Copyright: ®1996 AMEX, CBOE, PSE & PHLX


Help Contents
Contents

Chapter 1 - Introduction

Introduction

Chapter II - Options Nomenclature

Options Nomenclature

Chapter III - Options on Equity Securities

Options on Equity Securities

Features of Stock Options

Chapter IV - Index Options

About Indexes

Features of Index Options

Chapter V - Debt Options

Debt Options

Rates, Yields and Prices of Debt Securities

Treasury Securities

Yield-Based Options

Chapter VI - Foreign Currency Options

Foreign Currency Options

Market for Foreign Currencies

Special Characteristics of Foreign Currency Options

Special Features of Dollar-Denominated Foreign Currency Options

Cross-Rate Foreign Currency Options

Special Features of Cross-Rate Options

Cash-Settled Foreign Currency Options

Chapter VII - Flexibly Structured Options

Flexibly Structured Options

Special Features of Flexibly Structured Options

Chapter VIII - Exercise and Settlement

Exercise and Settlement

How to Exercise

Assignment

Settlement

Chapter IX - Tax Considerations, Transactions Costs and Margin Requirements

Tax Considerations, Transactions Costs and Margin Requirements

Tax Considerations

Transaction Costs

Margin Requirements

Chapter X - Principal Risks of Options Positions

Principal Risks of Options Positions

Risks of Option Holders

Risks of Option Writers

Other Risks

Special Risks of Index Options

Special Risks of Debt Options

Special Risks of Foreign Currency Options

Special Risks of Flexibly Structured Options

Chapter XI - Scope and Limitations of this Booklet

Scope and Limitations of this Booklet

Supplements

November 8, 1995 Supplement to Characteristics and Risks of Standardized Options

October, 1996 Supplement to Characteristics and Risks of Standardized Options

Copyright Notice

Copyright Notice


Introduction

This document is periodically revised.  If you would like the most recent

version write:

Chicago Board Options Exchange

Dept of Investors Services

400 South LaSalle Street

Chicago, IL  60605

This booklet relates solely to options issued by The Options Clearing Corporation ("OCC"), and all references to "options" in this booklet are applicable only to such options.  As of the date of this booklet, options are traded on the United States markets listed on the inside front cover page and on the European Options Exchange in Amsterdam, The Netherlands.  In the future, options may be traded on other markets within or outside the United States.  The markets on which options are traded at any given time are referred to in this booklet as the "options markets."

OCC is a registered clearing agency, and each U.S. options market is a national securities exchange, that is subject to regulation by the Securities and Exchange Commission ("SEC") under the Securities Exchange Act of 1934.  Foreign options markets, and their members, are not generally subject to regulation by the SEC or to the requirements of the securities or other laws of the U.S. and may not be subject to the jurisdiction of U.S. courts.

What is an option?  An option is the right either to buy or to sell a specified amount or value of a particular underlying interest at a fixed exercise price by exercising the option before its specified expiration date.  An option which gives a right to buy is a call option, and an option which gives a right to sell is a put option.  Calls and puts are distinct types of options, and the buying or selling of one type does not involve the other.

EXAMPLE:  An option to buy 100 shares of common stock of the XYZ Corporation at a specified exercise price would be an XYZ call option.  An option to sell 100 shares of common stock of the XYZ Corporation at a specified exercise price would be an XYZ put option.

There are two different kinds of options -- physical delivery options and cash-settled options.  A physical delivery option gives its owner the right to receive physical delivery (if it is a call), or to make physical delivery (if it is a put), of the underlying interest when the option is exercised.  A cash-settled option gives its owner the right to receive a cash payment based on the difference between a determined value of the underlying interest at the time the option is exercised and the fixed exercise price of the option.  A cash-settled call conveys the right to receive a cash payment if the determined value of the underlying interest at exercise -- this value is known as the exercise settlement value --  exceeds the exercise price of the option, and a cash-settled put conveys the right to receive a cash payment if the exercise settlement value is less than the exercise price of the option.

Each options market selects the underlying interests on which options are traded on that market.  Options are currently available covering four types of underlying interests:  equity securities, stock indexes, government debt securities, and foreign currencies.  Options on other types of underlying interests may become available in the future.

Most options have standardized terms -- such as the nature and amount of the underlying interest, the expiration date, the exercise price, whether the option is a call or a put, whether the option is a physical delivery option or a cash-settled option, the manner in which the cash payment and the exercise settlement value of a cash-settled option are determined, the multiplier of a cash-settled option, the style of the option, whether the option has automatic exercise provisions, and adjustment provisions.  These standardized terms are generally described in Chapter II.  Each U.S. options market publishes specification sheets setting forth the particular standardized terms of the options traded on that options market.  (The options markets may also provide for trading in options whose terms are not all fixed in advance.  Rather, subject to certain limitations, the parties to transactions in these options may designate certain of the terms.  These flexibly structured options are discussed in Chapter VII of this booklet.)

Options having the same standardized terms are identical and comprise an options series.  The standardization of terms makes it more likely that there will be a secondary market in which holders and writers of options can close out their positions by offsetting sales and purchases.  By selling an option of the same series as the one he bought, or buying an option of the same series as the one he wrote, an investor can close out his position in that option at any time there is a functioning secondary options market in options of that series.

In some instances, options of the same series may be traded on more than one options market at the same time.  Options that are so traded are called multiply-traded options.  Options traded on a U.S. options market may also be traded on a foreign options market.  These options are referred to as internationally-traded options.  Multiply-traded and internationally-traded options can ordinarily be purchased and written, and positions in these options can ordinarily be liquidated in offsetting closing transactions, in any of the options markets in which the options are traded.  However, because premiums are affected by market forces, the premiums for identical multiply-traded or internationally-traded options may not be the same in all markets at any given time.

If an options market learns that a particular underlying interest no longer meets its requirements for options trading or is not eligible for trading in all U.S. jurisdictions, or if an options market decides to discontinue trading in a particular options series for another reason, the options market may stop introducing new options on that underlying interest and may in certain circumstances impose restrictions on transactions that open new positions in options series that have been previously introduced, although trading in the options series will ordinarily continue on at least one options market until its expiration.

Options generally are traded on U.S. options markets during normal day-time business hours of U.S. securities exchanges and for a short period afterward.  However, trading in options may not be confined to those hours.  Trading in evening and night trading sessions occurs in options on foreign currencies and may in the future occur in other types of options.  Moreover, when there are unusual market conditions, an options market may authorize trading to continue for a substantially longer period than under normal conditions.  Trading in an expiring option may close at an earlier time than trading in other options.  Trading hours for options are also subject to change from time to time.  Readers should ascertain the trading hours of the particular options they are interested in trading from the options markets where those options are traded.  Readers should also be aware that trading in underlying interests is not confined to normal exchange trading hours.  For example, underlying foreign currencies and debt securities are traded in international markets on virtually an around-the-clock basis, and underlying equity securities may be traded in foreign markets when U.S. markets are closed and in some U.S. markets after the close of their normal trading hours.

-------------------------------------

Readers should be aware that this booklet has been written to meet the requirements of an SEC rule that requires the U.S. options markets to prepare, and brokerage firms to distribute, a booklet that briefly and generally describes the characteristics of options and the risks to investors of maintaining positions in options.  Options are versatile instruments that can be used in a wide variety of investment strategies.  They give the investor the ability to create positions that reflect the investor's opinion of an underlying interest and to select investment strategies that reflect the investor's tolerance for risk.  This booklet is not designed to describe the various potential benefits of options or how investors may use options to enhance their investment strategies or to reduce risk.  Numerous other publications, including some prepared by the U.S. options markets that are available upon request, contain discussions of the uses and potential benefits of options and of the various trading and investment strategies that can be employed with options.  Readers who wish to balance the general discussion of risks that is contained in this booklet with a discussion of options uses, benefits and strategies should consult one or more of these other publications.

Readers should read and understand this booklet in its entirety, since a number of the separate chapters will be relevant to every reader interested in buying or writing options.  For example, a reader who is interested in options on equity securities should fully read not only Chapter III, but also should read Chapters II, VIII and IX, as well as the discussion of risks in Chapter X.  Readers should also be aware that, although this booklet seeks to describe the various characteristics of options and the risks that are unique to being an investor in options, there are many matters which are beyond the scope of this booklet that are not discussed.  Chapter XI contains a discussion of the scope and limitations of this booklet.


Options Nomenclature

This chapter contains a description of the standardized terms, and of some of the special vocabulary, applicable to options.  Most of the nomenclature is the same for options on the various types of underlying interests.  Differences that are applicable to options on a particular underlying interest will be described in the chapter devoted to that underlying interest.

Certain terms -- options, options markets, call options, put options, physical delivery options, cash-settled options, options series, multiply-traded options and internationally-traded options -- have been defined in Chapter I.  Readers interested in those definitions should consult that chapter.

OPTION HOLDER; OPTION WRITER—The option holder is the person who buys the right conveyed by the option.

EXAMPLE:  The holder of a physical delivery XYZ call option has the right to purchase shares of XYZ Corporation stock at the specified exercise price upon exercise prior to the expiration of the option.  The holder of a physical delivery XYZ put option has the right to sell shares of XYZ Corporation at the specified exercise price upon exercise prior to the expiration of the option.  The holder of a cash-settled option has the right to receive an amount of cash equal to the cash settlement amount (described below) upon exercise prior to the expiration of the option.

The option writer is obligated -- if and when assigned an exercise -- to perform according to the terms of the option.  The option writer is sometimes referred to as the option seller.  An option writer who has been assigned an exercise is known as an assigned writer.

EXAMPLE:  If a physical delivery XYZ call option is exercised by the holder of the option, the assigned writer must deliver the required number of shares of XYZ common stock.  He will be paid for the shares at the specified exercise price regardless of their current market price.

If a physical delivery put option is exercised, the assigned writer must purchase the required number of shares at the specified exercise price regardless of their current market price.  If a cash-settled option is exercised, the assigned writer must pay the cash settlement amount.

No certificates are issued to evidence options.  Investors look to the confirmations and statements that they receive from their brokerage firms to confirm their positions as option holders or writers.  An option holder looks to the system created by OCC's rules, rather than to any particular option writer, for performance of the option he owns.  Similarly, option writers must perform their obligations under the OCC system and are not obligated to any particular option holder.  Since every options transaction involves both a holder and a writer, it follows that the aggregate rights of option holders under the system are matched by the aggregate obligations of option writers.

