Since we do not recommend uncovered selling of options, approvalbeyond level 3 is unnecessary. At that point, traders can use a variety ofsimple  strategies  like  straight  calls  and  puts,  as  well  as  more  complextrades such as spreads, straddles, and collars.
In  order  to  avoid  the  frustration  of  opening  an  account  with  a  ﬁrmthat will not allow trading in more advanced levels, new traders will wantto ﬁnd out the brokerage ﬁrm’s policy regarding options approval beforefunding an account. The best way to do this is to contact the ﬁrm’s optionsapproval  department  by  phone.  If  you  have  little  or  no  experience,  askthem what steps you need to take in order to trade the more complex op-tions strategies (level 3). It sometimes helps to specify which trades (i.e.,spreads,  straddles,  collars,  etc.)  you  intend  to  trade.  Often,  the  ﬁrm  willask you to write a letter or somehow demonstrate that you understand therisks of trading options. After that, most ﬁrms will allow you to fund theaccount and to begin implementing those options trading strategies thatinterest you.
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ROLES AND RESPONSIBILITIES OF ALL BROKERS
Regardless  of  whether  the  broker  charges  high  or  low  commissions,  allbrokers are regulated by the Securities and Exchange Commission (SEC)and are required to meet certain standards when dealing with customers.Speciﬁcally, the Securities Exchange Act of 1934 puts forth certain provi-sions that all brokers must adhere to.
• Duty  of  fair  dealing. This  includes  the  duty  to  execute  orderspromptly, disclosing material information (information that a broker’sclient would consider relevant as an investor), and charge prices thatare in line with those of competitors.
• Duty  of  best  execution. The broker has a responsibility to complete
customer orders at the most favorable market prices possible.
• Customer conﬁrmation rule. The broker must provide the investor withcertain  information  at  or  before  the  execution  of  the  order  (i.e.,  date,time, price, number of shares, commission, and other information).• Disclosure of credit terms. At the time an account is opened, a brokermust provide the customer with the credit terms and, in addition, pro-vide credit customers with account statements quarterly.
• Restriction of short sales. This rule bars an investor from selling anexchange-listed security that they do not own (in other words, sell astock short) unless the sale is above the price of the last trade.
• Trading during offerings. Rule 101 prohibits the broker from buyinga  stock  that  is  being  offered  during  the  “quiet  period”—one  to  ﬁvedays before and up to the offering.
• Restrictions  on  insider  trading. Brokers  have  to  establish  writtenpolicies  and  procedures  to  ensure  that  employees  do  not  misusematerial nonpublic (or inside) information.
WHY PAY HIGH COMMISSIONS?
In a world of low-cost (in some cases, no-cost) trading and strict governmentregulation of brokers, does it ever make sense to pay the high commissionsof a full-service broker? Sometimes it does. While investors are protected toan extent by federal securities laws, they are not protected from poor invest-ment decisions. Investors often lose money in the stock market. There arerisks and, in a world of do-it-yourself investing, the investor is ultimatelyresponsible for ensuring that investment decisions are wise.
The ultimate goal in investing is to preserve capital and improve your ﬁ-nancial well-being. Investors are sometimes uncertain about the risks asso-ciated with an investment. If you are reading this book, you are probably
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not  one  of  them.  But,  at  times,  a  full-service  ﬁrm  can  be  helpful.  For  in-stance, ﬁrms like Merrill Lynch, Morgan Stanley Dean Witter, and Pruden-tial have ﬁnancial advisers or consultants who offer investment advice fora commission or fee. Sometimes paying a higher commission in exchangefor  objective  ﬁnancial  advice  is  sensible.  The  important  element  in  theequation, of course, is being conﬁdent that the information is objective andworthwhile. To ﬁnd out, you can ask the perspective ﬁnancial consultant anumber of questions. The SEC has compiled a list of helpful questions toask which can be accessed at its web site (www.sec.gov).
