  to  do  with  time  and  stress.Nonetheless, every trade should consist of a high reward-to-risk ratio, re-sulting in a high probability of success.
Another part of successful trading has to do with money managementand setting up the appropriate system. Since emotions play a huge part intrading, traders are encouraged to avoid emotional trading. Fear and greedmove the markets, but good traders stick to their plans, using preset exitpoints. Exit strategies include time exits, proﬁt exits, and loss exits. It isvery difﬁcult to rid yourself of emotion when trading, but by understand-ing your exits and goals in advance, you can gain control of this detrimentto trading success.
Ultimately, you need to rely on your own knowledge and research tobecome a successful trader. Many who have relied on analyst commentsand  advice  from  self-proclaimed  gurus  have  ultimately  found  failure.There are many companies available to help you learn the rules of trading,including  Optionetics,  but  ultimately  it  is  up  to  you  to  do  the  researchnecessary and to enter and exit a trade correctly.
188
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QUESTIONS AND EXERCISES
1. Name as many elements of a good investment as you can.
____________________________________________________________
____________________________________________________________
____________________________________________________________
____________________________________________________________
2. ______________ of any investment must take into account the fol-lowing elements: potential risk, potential reward, the probability ofsuccess, and how long the investment takes to make