The OCC system is designed so that the performance of all options is between OCC and a group of firms called Clearing Members that carry the positions of all option holders and option writers in their accounts at OCC.  To qualify as a Clearing Member, a firm must meet OCC's financial requirements.  In addition, Clearing Members must provide OCC with collateral for the positions of option writers that they carry and must contribute to Clearing Funds that protect OCC against a Clearing Member's failure.  The Clearing Members' guarantees of the performance of options writers' obligations, the financial strength of the Clearing Members, the collateral that they deposit, the obligations of correspondent clearing corporations, and the Clearing Funds together make up the OCC system backing the performance of options.  This system is discussed in more detail in the OCC prospectus referred to in paragraph 1 of Chapter XI.

EXERCISE PRICE—In the case of a physical delivery option, the exercise price (which is sometimes called the "strike price") is the price at which the option holder has the right either to purchase or to sell the underlying interest.

EXAMPLE:  A physical delivery XYZ 40 call option gives the option holder the right to purchase 100 shares of XYZ stock at an exercise price of $40 a share.  A physical delivery XYZ 40 put option gives the option holder the right to sell 100 shares of XYZ common stock at an exercise price of $40 a share.

The exercise price of a cash-settled option is the base for the determination of the amount of cash, if any, that the option holder is entitled to receive upon exercise (see the discussion of "Cash Settlement Amount and Exercise Settlement Value" below).

Exercise prices for each options series are established by the options market on which that series is traded at the time trading in the series is introduced, and are generally set at levels above and below the then market value of the underlying interest.  The options markets generally have authority to introduce additional series of options with different exercise prices based on changes in the value of the underlying interest, or in response to investor interest, or in unusual market conditions, or in other circumstances.

EXPIRATION DATE—This is the date on which the option expires.  If an option has not been exercised prior to its expiration, it ceases to exist -- that is, the option holder no longer has any rights, and the option no longer has any value.  The expiration dates for the various options series are fixed by the options market on which the series trades.  Readers should learn the expiration date of each option they wish to buy or write.

STYLE OF OPTION—The style of an option refers to when that option is exercisable.  At the date of this booklet there are three different styles of options -- American-style, European-style and capped.  Subject to certain limitations prescribed in the rules of OCC or the options markets and subject to applicable law, these three styles are exercisable at the following times:

An American-style option may be exercised at any time prior to its expiration.

A European-style option may be exercised only during a specified period before the option expires.  Every European-style option being traded at the date of this booklet is exercisable only on its expiration date.

A capped option will be automatically exercised prior to expiration if the options market on which the option is trading determines that the value of the underlying interest at a specified time on a trading day "hits the cap price" for the option.  Capped options may also be exercised, like European-style options, during a specified period before expiration.  This period is the expiration date for all capped options traded at the date of this booklet.  The special terminology applicable to capped options is discussed at the end of this chapter.

European-style or capped options having an expiration period that is longer or shorter than their expiration date may be introduced for trading in the future.

UNIT OF TRADING; CONTRACT SIZE—The unit of trading (which is sometimes referred to as the contract size) of a physical delivery option is the amount of the underlying interest that is subject to being purchased or sold upon the exercise of a single option contract.  For example, the unit of trading for most options on equity securities is 100 shares.  Thus, a physical delivery XYZ 50 call will give its holder the right upon exercise to purchase 100 shares of XYZ at $50 per share.  If the option is trading at a premium of, say, $4 per share, then the aggregate premium for a single option contract would be $400.

The contract size of a cash-settled option is determined by the multiplier that is fixed by the options market on which the options series is traded.  The multiplier determines the aggregate value of each point of the difference between the exercise price of the option and the exercise settlement value of the underlying interest.  For example, a multiplier of 100 means that for each point by which a cash-settled option is in the money upon exercise, there is a $100 increase in the cash settlement amount.  Similarly, if an option with a multiplier of 100 is trading at a premium of, say, $4, then the aggregate premium for a single option contract would be $400.

EXERCISE—If the holder of a physical delivery option wishes to buy (in the case of a call) or sell (in the case of a put) the underlying interest at the exercise price -- or, in the case of a cash-settled option, to receive the cash settlement amount -- his option must be exercised.  In order to exercise most options, option holders must give exercise instructions to their brokerage firm in accordance with the firm's procedures prior to the firm's exercise cut-off time.  The exercise process is discussed in Chapter VIII.  Every option holder should understand this process and should learn his brokerage firm's procedures concerning exercise, and its exercise cut-off time, for each option he may buy.

Although an option holder must assure that action is taken to exercise most options, capped options and certain cash-settled options provide for automatic exercise in specified circumstances.  Other options having automatic exercise provisions may be introduced for trading in the future.

The rules of the options markets generally limit the total number of puts or calls on the same underlying interest that a single investor or group of investors acting in concert may exercise during a specified time period.  Information concerning the exercise limits for particular options is available from the options market on which those options are traded or from brokerage firms.

The right to exercise an option may be restricted in certain circumstances.  This is discussed under "Risks of Option Holders" in Chapter X.

When an option has been exercised, OCC will assign the exercise in accordance with its rules to a Clearing Member whose account with OCC reflects the writing of an option of the same series.  The Clearing Member may, in turn, assign this exercise to one of its customers who is a writer in accordance with the Clearing Member's procedures, and the assigned writer will then be obligated to perform the obligations of the option -- that is, to sell (in the case of a physical delivery call) or buy (in the case of a physical delivery put) the underlying interest at the exercise price, or, in the case of a cash-settled option, to pay the cash settlement amount.  The assignment process is discussed further in Chapter VIII.

CASH SETTLEMENT AMOUNT, SETTLEMENT CURRENCY and EXERCISE SETTLEMENT VALUE—The cash settlement amount is the amount of cash that the holder of a cash-settled option is entitled to receive upon exercise.  It is the amount by which the exercise settlement value of the underlying interest of a cash-settled call exceeds the exercise price, or the amount by which the exercise price of a cash-settled put exceeds the exercise settlement value of the underlying interest, multiplied by the multiplier for the option.

EXAMPLE:  Assume that a holder of a cash-settled call on the XYZ index that has an exercise price of 80 exercises it when the exercise settlement value of the index is 85.  If the multiplier for XYZ index options is 100, the assigned writer would be obligated to pay, and the exercising holder would be entitled to receive, a cash settlement amount of $500 ($85 minus $80 multiplied by 100 = $500).

The currency in which the cash settlement amount is payable is called the settlement currency.  The settlement currency for all cash-settled options with standardized terms that are trading at the date of this booklet is U.S. dollars.  It is possible that another currency will be the settlement currency for some options introduced in the future.

The manner of determining the exercise settlement value for a particular option series is fixed by the options market on which the series is traded.  The exercise settlement values for options on a particular underlying interest traded in one options market will not necessarily be determined in the same manner as the exercise settlement values for options or futures on the same underlying interest that may be traded in other markets.

Options markets may change the method of determining exercise settlement values for particular options series on specified days or on all days.  These changes may be made applicable to series outstanding at the time the changes become effective.  Alternatively, an options market might phase in a change in the method of determining exercise settlement values by opening new series of options identical to outstanding series in all respects other than the method for calculating exercise settlement values.  Such new series would trade alongside the old series until both series expire, but the two series would not be interchangeable.  In the future, options markets may, subject to regulatory approval, introduce options whose exercise settlement values may not exceed a specified maximum amount.

ADJUSTMENT and ADJUSTMENT PANEL—Adjustments may be made to some of the standardized terms of outstanding options upon the occurrence of certain events.  Adjustments that may be made to a particular type of options are discussed in the chapter relating to that type.

The determination of whether to adjust outstanding options in response to a particular event, and, if so, what the adjustment should be, is made by a majority vote of an adjustment panel.  An adjustment panel for an options series consists of two representatives of each U.S. options market on which the series is traded and one representative of OCC, who votes only to break a tie.  Every determination by an adjustment panel is within its sole discretion and is binding on all investors.

PREMIUM—The premium is the price that the holder of an option pays and the writer of an option receives for the rights conveyed by the option.  It is the price set by the holder and writer, or their brokers, in a transaction in an options market where the option is traded.  It is not a standardized term of the option.  The premium does not constitute a "down-payment."  It is simply and entirely a nonrefundable payment in full -- from the option holder to the option writer -- for the rights conveyed by the option.

The premium is not fixed by the options markets or by OCC.  Premiums are subject to continuous change in response to market and economic forces, including changes in the trading conditions on the markets where the particular options are traded.  The factors which may generally affect the pricing of an option include such variables as the current value of the underlying interest and the relationship between that value and the exercise price, the current values of related interests (e.g., futures on the underlying interest or other interests related to the underlying interest), the style of the option, the individual estimates of market participants of the future volatility of the underlying interest, the historical volatility of the underlying interest, the amount of time remaining until expiration, cash dividends payable on the underlying stock (in the case of stock and stock index options), current interest rates, current currency exchange rates (in the cases of foreign currency options and options whose premiums or cash settlement amounts are payable in a foreign currency), the depth of the market for the option, the effect of supply and demand in the options market as well as in the markets for the underlying interest and for related interests, the information then available about current prices and operations in the markets for the underlying interest and related interests, the individual estimates of market participants of future developments that might affect any of the foregoing, and other factors generally affecting the prices or volatility of options, underlying interests, related interests or securities generally.  Also see the discussion below of "Intrinsic Value and Time Value."  Readers should not assume that options premiums will necessarily conform or correlate with any theoretical options pricing formula, chart, last sale, or the prices of the underlying interest, related interests or other options at any particular time.

The currency in which the premium is payable is called the premium currency.  The premium currency for most options is U.S. dollars.  However, the premium currency for cross-rate foreign currency options, which are discussed in Chapter VI, is a foreign currency, and other options with premiums payable in a foreign currency may be introduced after the date of this booklet.

OPENING TRANSACTION—This is a purchase or sale transaction by which a person establishes or increases a position as either the holder or the writer of an option.

CLOSING TRANSACTION—This is a transaction in which, at some point prior to expiration, the option holder makes an offsetting sale of an identical option, or the option writer makes an offsetting purchase of an identical option.  A closing transaction in an option reduces or cancels out an investor's previous position as the holder or the writer of that option.

EXAMPLE:  In June an investor buys a December XYZ 50 call at an aggregate premium of $500.  By September the market price of the option has increased to $700.  To seek to realize his $200 profit, the investor can direct his broker to sell an offsetting December XYZ 50 call in a closing transaction.  On the other hand, if by September the market price of the option has decreased to $300, the investor might still decide to sell the option in a closing transaction, thereby limiting his loss to $200.