Sometimes it makes sense to do both—that is, open an account with abrokerage  ﬁrm  to  handle  some  of  your  retirement  savings,  money  youhave saved for an education, or other aspects of your portfolio, and thentake  a  smaller  percentage  to  trade  options  in  a  self-directed  online  ac-count. For example, you might split your portfolio into 75 percent conser-vative  investments  and  25  percent  with  more  aggressive  options  tradeslike long-term bull call spreads.
CONCLUSION
If you are motivated to the point that you want to invest in stocks, ﬁndinga  broker  and  opening  an  account  are  relatively  straightforward  tasks.Over the long run, however, ﬁnding a broker to meet your particular in-vestment needs can prove complicated. If you plan on doing one or twotrades and are not seeking help with respect to your overall ﬁnancial plan,a discount broker who simply executes your orders is appropriate. How-ever, if you are not sure about whether the investment is a wise one, a full-service  broker,  while  charging  higher  commissions,  may  offer  youobjective and worthwhile information. Therefore, the ﬁrst step in select-ing a broker is determining the level of ﬁnancial advice you need, if any.
Regardless of whether you trade one or a hundred times a month, bro-kers  have  a  duty  to  execute  orders  promptly  and  at  the  best  possibleprice. While it is difﬁcult to monitor the brokerage ﬁrm from the time yourorder is submitted until the time it is executed, there are some things youcan do. If you trade actively, monitor the market in real time and watchyour trade take place. In addition, consider submitting limit orders (pricedbetween  the  bid  and  the  offer).  Finally,  if  you  have  a  bad  trade—or  inStreet parlance, a bad ﬁll—contact your broker’s customer service depart-ment and ﬁnd out what happened. If the problem persists, remind them oftheir “duty of best execution.” If that doesn’t work, change brokers.
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ProcessingYourTrade
Most investors never realize the number of steps required for a trade
to occur and the incredible speed involved. Technology has madethis  process  almost  unnoticeable  to  the  average  investor.  Whenyou  contact  your  stock  or  futures  broker,  you  begin  a  process  that,  inmany cases, can be completed in 10 seconds or less, depending on the typeof trade you want to execute. There are various types of orders that areplaced between customers and brokerage ﬁrms. The faster technology be-comes,  the  faster  a  trader’s  order  gets  ﬁlled.  Let’s  take  a  closer  look  atwhat happens when you place an order.
EXCHANGES
Stocks, futures, and options are traded on organized exchanges through-out the world, 24 hours a day. These exchanges establish rules and proce-dures  that  foster  a  safe  and  fair  method  of  determining  the  price  of  asecurity. They also provide an arena for the trading of securities. Over theyears, the various exchanges have had to update themselves with the ever-increasing demands made by huge increases in trading volume. The NewYork  Stock  Exchange  (NYSE)—probably  the  best  known  of  the  ex-changes—not too long ago traded 100 million shares as a high. Today wesee 700, 800, 900 million, and even 1 billion shares trading in a day.
Stocks, futures, and options exchanges are businesses. They providethe public with a place to trade. Each exchange has a unique personalityand  competes  with  other  exchanges  for  business.  This  competitiveness
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keeps  the  exchanges  on  their  toes.  Exchanges  sell  memberships  on  theexchange ﬂoor to brokerage ﬁrms and specialists. They must be able to re-act to the demands of the marketplace with innovative products, services,and technological innovations. If everyone does his or her job, then youwon’t even know where your trade was executed.
In addition, exchanges all over the world are linked together regard-less of different time zones. Prices shift as trading ends in one time zone,moving  activity  to  the  next.  This  global  dynamic  explains  why  sharesclose at one price and open the next day at a completely different price atthe same exchange. With the increased use of electronic trading in globalmarkets, these price movements are more unpredictable than ever before.The primary U.S. stock exchanges are the New York Stock Exchange,the American Stock Exchange (Amex), and Nasdaq. There is a host of oth-ers that do not get as much publicity as the big three. However, each ex-change certainly produces its share of activity. These include the PaciﬁcExchange  in  San  Francisco,  the  Chicago  Stock  Exchange,  the  BostonStock Exchange, and the Philadelphia Stock Exchange. The major inter-national exchanges are in Tokyo, London, Frankfurt, Johannesburg, Syd-ney, Hong Kong, and Singapore.
