the  trade  as  is,  or  make  an adjustment.Discussion: There  are  advantages  and  disadvantages  to  each  ofthe three courses of action. So, ultimately, the best alternative will
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depend on the speciﬁc situation. Since the key to proﬁtable tradinglies in assessing the available choices, learning the beneﬁts of adjust-ing can help you to become a more proﬁtable trader.
2. An  adjustment  can  be  made  by  ______________  to  offset  your  posi-
tion to bring it back to delta neutral.Answer: D—All of the above (buying or selling options, futures, orstocks).Discussion: Delta  neutral  trades  are  created  by  simultaneouslypurchasing (or selling) the underlying asset (stocks, futures, exchange-traded  funds,  etc.)  along  with  the  purchase  (or  sale)  of  optionscontracts.
3. Name the two sides of a delta neutral trade.
Answer: Hedge and directional bet.Discussion: You can think of a delta neutral position as two trades.The ﬁrst is a directional bet on a market, stock, or futures contract.The other is a hedge in case the directional bet goes awry.
4. Stock has a ______________ delta.
Answer: A—Fixed.Discussion: Delta is the measure of the price change of a derivativerelative to the price change of an underlying asset. The delta of an op-tions contract can change as the price of the underlying asset moveshigher or lower. It varies. However, stocks (and futures contracts) al-ways have a delta equal to 100. If a stock price moves up $1, the posi-tion  increases  in  value  by  $1  times  the  number  of  shares.  It  nevervaries; it is ﬁxed.
5. Options have ______________ deltas.
Answer: B—Variable.Discussion: Each  options  contract  has  a  unique  delta  that  changesover time. It can range between 0 and 100. An option with a high deltawill  move  very  much  like  the  price  of  the  underlying  asset.  For  in-stance,  a  contract  with  a  delta  of  100  will  experience  a  one-to-oneprice  movement  with  the  price  changes  of  the  underlying  asset.Importantly, however, the delta can change over time. It is variable.
6. ATM options are easy to work with because they have ______________.
Answer: C—High liquidity and thin price spreads.Discussion: At-the-money options tend to attract the most amountof interest and are often more liquid than other strike prices for that
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reason.  The  spreads,  or  difference  between  bids  and  offers,  will often be smaller as well. This is especially true for the near-term orfront-month options.
7. Time-based adjustments are based on ______________.
Answer: B—Regular intervals (days, weeks, months, etc.).Discussion: Strategists  sometimes  use  regular  time  intervals  todecide when to adjust a position. For instance, a trader might decideto adjust the position every two weeks. This is an example of a time-based adjustment.
8. Event-based adjustments are most likely to occur ______________.
Answer: A—When a special event dictates the adjustment.Discussion: Some options traders wait for a speciﬁc event to dictatewhen  an  adjustment  should  be  implemented  on  an  open  position.Earnings announcements, takeover talk, and management shake-upsare examples of events that might trigger an adjustment to an openstock option position.
9. What is the key advantage of using an at-the-money option?
Answer: B—It is more likely to have high open interest and liquidity.Discussion: At-the-money options tend to have higher levels of openinterest when compared to other strike prices. High open interest, inturn, is a sign of liquidity and robust levels of trading activity. Theseoptions tend to be more liquid than others.
10. Calls have ___________ deltas.
Answer: C—Positive.Discussion: As  the  price  of  the  underlying  asset  moves  higher,  thecall will appreciate in value. Thus, the call option has a positive delta.Calls move in the same direction as the price of the underlying asset.
11. Puts have ___________ deltas.
Answer: A—Negative.Discussion: As  the  price  of  the  underlying  asset  moves  higher, the put option will lose value. As the price of the underlying assetfalls,  the  put  will  increase  in  value.  Therefore,  puts  have  negativedeltas.  They  move  in  the  opposite  direction  to  the  price  of  the underlying asset.
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MEDIA ASSIGNMENT
In this chapter, readers are encouraged to use the options calculator at theChicago Board Options Exchange to ﬁnd the deltas of a call, a put, a strad-dle, and a long synthetic straddle. Readers should notice that as the stockprice moves higher, the delta of the call increases. Meanwhile, the delta ofthe put also increases (becomes less negative). Using the numbers providedwould produce a table similar to the one shown.