Although holders of American-style options have the right to exercise at any time before expiration, holders frequently elect to realize their profits or losses by making closing transactions because the transaction costs of the closing transactions may be lower than the transaction costs associated with exercises, and because closing transactions may provide an opportunity for an option holder to realize the remaining time value (described below) of the option that would be lost in an exercise.  The limited period of exercisability of a European-style or capped option means that (except for the possibility of automatic exercise of a capped option) the holder's only means of realizing profit or loss on the option when the option is not exercisable is by selling the option in a closing transaction.

POSITION LIMITS—The rules of the options markets generally limit the maximum number of options on the same side of the market (i.e., calls held plus puts written, or puts held plus calls written) with respect to a single underlying interest that may be carried in the accounts of a single investor or group of investors acting in concert.  These limits -- which are called position limits -- differ for options on different underlying interests.  Information concerning the position limits for particular options is available from the options market on which those options are traded or from brokerage firms.

COMBINATIONS; SPREADS and STRADDLES—Combination positions are positions in more than one option at the same time.  Spreads and straddles are two types of combination positions.  A spread involves being both the buyer and writer of the same type of option (puts or calls) on the same underlying interest, with the options having different exercise prices and/or expiration dates.  A straddle consists of purchasing or writing both a put and a call on the same underlying interest, with the options having the same exercise price and expiration date.

LONG and SHORT—The word long refers to a person's position as the holder of an option, and the word short refers to a person's position as the writer of an option.

COVERED CALL WRITER—If the writer of a physical delivery call option owns or acquires the amount of the underlying interest that is deliverable upon exercise of the call, he is said to be a covered call writer.

EXAMPLE:  An individual owns 100 shares of XYZ common stock.  If he writes one physical delivery XYZ call option -- giving the call holder the right to purchase 100 shares of the stock at a specified exercise price -- this would be a covered call.  If he writes two such XYZ calls, one would be covered and one would be uncovered.

The distinction between covered and uncovered call writing positions is important since uncovered call writing can involve substantially greater exposure to risk than covered call writing.  A call option writer who is not a covered writer may hold another option in a spread position and thereby offset some or all of the risk of the option he has written.  However, the spread may not offset all of the risk of the uncovered writing position.  For example, if the long portion of the spread has a higher exercise price than the exercise price of the short, or if the long has an earlier expiration date than the expiration date of the short, then the writer may still be exposed to significant risks from his uncovered writing position.

AT THE MONEY—This term means that the current market value of the underlying interest is the same as the exercise price of the option.

IN THE MONEY—A call option is said to be in the money if the current market value of the underlying interest is above the exercise price of the option.  A put option is said to be in the money if the current market value of the underlying interest is below the exercise price of the option.

EXAMPLE:  If the current market price of XYZ stock is $43, an XYZ 40 call would be in the money by $3.

OUT OF THE MONEY—If the exercise price of a call is above the current market value of the underlying interest, or if the exercise price of a put is below the current market value of the underlying interest, the option is said to be out of the money by that amount.

EXAMPLE:  With the current market price of XYZ stock at $40, a call with an exercise price of $45 would be out of the money by $5 -- as would a put with an exercise price of $35.

INTRINSIC VALUE and TIME VALUE—It is sometimes useful to consider the premium of an option as consisting of two components:  intrinsic value and time value.  Intrinsic value reflects the amount, if any, by which an option is in the money.  Time value is whatever the premium of the option is in addition to its intrinsic value.  An American-style option may ordinarily be expected to trade for no less than its intrinsic value prior to its expiration, although occasionally an American-style option will trade at less than its intrinsic value.  Because European-style and capped options are not exercisable at all times, they are more likely than American-style options to trade at less than their intrinsic value when they are not exercisable.

EXAMPLE OF A CALL WITH INTRINSIC VALUE:  At a time when the current market price of XYZ stock is $46 a share, an XYZ 40 call would have an intrinsic value of $6 a share.  If the market price of the stock were to decline to $44, the intrinsic value of the call would be only $4.  Should the price of the stock drop to $40 or below, the call would no longer have any intrinsic value.

EXAMPLE OF A PUT WITH INTRINSIC VALUE:  At a time when the current market price of XYZ stock is $46 a share, an XYZ 50 put would have an intrinsic value of $4 a share.  Were the market price of XYZ stock to increase to $50 or above, the put would no longer have any intrinsic value.

EXAMPLE OF TIME VALUE:  At a time when the market price of XYZ stock is $40 a share, an XYZ 40 call may have a current market price of, say, $2 a share.  This is entirely time value.

An option with intrinsic value may often have some time value as well -- that is, the market price of the option may be greater than its intrinsic value.  This could occur with an option of any style.

EXAMPLE:  With the market price of XYZ stock at $45 a share, an XYZ 40 call may have a current market price of $6 a share, reflecting an intrinsic value of $5 a share and a time value of $1 a share.

An option's time value is influenced by several factors (as discussed above under "Premium"), including the length of time remaining until expiration.  An option is a "wasting" asset; if it is not sold or exercised prior to its expiration, it will become worthless.  As a consequence, all else remaining the same, the time value of an option usually decreases as the option approaches expiration, and this decrease accelerates as the time to expiration shortens.  However, there may be occasions when the market price of an option may be lower than the market price of another option that has less time remaining to expiration but that is similar in all other respects.

An American-style option's time value is also influenced by the amount the option is in the money or out of the money.  An option normally has very little time value if it is substantially in the money.  Although an option that is substantially out of the money has only time value, the amount of that time value is normally less than the time value of an option having the same underlying interest and expiration that is at the money.

Another factor influencing the time value of an option is the volatility of the underlying interest.  All else being the same, options on more volatile interests command higher premiums than options on less volatile interests.

Time value is also influenced by the current cost of money.  Increases in prevailing interest rates tend to cause higher premiums for calls and lower premiums for puts, and decreases in prevailing interest rates tend to cause lower premiums for calls and higher premiums for puts.

------------------------------------

The following is a description of the terminology applicable to capped options:

CAP INTERVAL—The cap interval is a constant established by the options market on which a series of capped options is traded.  The exercise price for a capped-style option plus the cap interval (in the case of a call), or minus the cap interval (in the case of a put), equals the cap price for the option.  For example, if a capped call option with an exercise price of 360 has a cap interval of 30, then the cap price at which the option will be automatically exercised would be 390.

CAP PRICE—The cap price is the level that the automatic exercise value of a capped option must reach in order for the option to be automatically exercised.  The cap price of a call option is above, and of a put option below, the exercise price of the option.

EXAMPLE:  A 360 ABC capped call index option has an exercise price of 360 and a cap interval of 30.  The call option has a cap price of 390.

EXAMPLE:  A 310 XYZ capped put index option has an exercise price of 310 and a cap interval of 20.  The put option has a cap price of 290.

AUTOMATIC EXERCISE VALUE—The automatic exercise value of a capped option is the price or level of the underlying interest determined in a manner fixed by the options market on which the option is traded for each trading day as of a specified time of that day.

EXAMPLE:  A 310 XYZ capped put index option has a cap interval of 20, and therefore has a cap price of 290.  Assume that the options market on which the option is traded has specified the close of trading on each trading day as the time for determining the automatic exercise value on the XYZ index, and that the index level reaches a low of 289 during a particular trading day, but is at 291 at the close.  The automatic exercise value has not reached the cap price, and the automatic exercise feature of the option is not triggered, because the index level was not at or below the cap price at the time of day specified by the options market for determining the automatic exercise value.

CASH SETTLEMENT AMOUNT—This is the cash amount that the holder of a cash-settled capped option is entitled to receive upon the exercise of the option.  In the case of a capped option that has been automatically exercised, the cash settlement amount is equal to the cap interval times the multiplier for the option, even if the automatic exercise value on the day that the automatic exercise feature is triggered exceeds (in the case of a call) or is less than (in the case of a put) the cap price.  If the capped option is voluntarily exercised at expiration, the cash settlement amount is determined in the same manner as for other styles of cash-settled options.

EXAMPLE:  A 360 ABC capped call index option has a cap interval of 30 and a multiplier of 100.  The automatic exercise value of the ABC index is 396 on a particular trading day.  The call option is automatically exercised, and the cash settlement amount is $3000 (equal to the cap interval of 30 times the multiplier of 100).

EXAMPLE:  A 360 ABC capped call index option has a cap interval of 30 and a multiplier of 100.  The automatic exercise value of the ABC index never equals or exceeds the cap price of 390 during the life of the option, and the exercise settlement value of the option is 367 on the final trading day.  Upon exercise of the option, the holder is entitled to receive a cash settlement amount of $700 (equal to the multiplier of 100 times the difference between the exercise settlement value of 367 and the exercise price of 360).


Options on Equity Securities

The term "stock options" is used broadly in this booklet to include not only options on common stocks but also options on all other types of equity securities, such as limited partnership interests, "American Depository Receipts" and "American Depository Shares" representing interests in foreign entities, and preferred stocks.  Options are available on exchange-traded equity securities, on unlisted equity securities traded in the NASDAQ stock market and designated as national market system securities, and on equity securities traded both in the NASDAQ stock market and on exchanges.  The NASDAQ stock market is primarily an inter-dealer trading system as contrasted with exchange auction markets.

Issuers of underlying equity securities do not participate in the selection of their securities for options trading (although some options markets may determine not to select an underlying security without the consent of the issuer of that security).  Issuers of underlying equity securities have no responsibility regarding the issuance, the terms, or the performance of options, and option holders have no rights as security holders of such issuers.

The principal risks of holders and writers of stock options are discussed in Chapter X.  Readers interested in buying or writing stock options should carefully read that chapter.


Features of Stock Options

Each stock option generally covers 100 shares of the underlying security, although, as described below, the number of underlying shares may be adjusted as a result of certain events.

The exercise prices of the stock options that are traded at the date of this booklet are stated in U.S. dollars per share.  The exercise price of an option must each be multiplied by the number of shares underlying the option in order to determine the aggregate exercise price and aggregate premium of that option.

EXAMPLE:  An XYZ 40 call gives the buyer the right to purchase 100 shares of XYZ stock at a price of $40 per share, or a total price of $4,000.

In the future, stock options may, with regulatory approval, be introduced that have exercise prices in a foreign currency.

Adjustments may be made to certain of the standardized terms of outstanding stock options when certain events occur, such as a stock dividend, stock distribution, stock split, reverse stock split, rights offering, distribution, reorganization, recapitalization, reclassification in respect of an underlying security, or a merger, consolidation, dissolution or liquidation of the issuer of the underlying security.  In the following discussion, there is a brief description of a number of general adjustment rules applicable to stock options that are in effect at the date of this booklet.  Such rules may be changed from time to time with regulatory approval.  An adjustment panel has the authority to make such exceptions as it determines to be appropriate to any of the general adjustment rules.