The primary commodities exchanges include: Chicago Mercantile Ex-change (CME); Chicago Board of Trade (CBOT); New York Mercantile Ex-change  (NYMEX);  COMEX  (New  York);  Kansas  City  Board  of  Trade;Coffee, Cocoa and Sugar Exchange (New York); and the Commodity Ex-change (CEC). The Commodity Futures Trading Commission (CFTC) andthe  National  Futures  Association  (NFA)  currently  regulate  the  nation’scommodity futures industry. Created by the Commodity Futures TradingCommission Act of 1974, the CFTC has ﬁve futures markets commission-ers  who  are  appointed  by  the  U.S.  President  and  subject  to  Senate  ap-proval. The rules of the SEC and the CFTC differ in some areas, but theirgoals remain similar. They are both charged with ensuring the open andefﬁcient operation of exchanges.
EXPLORING THE FOREX
The term FOREX is derived from “foreign exchange” and is the largestﬁnancial market in the world. Unlike most markets, the FOREX marketis  open  24  hours  per  day  and  has  an  estimated  1.2  trillion  in  turnoverevery day. The FOREX market does not have a ﬁxed exchange. It is pri-marily  traded  through  banks,  brokers,  dealers,  ﬁnancial  institutions,and private individuals.
A common term in the FOREX arena you will run into is “Interbank.”
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Originally this was just banks and large institutions exchanging informa-tion about the current rate at which their clients or themselves were pre-pared to buy or sell a currency. Now it means anyone who is prepared tobuy  or  sell  a  currency.  It  could  be  two  individuals  or  your  local  travelagent offering to exchange euros for U.S. dollars.
However, you will ﬁnd that most of the brokers and banks use central-ized feeds to ensure the reliability of a quote. The quotes for bid (buy) andoffer  (sell)  will  all  be  from  reliable  sources.  These  quotes  are  normallymade up of the top 300 or so large institutions. This ensures that if theyplace an order on your behalf that the institutions they have placed the or-der with are capable of fulﬁlling the order.
Just  as  with  other  securities  on  other  exchanges,  you  will  see  twonumbers.  The  ﬁrst  number  is  called  the  bid  and  the  second  number  iscalled  the  ask.  For  example,  using  the  euro  against  the  U.S.  dollar  youmight see 0.9550/0.9955. The ﬁrst number is the bid price and is the priceat which traders are prepared to buy euros against the U.S. dollar.
Spot  or  cash  market  FOREX  is  traditionally  traded  in  lots,  also  re-ferred to as contracts. The standard size for a lot is $100,000. In the pastfew  years,  a  mini-lot  size  has  been  introduced  of  $10,000  and  this  againmay change in the years to come. They are measured in pips, which is thesmallest  increment  of  that  currency.  To  take  advantage  of  these  tinyincrements it is desirable to trade large amounts of a particular currencyin order to see any signiﬁcant proﬁt or loss.
Leverage ﬁnanced with credit, such as that purchased on a margin ac-count, is very common in FOREX. A margined account is a leverageableaccount in which FOREX can be purchased for a combination of cash orcollateral  depending  what  your  broker  will  accept.  The  loan  in  the  mar-gined  account  is  collateralized  by  your  initial  margin  or  deposit.  If  thevalue of the trade drops sufﬁciently, the broker will ask you to either putin more cash, sell a portion of your position, or even close your position.Margin  rules  may  be  regulated  in  some  countries,  but  margin  require-ments and interest vary among broker/dealers; so always check with thecompany you are dealing with to ensure you understand its policy.
