.6. Month—delivery month of the contract.7. Price—instructions regarding price execution.Discussion: Though a trader doesn’t need to follow this exact format, it is a good idea to develop a system that works well for you andyour broker. Generally, all of these components will need to be partof the order when placed on the phone. Even when using the Internet, it is a good idea to have this information written down to makesure no errors are made.15. If you place a ______________, you will get an immediate fill at thecurrent price.Answer: B—Market order.Discussion: Market orders are the best-known type of order and areused frequently when trading stock. However, an options tradershould use limit orders to avoid getting filled at a price much differentthan expected. Market orders should be used only when a traderneeds an immediate fill and is trading a highly liquid security.16. If you place a ______________, you will have to wait until the priceyou want gets hit before the broker can execute your trade.Answer: A—Limit order.Discussion: Limit orders might take a longer time to fill, but theyprotect traders from getting a price they didn’t want. Limit orderswork well when trading options because liquidity on some optionsmight not be high enough to use market orders.17. You want to place the following market order: Short 100 Shares ofIBM @ $87 and Long 2 September IBM 90 ATM Calls. What would youtell your broker?Answer: “I want to buy two September/Labor Day IBM at-the-moneycalls and sell 100 shares of IBM at the market.”
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Discussion: The term Labor Day is used to clarify that the month isSeptember and not December. This isn’t necessary, but it helps ensure that the broker understands the complete trade. The clearer youare, the better the chance that the trade will be filled correctly.18. The more volatile the market is, the ______________ the bid-askspread will be.Answer: B—Wider.Discussion: High volatility creates high risk for floor traders. Hence,the higher the risk to the floor trader, the higher the bid-ask spreadwill be. This is most notable when trading options because volume ismuch lighter for options than for most stocks.19. Floor prices primarily depend on ______________.Answer: D—Liquidity and volatility.Discussion: Supply and demand play a major role in the prices forstocks and options. When there isn’t much demand for a stock or option, the bid-ask spread will normally be wider. When volatility is highfor a security, the bid-ask spread will be wider as well. This is why itis important to trade securities with liquidity.
MEDIA ASSIGNMENTToday, six U.S. options exchanges compete for your trades. Some, like theChicago Board Options Exchange and the American Stock Exchange,have been around for quite some time. Others, such as the Boston OptionsExchange and the International Securities Exchange, are relatively newplayers on the scene. The two largest, which handle the majority of options volume today, are the Chicago Board Options Exchange and the International Securities Exchange.All six options exchanges have excellent web sites. In this chapter,readers are encouraged to visit each one and pay special attention to thehistory of each exchange as well as the areas of the site that explain howeach is designed or structured. Doing so provides better insight into theworkings and flavor of each exchange, which will also help you to betterunderstand how options trades are processed.
VOCABULARY DEFINITIONSExchange: Place where a stock or an option, a future, or other derivative is bought and sold. The best-known exchange is the New YorkStock Exchange.
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Limit order: An order to buy a stock at or below a specified price or tosell a stock at or above a specified price. For instance, you could tell abroker, “Buy me 100 shares of XYZ Corporation at $8 or less” or “Sell 100shares of XYZ at $10 or better.”Market maker: A dealer willing to accept the risk of holding a particularsecurity in his or her own account to facilitate trading in that security. Onthe over-the-counter markets, there are individuals and companies thatmaintain bids and offers for stocks. They must be prepared to buy or sellstocks from investors at any time.Market order: An order to buy or sell securities at the price given at thetime the order reaches the market. This can be different from the price onthe broker’s screen, depending on how fast the market is moving. A market order is to be executed immediately at the best available price, and isthe only order that guarantees execution.Options Clearing Corporation (OCC): Established in 1973, the organization processes and guarantees the standardized options contracts thattrade on the U.S. options exchanges. It is the world’s largest equity derivatives clearing organization.Options Industry Council (OIC): A nonprofit association created to inform and educate investors about the benefits of listed options contracts.Formed in 1992, the OIC is sponsored by the major options exchanges andthe Options Clearing Corporation (OCC).Specialist: A stock exchange member who stands ready to quote andtrade certain securities either for his or her own account or for customeraccounts. The specialist’s role is to maintain a fair and orderly market inthe stocks for which he or she is responsible. A trader on the market flooris assigned to fill bids/orders in a specific stock out of his or her own account when the order has no competing bid/order to ensure a fair and orderly market.