As a general rule, no adjustment is made for ordinary cash dividends or distributions.  A cash dividend or distribution by most issuers will generally be considered "ordinary" unless it exceeds 10% of the aggregate market value of the underlying security outstanding.  The options markets are considering an amendment to the general rules which, if adopted and approved by the regulators, would provide that a cash dividend or distribution by an issuer that is a closed-end investment company may not be considered to be "ordinary" if it exceeds 5% of such aggregate market value.  Determinations whether to adjust for cash dividends or distributions in excess of those amounts are made on a case-by-case basis.

Because stock options are not generally adjusted for ordinary cash dividends and distributions, covered writers of calls are entitled to retain dividends and distributions earned on the underlying securities during the time prior to exercise.  However, a call holder becomes entitled to the dividend if he exercises the option prior to the ex-dividend date even though the assigned writer may not be notified that he was assigned an exercise until after the ex-date.  Because call holders may seek to "capture" an impending dividend by exercising, a call writer's chances of being assigned an exercise may increase as the ex-date for a dividend on the underlying security approaches.

As a general rule, stock dividends, stock distributions and stock splits can result in an adjustment in the number of underlying shares or the exercise price, or both.

EXAMPLE:  An investor bought an XYZ 60 option -- either a call or a put -- and XYZ Corporation subsequently effected a 3 for 2 stock distribution.  Instead of covering 100 shares of stock at an exercise price of $60 a share, each outstanding option could be adjusted to cover 150 shares at an exercise price of $40 per share.

However, when a stock distribution results in the issuance of one or more whole shares of stock for each outstanding share -- such as a 2 for 1 stock split -- as a general rule the number of underlying shares is not adjusted.  Instead, the number of outstanding options is proportionately increased and the exercise price is proportionately decreased.

EXAMPLE:  Before a 2 for 1 stock split, an investor holds an option on 100 shares of XYZ stock with an exercise price of $60.  After adjustment for the split, he will hold two XYZ options, each on 100 shares and with an exercise price of $30.

An adjustment panel may make an exception to the general rule to adjust for stock dividends.  For example, in cases where the issuer of the underlying security announces or exhibits a policy of declaring regular stock dividends that do not individually exceed 10% of the amount of the underlying security outstanding, an adjustment panel may determine to treat the stock dividends as though they were ordinary cash dividends and to make no adjustment for them.

As a general rule, adjustments in exercise prices are rounded to the nearest 1/8 of a dollar, and adjustments in the number of underlying shares are rounded down to eliminate fractional shares.  In the latter case, the exercise price may be further adjusted to compensate for the elimination of the fractional shares.

Distributions of property other than the underlying security may require different adjustments.  For example, outstanding options might be adjusted to include the distributed property.

EXAMPLE:  If XYZ "spins off" its subsidiary ABC by distributing to its stockholders 2.5 shares of ABC stock for each share of XYZ stock, outstanding XYZ options might be adjusted to require delivery of 100 shares of XYZ stock plus 250 shares of ABC stock.

Alternatively, the exercise prices of outstanding options might be reduced by the value, on a per-share basis, of the distributed property, as determined by the adjustment panel.

Events other than distributions may also result in adjustments.  If all of the outstanding shares of an underlying security are acquired in a merger or consolidation, outstanding options will as a general rule be adjusted to require delivery of the cash, securities, or other property payable to holders of the underlying security as a result of the acquisition.

EXAMPLE:  If XYZ is acquired by PQR in a merger where each holder of XYZ stock receives $50 plus 1/2 share of PQR stock for each share of XYZ stock held, XYZ options might be adjusted to call for the delivery of $5,000 in cash and 50 shares of PQR stock instead of 100 shares of XYZ stock.

When an underlying security is wholly or partially converted into a debt security or a preferred stock, options that have been adjusted to call for delivery of the debt security or preferred stock may, as a general rule, be further adjusted to call for any securities distributed as interest or dividends on such debt security or preferred stock.

When an underlying security is converted into a right to receive a fixed amount of cash, options on that security will generally be adjusted to require the delivery upon exercise of a fixed amount of cash, and trading in the options will ordinarily cease when the conversion becomes effective. As a result, after such an adjustment is made all options on that security that are not in the money will become worthless and all that are in the money will have no time value. If the option is European-style (as may be the case for a flexibly structured stock option designated as a European-style option), the expiration date of the option will ordinarily be accelerated to fall on or shortly after the date on which the conversion of the underlying security to a right to receive cash occurs. Holders of an in the money option whose expiration date is accelerated must be prepared to exercise that option prior to the accelerated exercise cut off time in order to prevent the option from expiring unexercised. Writers of European-style options whose expiration date is subject to being accelerated bear the risk that, in the event of such an acceleration , they may be assigned an exercise notice and be required to perform their obligations as writers prior to the original expiration date. When the expiration date of a European-style option is accelerated, no adjustment will be made to reflect the accelerated expiration date. There is no assurance that the exercise settlement date for an accelerated option will coincide with the date that the cash payment to the holders of the underlying security becomes available from the issuer of the underlying security. Covered writers of an accelerated option may therefore be required to pay the cash amount in respect of the option before they receive the cash payment on the underlying security.

As a general rule, adjustments are not made for tender offers or exchange offers, whether by the issuer or a third party, and whether for cash, securities (including issuer securities), or other property.  This presents a risk for writers of put options, because a successful tender offer or exchange offer (whether by the issuer or by a third party) may have a significant effect on the market value of the security that the put writers would be obligated to purchase if the put options are exercised after the expiration of the offer.

As a general rule, adjustments will not be made to reflect changes in the capital structure of the issuer where all of the underlying securities outstanding in the hands of the public (other than dissenters' shares) are not changed into another security, cash or other property.

As a general rule, an adjustment that is made in an option will become effective on the ex-date established by the primary market for trading in the underlying security.


About Indexes

As referred to in this booklet, an index is a measure of the prices of a group of securities or other interests.  Although indexes have been developed to cover a variety of interests, such as stocks and other equity securities, debt securities and foreign currencies, and even to measure the cost of living, indexes on equity securities (which are called stock indexes) are among the most familiar, and they are the only indexes that underlie options trading at the date of this booklet.  The following discussion refers only to stock indexes and stock index options.

Stock indexes are compiled and published by various sources, including securities markets.  An index may be designed to be representative of the stock market of a particular nation as a whole, of securities traded in a particular market, of a broad market sector (e.g., industrials), or of a particular industry (e.g., electronics).  An index may be based on the prices of all, or only a sample, of the securities whose prices it is intended to represent.  Indexes may be based on securities traded primarily in U.S. markets, securities traded primarily in a foreign market, or a combination of securities whose primary markets are in various countries.

A stock index, like a cost of living index, is ordinarily expressed in relation to a "base" established when the index was originated.

EXAMPLE:  On the starting or "base" date for a new value-weighted index, the total market values of the component securities (market price times number of shares outstanding) is $50 billion.  The publisher of the index will assign an arbitrary index level  -- say 100 -- to that base value.  If the total market value of the component stocks increases by 2% the next day (i.e., to $51 billion), the index level would rise to 102 (102% of the base level of 100).

The base may be adjusted from time to time to reflect such events as capitalization changes affecting the constituent securities of the index (e.g., issuance of new shares) or to maintain continuity when securities are added to or dropped from the index.  These adjustments are generally designed so that the index level will change only as a result of price changes of constituent securities during trading.

Securities may be dropped from an index because of events such as mergers and liquidations or because a particular security is no longer thought to be representative of the types of stocks constituting the index.  Securities may also be added to an index from time to time.  Adjustments in the base level of an index, additions and deletions of constituent securities, and similar changes are within the discretion of the publisher of the index and will not ordinarily cause any adjustment in the terms of outstanding index options.  However, an adjustment panel has authority to make adjustments if the publisher of the underlying index makes a change in the index's composition or method of calculation that in the panel's determination, may cause significant discontinuity in the index level.

Different stock indexes are calculated in different ways.  Accordingly, even where indexes are based on identical securities, they may measure the relevant market differently because of differences in methods of calculation.  Often the market prices of the securities in the index group are "capitalization weighted."  That is, in calculating the index value, the market price of each constituent security is multiplied by the number of shares outstanding.  Because of this method of calculation, changes in the prices of the securities of larger corporations will generally have a greater influence on the level of a capitalization weighted index than price changes affecting smaller corporations.

Other methods may be used to calculate stock indexes.  For example, in one method known as "equal-dollar weighting," the index is established by establishing an aggregate market value for every constituent security of the index and then determining the number of shares of each security by dividing such aggregate market value by the then current market price of the security.  The base level of the index is established by dividing the total market value of all constituent securities by a fixed index divisor.  Thereafter, the number of shares of the constituent securities and the index divisor are adjusted at periodic intervals in order to have each constituent security continue to represent an approximately equal dollar value in the index without distorting the level of the index.

Another method of calculation is simply to add up the prices of the securities in the index and divide by the number of securities in the index, disregarding numbers of shares outstanding.  Another method measures daily percentage movements of prices by averaging the percentage price changes of all securities included in the index.

Investors should keep in mind that an index can respond only to reported price movements in its constituent securities.  An index will therefore reflect the stock market as a whole, or particular market segments, only to the extent that the securities in the index are being traded, the prices of those trades are being promptly reported, and the market prices of those securities, as measured by the index, reflect price movements in the relevant markets.  The index level will be affected by all of the factors that may at the time affect prices in the relevant markets for the constituent securities of the index, including, among other things, applicable laws, regulations and trading rules, the market-making and order processing systems of those markets, the liquidity and efficiency of those markets, and the prices and price behavior of futures contracts on that index or a related index.

Certain trading strategies involving purchases and sales of index options, index futures, options on index futures or portfolios of certain of the securities in an index can affect the value of the index, the prices of the index futures, and, therefore, the prices of index options.  These transactions and the resulting impact may occur at any time -- and may accompany significant changes in the prices or volatilities of the stock and derivative markets -- including at or shortly before an expiration.  For example, traders holding positions in expiring index options or futures contracts hedged by positions in securities included in the index may attempt to liquidate their securities positions at or near the time for determining the final exercise settlement value of the options or futures contracts.  The resulting orders to liquidate these securities might result in significant changes in the level of the index.  Index options investors should be aware of the potential impact that these trading strategies can have on index levels at or near expiration, and the possibility that the values of index option positions will be affected accordingly.