Although  the  movement  today  is  toward  all  transactions  eventuallyﬁnishing with a proﬁt or loss in U.S. dollars, it is important to realize thatyour proﬁt or loss may not actually be in U.S. dollars. This trend towardU.S.  dollars  is  more  pronounced  in  the  United  States,  as  you  would  ex-pect.  Most  U.S.-based  traders  assume  they  will  see  their  balance  at  theend of each day in U.S. dollars
Preferably  you  want  a  company  that  is  regulated  in  the  country  inwhich  it  operates,  is  insured  or  bonded,  and  has  an  excellent  trackrecord. As a rule of thumb, nearly all countries have some kind of regu-latory  authority  that  will  be  able  to  advise  you.  Most  of  the  regulatory
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authorities  will  have  a  list  of  brokers  who  fall  within  their  jurisdictionand may provide you with a list. They probably will not tell you who touse  but  at  least  if  the  list  came  from  them,  you  can  have  some  conﬁ-dence in those companies.
Just as with a bank, you are entitled to interest on the money you haveon deposit. Some brokers may stipulate that interest is payable only on ac-counts over a certain amount, but the trend today is that you will earn in-terest  on  any  amount  you  have  that  is  not  being  used  to  cover  yourmargin. Your broker is probably not the most competitive place to earn in-terest, but that should not be the point of having your money with them inthe ﬁrst place. Payment on the portion of your account that is not beingused, and segregation of funds all go to show the reputability of the com-pany you are dealing with.
Policies  that  are  implemented  by  governments  and  central  bankscan play a major role in the FOREX market. Central banks can play animportant part in controlling the country’s money supply to ensure ﬁnan-cial stability.
A  large  part  of  FOREX  turnover  is  from  banks.  Large  banks  can literally trade billions of dollars daily. This can take the form of a ser-vice  to  their  customers,  or  they  themselves  might  speculate  on  theFOREX market.
The FOREX market can be extremely liquid, which is why it can bedesirable  to  trade.  Hedge  funds  have  increasingly  allocated  portions  oftheir  portfolios  to  speculate  on  the  FOREX  market.  Another  advantagehedge  funds  can  utilize  is  a  much  higher  degree  of  leverage  than  wouldtypically be found in the equity markets.
The FOREX market mainstay is that of international trade. Many com-panies  have  to  import  or  export  goods  to  different  countries  all  aroundthe  world.  Payment  for  these  goods  and  services  may  be  made  and  re-ceived  in  different  currencies.  Many  billions  of  dollars  are  exchangeddaily to facilitate trade. The timing of those transactions can dramaticallyaffect a company’s balance sheet.
Although you may not think it, the man in the street also plays a partin today’s FOREX world. Every time he goes on holiday overseas he nor-mally needs to purchase that country’s currency and again change it backinto his own currency once he returns. Unwittingly, he is in fact tradingcurrencies. He may also purchase goods and services while overseas andhis credit card company has to convert those sales back into his base cur-rency in order to charge him.
The key impression I would like to leave you with about the FOREX isthat it is more than the combined turnover of all the world’s stock marketson any given day. This makes it a very liquid market and thus an extremelyattractive market to trade.
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HISTORY OF OPTIONS
Stock options have been trading on organized exchanges for more than 30years.  In  1973,  the  ﬁrst  U.S.  options  exchange  was  founded  and  call  op-tions on 16 securities started trading. A few years later, put options begantrading. A decade later, index options appeared on the scene. Today, ﬁveexchanges  are  active  in  trading  options,  and  annual  options  trading  vol-umes continue to set records. Indeed, over the course of 30 years, fromthe early 1970s until now, a great deal has changed in the world of optionstrading. What was once the domain of mostly sophisticated professionalinvestors has turned into a vibrant and dynamic marketplace for investorsof all shapes and sizes.