Stock Price
Call Delta
Put Delta
60
70
75
80
0.10
0.39
0.57
0.72
–0.97
–0.63
–0.45
–0.29
The reader is also asked to compute the delta of the straddle when thestock price equals the strike price of 75. At that time, the position wouldhave a delta of +12 (57 – 45). The long synthetic straddle, which would in-clude 100 shares and two puts, would have a positive delta of 100 minus45 minus 45, or +10. Finally, the last question asks to compute the positiondeltas of the straddle and the long synthetic straddle when the stock pricereaches 80. In that case, the straddle would have a delta of 43 (72 – 29)and the long synthetic straddle would have a delta of 42 (100 – 29 – 29).So, what could the strategist do with the long synthetic straddle to movethe position closer to delta neutral? Buy one more put, which would givethe position a delta of only +13.
VOCABULARY DEFINITIONS
Adjustment: Making a change to a trade in order to bring it back to deltaneutral and alter the reward/risk ratio. Traders often make adjustments todelta neutral strategies like long straddles and long synthetic straddles.Directional trade: A trade that requires the underlying asset to move inone direction in order to produce proﬁts. To make a proﬁt, the trader mustdetermine before placing a directional trade which way the asset will go.Buying stocks is an example of a directional bet because the stock pricemust move higher in order to generate proﬁts.Event-based  adjustment: A  type  of  adjustment  to  an  options  contractthat is based on a speciﬁc event like an earnings announcement, a proﬁtreport, or a management change.
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Fixed delta: A delta ﬁgure that does not change due to any price changes.Stocks and futures contracts have a ﬁxed delta of plus or minus 100.Liquidity: The ease with which an asset can be converted to cash in themarketplace. A large number of buyers and sellers and a high volume oftrading activity provide high liquidity. Liquidity is a concern for any moneysthat  may  be  required  on  short  notice,  whether  for  emergencies  or  forplanned purchases.Negative delta: A delta that moves opposite to the price of the underly-ing asset. For instance, a put has a negative delta because as the underly-ing 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 underly-ing 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  infre-quent 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.
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CHAPTER 12
Choosingthe RightBroker
SUMMARY
Choosing 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 acces-sible 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 bro-kers. Some offer rock-bottom commissions, but nothing else. Others spe-cialize  in  a  speciﬁc  investment  (stocks,  bonds,  mutual  funds,  etc.),  andsome offer one-stop shopping to solve a variety of ﬁnancial needs. Choos-ing 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 EXERCISES
1. Deﬁne the word broker.
____________________________________________________________
____________________________________________________________
149
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2. What is the primary difference between a self-directed broker and a
full-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,  invest-
ment 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 ______________ can
be 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  for
the best available prices.
B.
C.
Is the responsibility of the trader, not the broker.
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 ASSIGNMENT
In order to learn more about brokers, let’s get online and ﬁnd some infor-mation. 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, on-line  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 infor-mation 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 vari-ous  news  sources.  A  number  of  ﬁnancial  publications  and  web  sites  alsoconduct annual rankings of brokerage ﬁrms. Barron’s provides a regular re-view of various brokerage ﬁrms (see, for instance, the article “Trading Up,”by Theresa Carey, March 8, 2004). In the spring of 2004, the weekly publica-tion 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 LIST
Broker
Full-service broker
Broker-assisted trade
Hedge fund
Broker/dealer
Churning
Clearinghouse
Commission
Discount broker
Duty of best execution
Execution
Fill
Front running
Inside information
Insider trading
Institutional investor
Listed/listing
Live broker
National Association of SecuritiesDealers (NASD)
Online broker
Options approval form
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Options Clearing Corporation(OCC)
Securities and ExchangeCommission (SEC)
Order
Self-directed broker
Payment for order ﬂow
Privileged information
Retail investor
Series 7
Ticket
SOLUTIONS
1. 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  and investors.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  the National Association of Securities Dealers.
2. What is the primary difference between a self-directed broker and a
full-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  secu-rity, 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 ______________ can
be 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 send-ing  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 prohib-ited 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  privi-leged information).Discussion: Front  running,  the  practice  of  trading  ahead  of  a  cus-tomer’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  institu-tional 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 ASSIGNMENT
After  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 broker-age 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 DEFINITIONS
Broker: A  person  or  ﬁrm  that  buys  and  sells  securities  for  cus-tomers.  Most  brokers  charge  commissions  for  executing  transactionsfor customers.Broker-assisted trade: A trade that is handled by a live broker. Many on-line 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  is executed.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 in-vestments. 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 de-rivatives,  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, compa-nies 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 ensur-ing 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 ex-changes  in  return  for  payments.  Various  brokerage  ﬁrms  engage