Readers who intend to trade index options should familiarize themselves with the basic features of the underlying indexes, including the general methods of calculation.  Readers who are attempting to follow a precise and sophisticated strategy involving index options may wish to inform themselves about the exact method for calculating each index involved.  Information regarding the method of calculation of any index on which options are traded, including information concerning the standards used in adjusting the index, adding or deleting securities, and making similar changes, is generally available from the options market where the options are traded.

The value level of every index underlying an option -- including the exercise settlement value -- is the value of the index as reported by the reporting authority designated by the options market where the option is traded as the official source for determining that index's value.  Unless OCC directs otherwise, every value as initially reported by the reporting authority is conclusively presumed to be accurate and deemed to be final for the purpose of calculating the cash settlement amount, even if the value is subsequently revised or determined to have been inaccurate.

Most indexes on which options are traded are updated during the trading day, and updated index levels are disseminated at frequent intervals.  Investors may determine current index levels from their brokerage firms; in addition, the closing levels of many underlying stock indexes are published in daily newspapers such as "The Wall Street Journal."  However, an index option may be traded in the options markets at a time when some, or even a substantial portion, of the constituent securities of the underlying index are not trading or when there is a lag in the reporting of prices in some or all of the constituent securities.  In those circumstances, the current reported index level will be based on non-current information, since its calculation will be based on the last reported prices for all constituent securities even though trading or price reporting in some of those securities is not current.


Features of Index Options

All index options that are traded at the date of this booklet are cash-settled.  Cash-settled index options do not relate to a particular number of shares.  Rather, the "size" of a cash-settled index option contract is determined by the multiplier of the option.  If the option market on which an option series is traded should decrease the multiplier for the series, an adjustment panel may adjust outstanding options of that series.

The exercise prices and premiums of the index options that are traded at the date of this booklet are expressed in U.S. dollars.  Subject to regulatory approval, trading in index options whose exercise prices or premiums are expressed in a foreign currency may be introduced in the future.  The total exercise price for a single option is the stated exercise price multiplied by the multiplier.

Premiums for index options are expressed in points and fractions of points.  Each point of premium of the options trading at the date of this booklet represents an amount equal to one U.S. dollar.  In order to determine the aggregate premium for a single index option, the quoted premium must be multiplied by the multiplier.

EXAMPLE:  An investor purchases a December 110 index call at 2-1/8.  The multiplier for that option is 100.  The aggregate dollar amount of the premium is $212.50 ($2-1/8 times 100 = $212.50).  Had the options market used a multiplier of 200, a premium of 2-1/8 would have meant an aggregate premium of $425.00.

The exercise settlement values of stock index options are determined by their reporting authorities in a variety of ways.  The exercise settlement values of some index options are based on the reported level of the index derived from the last reported prices of the constituent securities of the index at the closing on the day of exercise.  The exercise settlement values of other options are based on the reported level of the index derived from the opening prices of the constituent securities on the day of exercise.  If an option is exercised on a day that is not scheduled as a trading day for the constituent securities of the index, the exercise settlement value is based on the reported level of the index derived from the opening or closing prices (depending on the options series) of the constituent securities on the last prior day that is scheduled as a trading day.  If a particular constituent security does not open for trading on the day the exercise settlement value is determined, the last reported price of that security is used.  Other means for determining the exercise settlement values of some index options series have been, and may continue to be, established.  For example, the exercise settlement values for options on an index of foreign securities may be fixed in relation to a value fixed by a foreign exchange.

Investors should be aware that the exercise settlement value of an index option that is derived from the opening prices of the constituent securities may not be reported for several hours following the opening of trading in those securities.  A number of updated index levels may be reported at and after the opening before the exercise settlement value is reported, and there could be a substantial divergence between those reported index levels and the reported exercise settlement value.

Investors should also be aware that there is no single opening or closing price for securities primarily traded in the NASDAQ stock market.  A price of a NASDAQ security that is used in determining the level on a particular day of an index that includes the security will not necessarily be the price at which a majority of opening or closing trades in that security were effected on that day.

-----------------------------------

The principal risks of holders and writers of index options are discussed in Chapter X.  Readers interested in buying or writing index options should carefully read that chapter, particularly the discussions under the headings "Risks of Option Holders," "Risks of Option Writers," "Other Risks," and "Special Risks of Index Options."


Debt Options

Two kinds of debt options have been approved for trading at the date of this booklet.  One kind, called price-based options, are options which give their holders the right either to purchase or sell a specified underlying debt security or to receive a cash settlement payment based on the value of an underlying debt security (depending on whether the options are physical delivery or cash-settled options).  The other kind, called yield-based options, are options that are cash-settled based on the difference between the exercise price and the value of an underlying yield.  The distinctions between price-based and yield-based options are fundamental and should be understood by readers interested in investing in debt options.

At the date of this booklet, only yield-based options are being traded.  Although price-based options have traded in the past and may be traded in the future, no price-based option is traded at the date of this booklet.

The principal risks of holders and writers of debt options are discussed in Chapter X.  Readers interested in buying or writing debt options should not only read this chapter but should also carefully read Chapter X, particularly the discussions under the headings "Risks of Option Holders," "Risks of Option Buyers," "Other Risks," and "Special Risks of Debt Options."


Rates, Yields and Prices of Debt Securities

To understand debt options, an investor should understand the relationship between the rates or yields, which are different ways of expressing return on debt securities, and prices of debt securities.  (Coupon interest rates of a debt security express return as a percentage of the principal amount (par value) of the security.  Yields express return (or projected return) as a percentage of the amount invested.)  This relationship, simply stated, is that prices of debt securities move inversely to changes in rates.  Declining rates, whether on long-term bonds or money market instruments, will generally cause prices of outstanding debt securities to increase.  Conversely, rising rates across a particular maturity spectrum will generally cause the prices of outstanding debt securities of that maturity to decline.

EXAMPLE:  A 30-year Treasury bond pays interest at a 12% coupon rate.  The only time prior to maturity that investors will pay a price of 100 (that is, 100% of par value) for the bond is when the prevailing yield on such long-term Treasury bonds is exactly 12%.  Should rates move higher to, say, 14% for such Treasury bonds, the price of an outstanding 12% bond would have to decline to about 86 in order for the bond to yield 14%.  If rates on such bonds subsequently decline to 10%, the price of the 12% bond could be expected to rise substantially above par, since it would yield 10% at a price of 120.

Price-based call options become more valuable as the prices of the underlying debt securities increase, and price-based puts become more valuable as the prices of the underlying debt securities decline.  The relationship between interest rate changes, prices, and the value of price-based debt options can be expressed as follows:

Interest Rates (Yields) ↓     =     Prices ↑  =     Call ↑      Put ↓

Interest Rates (Yields) ↑     =     Prices ↓  =     Call ↓      Put ↑

In contrast, the exercise settlement value of a yield-based option is based on the difference between the value of an underlying yield and the exercise price of the option.  Since the underlying yields of yield-based options will increase as interest rates increase, and vice-versa, it follows that yield-based calls become more valuable as yields rise (i.e., as the prices of the debt securities from which the underlying yield is derived decline), and puts become more valuable as yields decline (and prices of such securities increase).  These relationships can be expressed as follows:

Interest Rates (Yields) ↓     =     Prices ↑  =     Call ↓     Put ↑

Interest Rates (Yields) ↑     =     Prices ↓  =     Call ↑     Put ↓


Treasury Securities

The underlying debt securities of price-based options and the debt securities from which the underlying yields of yield-based options are derived are all Treasury securities -- e.g., 30-year Treasury bonds, 10-year Treasury notes, 5-year Treasury notes  and Treasury bills.

Treasury bonds and notes are direct obligations of the United States that pay a fixed rate of interest semi-annually.  Bonds are issued for maturities of more than ten years (although many issues are callable prior to maturity).  Notes are issued for maturities of one to ten years, and are non-callable.  New issues of bonds and notes are sold periodically by the Treasury, usually on an auction basis.  The auction price is established by bidding and may be above or below par value.  Occasionally the Treasury will "reopen" an outstanding issue by auctioning additional principal amounts.  Government securities dealers make secondary markets in virtually all outstanding issues, but market activity and liquidity tend to center on the most recently auctioned issues.

Unlike Treasury bonds and notes, Treasury bills do not pay interest.  Instead, the Treasury sells bills at a discount from their principal amount (par value).  The investment return consists of the difference between the discounted purchase price and the principal amount payable at maturity.  Treasury bills are issued in maturities of 13, 26 or 52 weeks.

Return on Treasury bills is commonly expressed in terms of a discount rate which represents an annualization (based on a 360-day year) of the percentage discount at which the bills are sold.

EXAMPLE:  If a 13-week (91-day) Treasury bill with a principal amount of $1,000,000 is sold for $970,000, the actual discount would be $30,000 or 3% and the discount rate would be approximately 11.9% (360/91 times 3%).

Bills are auctioned by the Treasury on a regular basis, typically at weekly intervals for 13-week and 26-week bills and every four weeks for 52-week bills.  While dealers maintain secondary markets in all outstanding Treasury bills, activity tends to center in the most recently auctioned issues.  These are commonly referred to as the "current" 13-week, 26-week, and "year" bills, respectively.


Yield-Based Options

All yield-based options being traded at the date of this booklet are cash-settled European-style options.  The underlying yield of these options is the annualized yield to maturity of the most recently issued Treasury security of a designated maturity -- e.g., 30-year, 10-year, 5-year -- based upon quotations or prices determined in accordance with a method specified by the options market on which the option is traded.  If such security is a Treasury bill, the underlying yield is the annualized discount of the Treasury bill. (A discount represents a percentage of principal amount, rather than a return on investment, and is therefore not a true yield.)  Underlying yield is stated in terms of a yield indicator, which is the percentage yield multiplied by ten.  For example, if the yield is based on a Treasury bill having an annualized discount of 8.715%, the yield indicator would be 87.15.

The designated maturity of the Treasury security from which the underlying yield is determined is a standardized term of every yield-based option that is traded at the date of this booklet.  The specific Treasury security having that maturity is not fixed; rather, the underlying yield is derived from the outstanding security of the designated maturity that has the longest remaining life.  Newly-auctioned securities having the longest remaining life will replace old issues on the first trading day following their auction.  Thus, the specific Treasury security from which the underlying yield is derived may change during the life of the option.  Because yield-based options are European-style options, investors ordinarily will know prior to the time an option is exercisable the specific Treasury security from which its exercise settlement value will be determined.  However, an option may often be traded for weeks or months before that specific security is auctioned by the Treasury.  During that time, trading in the option will be based upon the yield for the Treasury security of the designated maturity that then has the longest remaining life.