The history of organized options trading dates back to the foundingof the Chicago Board Options Exchange (CBOE) in 1973. By the end ofthat year, options had traded on a total of 32 different issues and a littleover  1  million  contracts  traded  hands.  In  1975,  the  Securities  and  Ex-change  Commission  (SEC)  approved  the  Options  Clearing  Corporation(OCC),  which  is  still  the  clearing  agent  for  all  U.S.-based  options  ex-changes. As clearing agent, the OCC facilitates the execution of optionstrades  by  transferring  funds,  assigning  deliveries,  and  guaranteeing  theperformance of all obligations. The Securities and Exchange Commissionapproved the OCC roughly two years after the founding of the ﬁrst U.S.-based options exchange.
The early 1970s also witnessed other important events related to op-tions trading. For instance, in 1973, Fischer Black and Myron Scholes pre-pared  a  research  paper  that  outlined  an  analytic  model  that  woulddetermine the fair market value of call options. Their ﬁndings were pub-lished in the Journal of Political Economy and the model became knownas the Black-Scholes option pricing model. Today it is still the option pric-ing model most widely used by traders.
As more investors began to embrace the use of stock options, otherexchanges started trading these investment vehicles. In 1975, both thePhiladelphia  Stock  Exchange  (PHLX)  and  the  American  Stock  Ex-change (AMEX) began trading stock options. In 1976, the Paciﬁc StockExchange  (PCX)  entered  the  options-trading  scene.  All  three  becamemembers of the OCC, and all three still trade options today. In addition,in 1977, the SEC permitted the trading of put options for the ﬁrst time.In 1975, 18 million option contracts were traded. By 1978, the numberhad soared to nearly 60 million.
The 1980s also saw an explosion in the use of options, which eventu-ally peaked with the great stock market crash of 1987. The Chicago BoardOptions Exchange launched the ﬁrst cash-based index in the early 1980s.In 1983, the exchange began trading options on the S&P 100 index (OEX).
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The  OEX  was  the  ﬁrst  index  to  have  listed  options.  In  1986,  the  CBOEVolatility Index (VIX) became the market’s ﬁrst real-time volatility index.VIX was based on the option prices of the OEX. In 2003, it was modiﬁedand is now based on S&P 500 Index (SPX) options.
The  early  1980s  saw  a  growing  interest  in  both  stock  and  index  op-tions. From 1980 until 1987, annual options volume rose from just under100  million  contracts  to  just  over  300  million.  After  the  market  crash  inOctober  1987,  however,  investor  enthusiasm  for  options  trading  wanedand  less  than  200  million  contracts  traded  in  the  year  1991,  or  roughlytwo-thirds of the peak levels witnessed in 1987.
Throughout most of the 1990s, trading activity in the options marketimproved. In 1990, long-term equity anticipation securities (LEAPS) wereintroduced. The OCC and the options exchanges created the Options In-dustry Council (OIC) in 1992. The OIC is a nonproﬁt association createdto educate the investing public and brokers about the beneﬁts and risksof exchange-traded options. In 1998, the options industry celebrated its25th  anniversary.  In  1999,  the  American  Stock  Exchange  began  tradingoptions on the Nasdaq 100 QQQ (QQQ)—an exchange-traded fund that isamong the most actively traded in the marketplace today. That same year,total  options  volume  surpassed  one-half  million  contracts  for  the  ﬁrsttime ever.
In  the  year  2000,  a  new  options  exchange  arrived  on  the  scene.  OnMay  26,  2000,  the  International  Securities  Exchange  (ISE)  opened  forbusiness. It was the ﬁrst new U.S. exchange in 27 years. In addition, ISEbecame the ﬁrst all-electronic U.S. options exchange. In 2001, the optionsexchanges  converted  prices  from  fractions  to  decimals.  In  2003,  morethan 900 million contracts traded, nearly four times greater than 10 yearsbefore. Therefore, despite the three-year downturn in the U.S. stock mar-ket, options trading continued to grow.
On  February  6,  2004,  the  Boston  Options  Exchange  (BOX)  made  itsdebut  as  the  sixth  options  exchange  and  began  trading  a  handful  of  op-tions contracts. The exchange was the second all-electronic exchange andis already another key player in the burgeoning options market.