CHAPTER 14
MarginandRisk
SUMMARYEvery investment or trade has a potential risk and a possible reward.Theoretically, the greater an investment’s risk, the greater the potentialreward. However, in the options market, it is possible to create tradesthat have relatively high rewards, but limited risk. In addition, somestrategies have unlimited risks, but only modest rewards. By the conclusion of this book, the reader should understand this relationship andshould be able to utilize strategies that minimize risk while maximizingpotential rewards.In this chapter, the basic concepts of risk and margin are explored. Aswe have duly noted, risk is inherent in every trade. There are ways to minimize it, but risk is always a factor to consider. For example, what is therisk of holding cash? Is there a risk? Yes, the risk of holding paper currency is that inflation will erode its purchasing power. So, regardless of theinvestment or strategy, risk is one of the most important characteristics ofeach investment’s viability.Meanwhile, margin, which is the amount of cash required to beon deposit with a trader’s clearing firm in order to execute a trade, canalso alter the reward/risk ratio. In this chapter, the reader will learnwhat margin is and how it works, as well as its key advantages anddisadvantages.
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QUESTIONS AND EXERCISES1. What are the two key elements that characterize attractive trades?1. _________________________________________________________2. _________________________________________________________2. What are the two most important factors in determining the cost ofan investment?1. _________________________________________________________2. _________________________________________________________3. A/an ______________ requires you to put up 100 percent of the moneyto execute the trade.A. Margin trade.B. Cash trade.C. Open trade.D. None of the above.4. A/an ______________ allows you to put up a percentage of the calculated amount in cash and the rest is “on account.”A. Margin trade.B. Cash trade.C. Open trade.D. None of the above.5. ______________ is defined as the amount of cash required to beon deposit with your clearing firm to secure the integrity of thetrade.A. Deposit.B. Commission.C. Adjustment.D. Margin.
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6. A/an ______________ allows traders and investors to leverage theirassets to produce a higher return.A. Cash account.B. Margin account.C. Absorption account.D. Adjunct account.7. Margin accounts allow traders to extract up to ______________ of thecash value of their securities.A. 25 percent.B. 50 percent.C. 75 percent.D. 100 percent.8. Using a margin account, if you buy 500 shares of XYZ at $100, howmuch will this trade cost you, not including commissions?A. $10,000.B. $20,000.C. $25,000.D. $50,000.9. A ______________ from your broker requires you to place additionalfunds in your account. If you do not place these additional funds inyour account, your position will be liquidated.A. Margin ratio.B. Margin account.C. Margin requirement.D. Margin call.10. True or False: If you are trading delta neutral using futures and options, your margin will be close to zero, which means you will neverget a margin call.11. If the ______________ of your trade increases, then the margin willalso increase.A. Implied risk.B. Risk premium.
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C. Risk arbitrage.D. Perceived risk.12. If you do not have additional funds to place in your account to covera margin call, your position will be ______________.A. Placed on hold.B. Liquidated.C. Traded by the brokerage firm.D. None of the above.13. Based on the rules of the Securities and Exchange Commission andthe clearing firms, margin for stocks equals ______________ of theamount of the trade.A. 25 percent.B. 35 percent.C. 50 percent.D. 75 percent.14. For stock options, each point equals ______________.A. $10.B. $100.C. $500.D. An amount that depends on the stock.15. Selling ______________ options, or placing an unprotected trade, hasthe highest risk and the highest margin requirements.A. Naked.B. Call.C. Put.D. Covered.16. Combining the buying and selling of options, stocks, and/orfutures creates a more complex calculation; however, this will______________ your margin requirements.A. Increase.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 potentialreturn but can result in increased risk.A. Volatility.B. Liquidity.C. Flexibility.D. Leverage.