EXAMPLE:  Yield-based options whose yield is based on 5-year Treasury notes expiring in December are opened for trading on the business day following the September auction of 5-year notes.  Trading in the options will be based upon current yields for the September issue until the October auction of 5-year notes.  Beginning on the trading day following the October auction, trading will be based upon current yields for the new 5-year notes.  The same process will occur in November.  If the options expire on or after the auction date for 5-year notes in December, their exercise settlement value will be based upon the then current yield for the December issue.

Current bid and asked quotations for recently issued Treasury securities of particular maturities are available from normal market sources.  Current yield indicator values based upon a sampling of bid and asked quotations from primary dealers are disseminated at frequent intervals during the trading day by an options reporting source.  Exercise settlement values for yield-based options whose underlying yields are derived from Treasury securities are based upon the spot yield for the security at a designated time on the last trading day of the option, as announced by the Federal Reserve Bank of New York.

The aggregate cash settlement amount that the assigned writer of a yield-based option is obligated to pay the exercising option holder is the difference between the exercise price of the option and the exercise settlement value of the underlying yield on the last trading day before expiration, as reported by a designated reporting authority, multiplied by the multiplier for the option.  Different yield-based options may have different multipliers.

The exercise prices of yield-based options are expressed in terms of the yield indicator.  For example, an exercise price of 82.50 would represent a yield of 8.25%.

Each point of premium will correspond to .1% in yield.  The dollar value of the premium for a single yield-based option will equal the quoted premium multiplied by the dollar value of the option multiplier.  Thus, a premium of 2½ would equal a premium of $250 for an option having a multiplier of 100, or $5000 for an option having a multiplier of 2000.

The premiums of yield-based options are affected by the factors discussed under "Premium" in Chapter II.  Because yield-based options are European-style options and the underlying yield is determined from the most recently auctioned Treasury security with the longest remaining life, a major factor affecting the pricing of such options is likely to be the estimates of market participants of the anticipated yield at expiration, and current yield may be a less significant pricing factor.

Settlement of exercises of yield-based options takes place on the business day immediately following the day of exercise.  Investors may determine from their brokerage firms when and how settlement amounts will be credited or debited to their brokerage accounts.

If the U.S. Department of the Treasury ceases to issue, or changes the terms or the schedule of issuance of, Treasury securities of a designated maturity, an adjustment panel has discretion to adjust the terms of the series by substituting other Treasury securities or to make such other adjustment as the adjustment panel may determine.  If the options market on which a particular yield-based option is traded should decrease the multiplier for the option, the adjustment panel has discretion to adjust outstanding options affected by the change by proportionately subdividing them or by taking other action.

Rules of the options market on which yield-based options are traded may permit or require suspension of trading in the options if current quotations for the last-auctioned Treasury securities of the designated maturity become unavailable or unreliable.  For a discussion of the risks involved in trading halts, see the discussion in Chapter X under "Other Risks."


Foreign Currency Options

Foreign currency options-- sometimes referred to simply as currency options-- are options to purchase or sell one currency at a price denominated in another currency.  The price of one currency in terms of another currency is known as an exchange rate.  The exercise price of a currency option thus represents an exchange rate.  The currency in which the premium and exercise price are denominated is referred to as the trading currency.  The currency to be purchased or sold at the exercise price is the underlying currency.

Certain of the foreign currency options discussed in this chapter, which are referred to as dollar-denominated foreign currency options, are options to purchase or sell underlying foreign currencies for U.S. dollars, and their exercise prices represent the exchange rates of the underlying foreign currencies with respect to the U.S. dollar.  Other options (which are referred to as cross-rate foreign currency options or cross-rate options) that are discussed below under "Cross-Rate Foreign Currency Options" are options to purchase or sell an underlying foreign currency at an exercise price that is denominated in another foreign currency.  The exercise price of a cross-rate option therefore represents an exchange rate between two foreign currencies.

While most of the foreign currency options that are traded at the date of this booklet are physical delivery options, trading has been introduced in cash-settled foreign currency options.  These options are discussed below under "Cash-Settled Foreign Currency Options."

The term "foreign currency" includes not only the currencies of individual nations, but also the European Currency Unit ("ECU").  The ECU, which is composed of specified amounts of various European currencies, is the official medium of exchange of the European Economic Community's European Monetary System and is primarily intended for use in international commerce.  As used in this booklet, the term "sovereign government" includes the European Economic Community.

The principal risks of holders and writers of foreign currency options are discussed in Chapter X.  Readers interested in buying or writing foreign currency options should not only read this chapter but should also carefully read Chapter X, particularly the discussions under the headings "Risks of Option Holders," "Risks of Option Buyers," "Other Risks," and "Special Risks of Foreign Currency Options."


Market for Foreign Currencies

Understanding the risks inherent in foreign currency options requires familiarity with the characteristics of the markets for the underlying currencies.  Readers will find extensive literature on the subject, and this chapter can do no more than briefly summarize the most fundamental characteristics of those markets as they pertain to foreign currency options.

Foreign exchange rates can be free floating or may be subject to a variety of formal or informal governmental exchange rate control mechanisms.  Exchange rates of most Western nations are permitted to fluctuate in value relative to the U.S. dollar and to each other.  It must be kept in mind, however, that sovereign governments rarely voluntarily allow their currencies to float freely in response to economic forces.  To the contrary, sovereign governments use a variety of techniques, such as intervention by a country's central bank or imposition of regulatory controls, to affect the exchange rates of their currencies.  Thus, a special risk in trading options on foreign currencies is that governmental actions might be instituted which could interfere with freely determined currency valuation or even with movement of currencies across borders.  These risks are specifically addressed under "Special Risks of Foreign Currency Options" in Chapter X.

The market in foreign currencies exists in every large financial center in the world, and primarily consists of trading by the world's international banks.  In contrast to the stock market, the market for foreign currencies is decentralized, essentially free from government regulation designed to protect investors (although, as noted above, governments may take various actions that affect their own currencies and the markets on which they are traded), and extremely large.  Trading is generally conducted in units equivalent to $1 million to $5 million, and the market is not structured for trading or delivery of small amounts of currency.  While a "retail market" for foreign currencies is available for tourists and others engaged in smaller transactions, the prices available in that market are only generally related to prices in the "wholesale" interbank market, and it is unlikely that the prices in the retail market will be as favorable as the prices for transactions in large amounts of foreign currency.


Special Characteristics of Foreign Currency Options

Foreign currency options, like other options, provide opportunities for investment and pose risks to investors as a result of fluctuations in the value of the underlying interest.  Just as certain options on equity securities are priced in relation to the price of the underlying security, dollar-denominated foreign currency option prices will generally depend in significant part on the U.S. dollar value of the underlying foreign currency.  Similarly, the prices of cross-rate options will tend to depend on the relative values of the underlying currency and the trading currency.

The relationship between the value of an underlying foreign currency relative to the trading currency and the prices of options on that underlying foreign currency can be summarized as follows:

1.   If the value of an underlying foreign currency rises in relation to the trading currency, call premiums will normally increase and put premiums decrease.

2.   If the value of an underlying foreign currency decreases in relation to the trading currency, call premiums will normally decrease and put premiums increase.

EXAMPLE:  Assume a dollar-denominated call option gives its holder the right to purchase British pounds at $1.35 each.  At expiration, that option will have intrinsic value if the price of the British pound is above $1.35.  At the same time, it will have no intrinsic value if the price of the pound is equal to or below $1.35.  The change in the price of British pounds may result from a change in the value of the U.S. dollar relative to all other currencies ("strong" dollar, "weak" dollar), from a change peculiar to the British pound ("strong" pound, "weak" pound), or from a combination of the two.  In any case, the final measure of the intrinsic value of the option will be the value of the British pound relative to the U.S. dollar.

EXAMPLE:  Assume a cross-rate call option gives its holder the right to purchase British pounds at 2.50 German marks ("DM") each.  At expiration, that option will have intrinsic value if the price of the British pound in German marks is above DM2.50.  It will have no intrinsic value if the price is equal to or below DM2.50 at that time.  Changes in the exchange rate between German marks and British pounds may result from changes in the value of German marks relative to other currencies generally, from changes in the value of the British pound, or from a combination of the two.  In any case, the intrinsic value of the option will be determined by the value of the British pound relative to the German mark, and not to the U.S. dollar or any other currency.  However, as is noted in the following section, fluctuations in the value of the trading currency relative to other currencies may significantly affect investors who intend to convert their gains or losses into one of those other currencies.

Readers should note that the various expiration dates for foreign currency options are different from the expiration dates for options on other underlying interests.  Readers should determine the expiration date of each foreign currency option they wish to buy or write.


Special Features of Dollar-Denominated Foreign Currency Options

The amount of the foreign currency underlying each foreign currency option (i.e., the unit of trading) is specified by the options market on which the option is traded.

Exercise prices for currently available dollar-denominated options on foreign currencies other than the Japanese yen are stated in U.S. cents per unit of foreign currency.  Exercise prices for dollar-denominated Japanese yen options are expressed in hundredths of U.S. cents per unit.  In order to determine the total exercise price per contract, it is necessary to multiply the stated exercise price by the unit of trading of the particular option.

EXAMPLE:  A dollar-denominated put covering 31,250 British pounds with an exercise price of 130 would entitle the holder to sell the underlying pounds for an aggregate exercise price of $40,625 ($1.30 multiplied by 31,250).

EXAMPLE:  A dollar-denominated call covering 6,250,000 Japanese yen with an exercise price of 94 would entitle the holder to buy the underlying yen for an aggregate exercise price of $58,750 ($.0094 multiplied by 6,250,000).

Because the issuer of a particular foreign currency may unilaterally issue a new currency to replace its existing currency or alter the exchange rate or exchange characteristics of its existing currency with respect to other currencies, an adjustment panel has the discretion to adjust the terms of the options on such foreign currency.  (At the date of this booklet, the representative of OCC on an adjustment panel has the power to vote on adjustments to all foreign currency options whether or not the votes of the other panel members result in a tie.)  Ordinarily, the terms of foreign currency options will not be adjusted to reflect a devaluation or revaluation of a currency.  The monetary authorities of the European Economic Community may change the weighting and identity of the currencies comprising the ECU from time to time.  Except in extraordinary circumstances, the terms of ECU options will not be adjusted to reflect such changes.