EVOLUTION OF THE CHICAGO BOARD OPTIONS EXCHANGE
The CBOE has had quite an impact on the ﬁnancial world over the past31  years.  Formed  on  April  26,  1973,  the  CBOE  changed  this  country’sand the world’s approach to the markets forever. This new organizationintroduced the trading universe to standardized options contracts. The
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contract represented 100 shares of stocks with expiration dates attachedusing various months as their basis.
Today the CBOE is the largest options exchange in the United States,trading more than half of all U.S. options and accounting for over 90 per-cent of all index trading. To get to this point, the CBOE has been throughmany changes and has had a very interesting historical time line.
When  the  Chicago  Board  of  Trade  ﬁrst  opened  the  CBOE,  it  tradedonly call options on 16 equities. After four years of operation, put optionswere ﬁnally offered. This caused quite an explosion in option trading ac-tivity in 1977 and moved the SEC to bring to a halt any further options ex-pansion  until  a  formal  review  could  take  place.  The  review,  which  wasdesigned to protect the customer, lasted until March of 1980. From therethe CBOE quickly added option coverage to include 120 equities. Later inthat same year (1980) the CBOE and the Midwest Stock Exchange mergedtheir options operations.
In March 1983, one of the biggest developments in the CBOE’s historytook  place.  This  involved  introducing  the  trading  public  to  options  onbroad-based stock indexes. The impact was enormous, with the ﬁrst suchindex traded being the Standard & Poor’s 100 Index (OEX). This proved tobe a very active index, trading an average of more than 130,000 contractsper day in 1983.
This  surge  in  trading  volume  prompted  the  CBOE  to  move  into  itsown  facilities  in  1984,  leaving  the  CBOT  behind.  The  move  allowed  theCBOE  to  implement  key  trading  ﬂoor  technologies  enhancing  customerservice.  The  major  innovation  was  what  was  known  as  the  Retail  Auto-matic Execution System that facilitated the ﬁlling of customer orders atthe current bid or ask and reported back all within a matter of seconds.
The CBOE launched the Options Institute in 1985 to educate its majorcustomers such as retail account executives and institutional money man-agers. In 1989 options on Treasury securities were introduced. The optionvalues were pegged to changes in the U.S. Treasury yield curve.
In  1990,  the  needs  of  the  conservative  options  investor  were  ad-dressed  by  introducing  long-term  equity  anticipation  securities  (LEAPS)to the trading public. LEAPS allow investors to create positions that haveup to three years until expiration, which makes them particularly attrac-tive to the traditional buy-and-hold investor. In 1992 the CBOE expandedits coverage to include various sectors and foreign markets. This new de-velopment helped customers to better hedge their exposure to these areasas well as allowing investors to participate in different market spaces andthe continued globalization of the markets.
The  growth  continued  in  1997,  adding  another  cash-settled  indexbased on the Dow Jones Industrial Average, which quickly became theCBOE’s  most  popular  new  product.  At  the  same  time  options  on  the
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Dow Jones Transportation Average and Dow Jones Utility Average wereintroduced.
Of  course,  there  are  indeed  other  option  exchanges  that  do  exist  inthe United States such as the American Stock Exchange, the PhiladelphiaStock Exchange, and the Paciﬁc Exchange. However, by far the CBOE isthe options-trading king when one just looks at sheer volume. Going for-ward, the CBOE will continue to innovate and bring even more productsto the investment community, especially given the continued and growingpopularity of options.
STOCK AND STOCK OPTION ORDERS
If  you  are  trading  the  stock  market,  you  begin  by  placing  an  order  withyour broker, who passes it along to a ﬂoor broker, who then takes it to theappropriate specialist. At this time, the ﬂoor broker may or may not ﬁndanother ﬂoor broker who wants to buy or sell your order. If your brokercannot ﬁll your order, it is left with the specialist who keeps a list of all theunﬁlled orders, matching them up