MEDIA ASSIGNMENTThe next media assignment takes a closer look at margin and margin accounts. 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 advantage 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 Association of Securities Dealers web site, readers will find a wealth of information 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 understanding of margin including its potential benefits and pitfalls.
VOCABULARY LISTCash account
Margin call
Cash trade
Margin debt
Federal Reserve
Margin requirement
Leverage
Margin trade
Liquidation
Marginable security
Margin
Naked writing
Margin account
Risk
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SOLUTIONS1. 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 ofan 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 moneyto execute the trade.Answer: B—Cash trade.Discussion: In a cash trade, the investor is required to pay 100 percent 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 calculated 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 theirassets 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 thecash 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 initiating margin trades.8. Using a margin account, if you buy 500 shares of XYZ at $100, howmuch will this trade cost you, not including commissions?Answer: C—$25,000.Discussion: Buying 500 shares of XYZ at $100 a share wouldcost $50,000. Since the margin requirement is 50 percent, or half,the trader pays $25,000 for 500 shares if the stock is purchasedon 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 account 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 options, 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. 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.
12. 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, hasthe 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 futures 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 potentialreturn 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 example of leverage because by paying a small premium investors cancontrol a large number of shares.
MEDIA ASSIGNMENTMargin is a double-edged sword. While it can be used as leverage to generate 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 situation. The decision to use margin is an important one and therefore deserves careful consideration.In order to better understand the possible benefits and potential pitfalls of using margin, readers are encouraged to visit the “Margin Information” section of the NASD web site. It probably offers the mostcomprehensive look at margin available anywhere. Real world examples and situations help to understand exactly how margin accountswork. In addition, readers will find the latest margin statistics, information on purchasing on margin, as well as potential risks associated withmargin trading.As you can see, leverage will have a significant effect on the riskreward outlook when 50 percent margin is used to buy shares. Forinstance, 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 DEFINITIONSCash 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 isinitiated.Federal Reserve: The U.S. central bank that is responsible for monetarypolicy. The Federal Reserve will change interest rates and the money supply 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 security 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 collateralized 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 account; 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 valuation 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.
CHAPTER 15
A Short Coursein EconomicAnalyses
SUMMARYEconomists don’t often make good traders, but having a basic understanding of economic trends can help make sense of the day-to-day happenings 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 sudden and short-term in nature, they can cause volatility in the stock market 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 interest 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, investors 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 readers interested in trading stock index options, index futures, and evenshares of large companies, this chapter is designed to help you by providing a short course in economic analysis.
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QUESTIONS AND EXERCISES1. 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. If interest rates go sideways, stock prices will probably______________.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 pricesrise 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 buyerof stocks is a good idea because the stock market will have anupward bias.A. Increasing.B. Decreasing.C. Stable or increasing.D. Stable or decreasing.
MEDIA ASSIGNMENTIn 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 trading at 8:30 A.M. New York time. Furthermore, since many economic reports 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 weekday morning one hour before the start of stock trading. The report summarizes 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 LISTBond
Interest-bearing security
Bond trader
Inverse relationship
Chicago Board of Trade (CBOT)
Maturity
Correlation
Treasury bill
Economist
Treasury bond
Fed funds rate
Treasury note
Interest rate
Yield
SOLUTIONS1. 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 futures 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, including 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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both stocks and bonds. Rising interest rates are considered a negative for stocks and bonds, so if rates experience a sudden movehigher, stocks and bonds tend to fall.4. If interest rates go sideways, stock prices will probably______________.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 pricesrise 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. 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.7. If you find that interest rates are ______________, being a buyerof stocks is a good idea because the stock market will have anupward bias.Answer: D—Stable or decreasing.Discussion: Long-term periods of stable or falling interest ratesoften 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 ASSIGNMENTIf you have been watching the early morning news reports from the financial news services like CNBC and Bloomberg TV, you have probably noticed 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 interest 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 relationship between stock prices and bonds is fairly clear. Specifically, periods 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 DEFINITIONSBond: 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 investments. 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 degree, who makes forecasts regarding the economy, interest rates, andeconomic activity.Federal funds rate: The short-term interest rate controlled by the Federal Reserve. The Federal Reserve will change this interest rate to stimulate 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