Premiums for currently available dollar-denominated options on foreign currencies other than the French franc and the Japanese yen are expressed in U.S. cents per unit of foreign currency.

EXAMPLE:  If a dollar-denominated option covering 62,500 Swiss francs is purchased at a premium of .81, the cost of the option will be $506.25 (.81 cents, or $.0081, times the unit of trading of 62,500).

Premiums for currently available dollar-denominated French franc options are expressed in tenths of U.S. cents.

EXAMPLE:  If a dollar-denominated option covering 250,000 French francs is purchased at a premium of .65, the cost of the option will be $162.50 (.065 cents, or $.00065, times the unit of trading of 250,000).

Premiums for currently available dollar-denominated Japanese yen options are expressed in hundredths of U.S. cents.

EXAMPLE:  If a dollar-denominated option covering 6,250,000 Japanese yen is purchased at a premium of .42, the cost of the option will be $262.50 (.0042 cents, or $.000042, times the unit of trading of 6,250,000).

Settlement of exercises of physical delivery dollar-denominated and cross-rate options is significantly different from settlement of exercises of other types of options.  The following is a description of the settlement procedures pertaining to such options.

Exercises are settled through the facilities of OCC.  For this purpose, OCC has established banking arrangements permitting it to receive and deliver each underlying foreign currency in the country of origin in satisfaction of option exercises.  (Exercises and assignments of ECU options settle within a country or countries designated by OCC.)  Clearing Members ordinarily deliver or receive foreign currency on the fourth business day after exercise that is also a banking day for OCC's correspondent bank in the country of origin.  In the case of dollar-denominated options, cash settlement between OCC and Clearing Members (i.e., payment or receipt of the net exercise price for each day's exercises) takes place in the United States or other locations approved by OCC.  In some cases, a wholly-owned subsidiary of OCC -- The Intermarket Clearing Corporation -- which has the same settlement procedures as OCC, may act as OCC's agent in making foreign currency settlements with Clearing Members.

For purposes of settlement between an investor and his brokerage firm, applicable rules require a holder exercising a physical delivery put option and an assigned writer of a physical delivery call option to arrange for the deposit of the requisite units of the underlying foreign currency into a designated bank account in the country issuing that currency no later than the time by which OCC requires delivery to it of foreign currency by its Clearing Members.  Through this procedure, investors ordinarily rely upon their brokerage firms to make settlement with them.  However, OCC has established procedures whereby Clearing Members may permit customers to make settlement directly with an OCC correspondent bank.  (At the date of this booklet, such procedures are not yet available in the case of cross-rate options.)  Investors should consult their brokerage firms with respect to these procedures.

At the date of this booklet, OCC expects, subject to regulatory approval, to adopt exercise settlement procedures whereby OCC's obligation to deliver or pay for underlying foreign currencies in satisfaction of option exercises may be discharged by transferring the foreign currency to be delivered, or the net exercise price for foreign currency to be received, to an OCC correspondent bank that is obligated to complete the settlement.  Brokerage firms and their customers would then be relying on the correspondent bank to deliver or pay for the underlying foreign currency.

If OCC should determine that foreign governmental restrictions or taxes would prevent the orderly settlement of delivery foreign currency option exercises or would result in undue burdens on OCC or its Clearing Members, OCC has the authority to impose special exercise settlement procedures.  These could range from technical changes in delivery procedures to the fixing of U.S. dollar settlement prices.  OCC's authority to fix cash settlement prices for foreign currency options applies to both calls and puts.  Thus, OCC could authorize exercising foreign currency put holders, as well as assigned call writers, to pay a U.S. dollar settlement price in lieu of delivering the underlying foreign currency.  However, OCC also has the authority to prohibit exercises of foreign currency puts by holders who would be unable to deliver the underlying foreign currency.  The potential effects of such a prohibition are discussed in paragraph 5 under "Risks of Option Holders" in Chapter X.  If special exercise settlement procedures are imposed, investors may determine the nature of such procedures from their brokers.


Cross-Rate Foreign Currency Options

As noted at the beginning of this chapter, a cross-rate foreign currency option is an option to purchase or sell a foreign currency at an exercise price that is denominated in another foreign currency.  An example of a cross-rate option is an option to purchase British pounds at an exercise price denominated in Japanese yen -- that is, the trading currency would be the Japanese yen and the underlying currency would be the British pound.  The exercise price would be expressed as a certain number of yen per pound.  Premiums for cross-rate options are denominated in the trading currency.  Thus, in the above example, premiums would be in yen.

The cross-rate options that have been approved for trading as of the date of this booklet are physical delivery European-style options.  It is possible that other kinds of cross-rate options will be traded in the future.

Investors in cross-rate options should bear in mind that the magnitude and direction of any change in the value of the underlying currency in relation to the trading currency may be quite different from the magnitude and direction of any contemporaneous change in the value of either of those currencies in relation to a third currency, such as the U.S. dollar.  Thus, for example, the British pound may appreciate in relation to the Japanese yen at the same time that the pound depreciates in relation to the U.S. dollar.  As discussed in Chapter X under "Special Risks of Cross-Rate Options," this is of particular significance to investors who intend to convert their profits or losses on cross-rate options into U.S. dollars.

 All of the previous discussion in this chapter relating to foreign currency options in general applies equally to cross-rate options except to the extent that it is specifically limited to dollar-denominated options.  Certain special features of cross-rate options are discussed below.


Special Features of Cross-Rate Options

The amount of the foreign currency underlying each cross-rate option (i.e., the unit of trading) is specified by the options market on which the option is traded.

The exercise price of a physical delivery cross-rate option is the price (denominated in the trading currency) at which the underlying currency may be purchased or sold upon exercise of the option.  Exercise prices for cross-rate options are generally expressed in terms of units (or fractions of units) of the trading currency per unit of the underlying currency.  Therefore, in order to determine the total exercise price per contract, it is necessary to multiply the stated exercise price by the unit of trading of the particular option.

EXAMPLE:  The exercise prices of yen-denominated options covering underlying German marks are expressed in yen per mark.  Therefore, a put covering 1,000,000 German marks with an exercise price of 93 Japanese yen ("JY") would entitle the holder to sell the underlying marks for an aggregate exercise price of JY93,000,000 (JY93 multiplied by 1,000,000).

The discussion in this chapter of adjustments under the caption "Special Features of Foreign Currency Options" is applicable also to cross-rate options, except that adjustments in the terms of cross-rate options might be made to reflect events affecting the trading currency as well as events affecting the underlying currency.

Premiums for currently available cross-rate options are expressed in units and decimals of the trading currency per unit of the underlying currency.

EXAMPLE:  If a yen-denominated option covering 500,000 British pounds is purchased at a premium of 2.63, the cost of the option will be JY1,315,000 (JY2.63 times the unit of trading of 500,000).

Premium settlements of cross-rate options are effected in a trading currency other than U.S. dollars.  Similarly, in the event of exercise, the exercise price is paid in the trading currency.  OCC has established banking arrangements permitting it to receive and pay foreign currencies in the country of origin for purposes of both premium and exercise settlement of cross-rate options between OCC and its Clearing Members.  Customers ordinarily settle with their brokerage firms, although OCC may establish procedures whereby Clearing Members may permit customers to make exercise settlement directly with an OCC correspondent bank.  Each customer should consult his brokerage firm to determine the procedures and time requirements for payment of foreign currencies on settlement of transactions in, and exercises of, cross-rate options.

If OCC should determine that foreign governmental restrictions or taxes or other events beyond the control of OCC would prevent the orderly settlement of exercises of, or premium payments with respect to transactions in, cross-rate options or would result in undue burdens on OCC or its Clearing Members, OCC has the authority to impose special settlement procedures.  These could range from technical changes in payment procedures for the trading currency or underlying foreign currency to the fixing of U.S. dollar settlement prices payable in lieu of either currency.  OCC also has the authority to prohibit exercises of cross-rate options by holders who would be unable to meet the settlement obligations resulting from the exercise.  The potential effects of such a prohibition are discussed in paragraph 5 under "Risks of Option Holders" in Chapter X.  If special exercise settlement procedures are imposed, investors may determine the nature of such procedures from their brokerage firms.


Cash-Settled Foreign Currency Options

At the date of this booklet, cash-settled foreign currency options are also traded.  These options are dollar-denominated, European-style options.  Each cash-settled foreign currency option has an expiration date not more than approximately two weeks following the initiation of trading in the option.  Cash-settled foreign currency options having longer expirations may be traded in the future.

The discussion above in this chapter relating to dollar-denominated foreign currency options generally applies to cash-settled foreign currency options except to the extent that such discussion specifically applies to physical delivery options.

The contract size of a cash-settled foreign currency option, like the size of other foreign currency options, is expressed in terms of the amount of the underlying currency covered by the option.

EXAMPLE:  If the exercise price of a cash-settled call option on German marks is 60 (expressed as U.S. cents per mark), the exercise settlement value of the underlying currency is reported as 65, and the unit of trading is 62,500 marks, then the cash settlement amount of the option will be ($.65 minus $.60) multiplied by 62,500 = $3,125.

A cash-settled foreign currency option that, based on its exercise settlement value, is in the money on the expiration date will be automatically exercised on the expiration date.  In the future cash-settled foreign currency options may provide that they will be automatically exercised only if they are in the money by a specified amount on the expiration date.

At the date of this booklet, the exercise settlement value for cash-settled foreign currency options is based upon bid and offer quotations from a sampling of participants in the interbank spot market for the underlying foreign currency at a specified time on the expiration date.  The  time as of which the exercise settlement value is calculated and the method of calculation is determined by the options market on which the options are traded and may be changed by it at any time.  Any such change may be made applicable to options outstanding at the time of the change.

Another special feature of cash-settled foreign currency options having an expiration date of not more than two weeks following the initiation of trading is that option writers must deposit required margin with their brokerage firms within two business days of the trade date.  It should be noted that this is a shorter period than the normal period required for other options transactions.


Flexibly Structured Options

Flexibly structured options, like the other options discussed in this booklet, are traded on the U.S. options markets and are issued by OCC.  However, unlike other options, the terms of flexibly structured options are not all standardized.  When a flexibly structured option is purchased and sold in an opening transaction, the parties to the transaction have the flexibility, within limitations set forth in the rules of the options market on which the transaction occurs, to fix certain of the option's terms.  The terms of a flexibly structured option which may be fixed by the parties are called variable terms.  The flexibility to fix these variable terms is what makes flexibly structured options different from other options.

The principal risks of holders and writers of flexibly structured options are discussed in Chapter X.  Readers who are interested in buying or writing flexibly structured options should read not only this chapter but also all of Chapter X.

Because many of the terms of flexibly structured options are not standardized, it is less likely that there will be an active secondary market in which holders and writers of such options will be able to close out their positions by offsetting sales and purchases.  See paragraph 1 under "Special Risks of Flexibly Structured Options" in Chapter X.

The trading procedures established by the options markets for transactions in flexibly structured options differ from the procedures for transactions in other options.  Readers desiring information about the trading procedures of an options market for flexibly structured options may obtain that information from that market.

The options markets may fix minimum size or minimum monetary values for transactions in flexibly structured options.  Flexibly structured options may be useful to sophisticated investors seeking to manage particular portfolio and trading risks.  However, as a result of these minimums, as well as the special trading procedures and reduced likelihood of there being a secondary market, flexibly structured options transactions are not suitable for investors who are not financially able to bear the risks of maintaining such minimum positions in flexibly structured options.


Special Features of Flexibly Structured Options

DESIGNATION OF TERMS—The parties to an opening transaction in flexibly structured options may designate the option's variable terms in accordance with the rules of the options market where the transaction occurs.  Included among the terms that an options market may identify as variable terms are the specification and amount of the underlying interest, whether the transaction involves a put, call or spread, the style of the option, the exercise price, the cap interval of a capped option, the expiration date, the method for determining the exercise settlement value of a cash-settled option that is exercised on the expiration date, the settlement currency of a cash-settled option, the premium currency, and the trading currency of a foreign currency option.

Only those terms identified as variable terms by the options market where the opening transaction occurs may be designated by the parties.  All other terms are standardized in accordance with the rules of OCC and the options market.  The rules of an options market may impose limitations on the variable terms which the parties may designate.  For example, an options market may require that the expiration date of a flexibly structured option not fall within a specified period of time or that the life of the option not exceed a maximum permissible term.  As another example, if the exercise settlement value of an index option is based on a specified average, an options market may require that the average conform with the averaging parameters established by the market.  In addition, the underlying interest, the settlement currency, the premium currency and the trading currency, may be designated only from those available for flexibly structured options on the options market, and an options market may require that the premium currency be the same as the settlement currency.

The parties to an opening transaction in a flexibly structured call option on an individual stock may fix the exercise price of the option only at a price that would qualify under the rules of the options market where the opening transaction occurs as the exercise price of a series of non-flexibly structured option on the same stock, and that is evenly divisible by the applicable minimal exercise price interval on that market. For example, for a flexibly structured call option on a stock for which the minimum exercise price interval is $5, the exercise price may be designated as $25, $30, $35, $40, etc. This restriction does not apply to the exercise prices of flexibly structured stock put options. Investors considering strategies involving combinations of flexibly structured put and call stock options should therefore be aware of this difference between the two types of options.

MINIMUM SIZE REQUIREMENTS—Every transaction in flexibly structured options must satisfy the minimum size or monetary value requirements of the options market where the transaction occurs.  The minimum requirements may be larger for an opening transaction in a series in which there is no open interest than for other transactions (whether opening or closing) in that series.  An options market may also impose minimum size or monetary value requirements on exercises of flexibly structured options.  Information as to such minimums may be obtained from the options market where the options are traded.

POSITION and EXERCISE LIMITS—The options markets may establish special position and exercise limits for flexibly structured options.  Such limits may differ from the limits applicable to other options, although an options market may require that positions in certain flexibly structured options be aggregated with positions in certain other options.  Information concerning position and exercise limits of particular flexibly structured options may be obtained from the options market where the options are traded or from brokerage firms.

TRADING PROCEDURES—The trading hours and trading procedures for flexibly structured options may differ from the trading hours and procedures for other options.  These special procedures may mean that the market-making systems that are applicable to other options may not be applicable to flexibly structured options, that there may not be continuous quotations for flexibly structured options, and that quotations may be provided only in response to a specific request as the basis for trading with the party making the request.

EXERCISES and SETTLEMENTS—In general, the exercise, assignment and settlement of flexibly structured options occurs in the same manner as, and are subject to the same time frames and procedures that are applicable to, other options of the same style and having the same underlying interest.  See Chapter VIII.  However, unlike most other options, flexibly structured index options that are in the money on the expiration date may be exercised automatically. In the future it may be provided that flexibly structured index options will be exercised automatically only if they are in the money by a specified amount.

EXERCISE SETTLEMENT VALUE—The method of determining the exercise settlement value on the expiration date of a flexibly structured index option is a variable term that is fixed by the parties in their opening transaction.  For example, the parties may specify that such exercise settlement value  will be determined with reference to opening prices of the constituent securities of the index, their closing prices, an average of their high and low prices, an average of opening and closing prices, an average over a stated period of time, or another average that conforms with the parameters established by the options market.  However, under the OCC rules in effect at the date of this booklet, the method of determining the exercise settlement value for an exercise that occurs on a day other than the expiration date is not a variable term.  The exercise settlement value for such exercises of flexibly structured index options will be the value derived from the closing prices of the constituent securities on the day of exercise (as reported by the reporting authority), and the exercise settlement value of other flexibly structured options will be determined in the same manner as it is determined for other options on the same underlying interest that are traded on the options market where the opening transaction in the flexibly structured option occurred.

SETTLEMENT CURRENCY—The settlement currency may be a variable term to be fixed by the parties out of those currencies specified by the options market on which the transaction occurs as being available for flexibly structured options.  The settlement currency may be the currency in which the premium is payable.  In addition, brokerage firms may require their customers to make margin payments in the settlement currency.

If the settlement currency and premium currency are not U.S. dollars, settlement of premiums and exercises is generally made through the procedures and arrangements established by OCC for cross-rate foreign currency options.  See "Special Features of Cross-Rate Options" in Chapter VI.  If ECUs are the settlement currency, settlements can occur in the country or countries designated by OCC.


Exercise and Settlement

Although most option holders and writers close out their options positions by an offsetting closing transaction, investors should nonetheless be familiar with the rules and procedures applicable to exercise.  Such an understanding can help an option holder determine whether exercise might be more advantageous than an offsetting sale of the option.  An option writer needs to understand exercise procedures because of the possibility of being assigned an exercise.  Once an exercise of an option has been assigned to an option writer -- even though he may not yet have been notified of the assignment -- the writer can no longer effect a closing transaction in that option but must instead purchase or sell the underlying interest for the exercise price (or, in the case of a cash-settled option, pay the cash settlement amount).


How to Exercise

The period during which an option is exercisable depends on the style of the option. This is discussed under "Style of Option" in Chapter II.

In order to exercise most options traded at the date of this booklet, action must be taken by the option holder prior to the expiration of the option.  However, some options may be subject to automatic exercise.  For example, capped options are subject to automatic exercise if the automatic exercise value of the underlying interest hits the cap price for the option, and certain other options are subject to automatic exercise at expiration if they are then in the money (or, in the case of some options, in the money by a specified amount).

To exercise an option that is not subject to automatic exercise, the holder must direct his brokerage firm to give exercise instructions to OCC.  In order to ensure that an option is exercised on a particular day, the holder must direct his brokerage firm to exercise before the firm's cut-off time for accepting exercise instructions for that day.  Different firms may have different cut-off times for accepting exercise instructions from customers, and those cut-off times may be different for different options.

A brokerage firm's cut-off time for accepting exercise instructions becomes critical on the last trading day before an option expires.  An option that expires unexercised becomes worthless.  An option holder who intends to exercise an option before expiration must give exercise instructions to his brokerage firm before the firm's cut-off time for accepting exercise instructions on the last trading day before expiration.  Many brokerage firms accept standing instructions to exercise, or have procedures for the exercise of, every option which is in the money by a specified amount at expiration.  These procedures often incorporate by reference OCC's administrative procedures that provide for the exercise of every option that is in the money by a specified amount at expiration unless the Clearing Firm carrying the option in its accounts instructs OCC not to exercise the option.  Investors should determine from their brokerage firm the applicable cut-off times, the firm's procedures for submitting exercise instructions, and whether any of their options are subject to automatic exercise.  Investors should also determine whether the exercise of their options is subject to standing instructions of their brokerage firm, and, if so, they should discuss with the firm the potential consequences of such instructions.

In highly unusual circumstances (e.g., where a brokerage firm is unable to receive instructions from its customers), a firm may be authorized under applicable rules to make an exception to its regular cut-off time.  However, in order for an option to be exercised, the brokerage firm must in any event pass on its customer's exercise instructions to OCC before expiration.  OCC may allow exercises for a limited time after expiration in the unlikely event that OCC is unable to follow its normal procedures for receiving exercise instructions from Clearing Members on the expiration date.  Subject to that very limited exception, OCC has no authority to extend the expiration of any option.

Once an exercise instruction is given by a Clearing Member to OCC, it cannot ordinarily be revoked except to correct a bona fide error that is specified in a request filed by the Clearing Member prior to a deadline specified in OCC's rules.


Assignment

OCC assigns exercises in standardized lots to Clearing Member accounts that reflect the writing of options identical to the exercised options.  A description of OCC's assignment procedures is available from OCC on request at the address set forth in paragraph 1 of Chapter XI of this booklet.  Assignments are ordinarily made prior to the commencement of trading on the business day following receipt by OCC of the exercise instruction.  In the case of options traded in evening sessions, exercise instructions received by OCC on a business day are ordinarily assigned prior to the opening of trading in that day's evening session.

If exercises are assigned by OCC to a Clearing Member's customers' account, the Clearing Member must then assign them to customers maintaining positions as writers of the exercised options series.  The rules of the options markets require their member firms to allocate assignments to customers either on a random selection basis or on a "first-in, first-out" basis and to inform their customers which method is used and how it works.  Regardless of the method used, option writers are subject to the risk each day their options are exercisable that some or all of them may be assigned.  (See the discussion in Chapter X under "Risks of Option Writers.")

It is possible that an option writer will not receive notification from its brokerage firm that an exercise has been assigned to him until one or more days following the date of the initial assignment to the Clearing Member by OCC.  This creates a special risk for uncovered writers of physical delivery call stock options.  This is discussed in paragraph 8 under "Risks of Options Writers" in Chapter X and under "Settlement" in this chapter.


Settlement

Settlements between brokerage firms or their agents on virtually all exercised physical delivery stock options are routinely handled through stock clearing corporations in much the same way as ordinary purchases and sales of the underlying equity security.  Promptly after the exercise and assignment of a physical delivery stock option, OCC reports it to the designated stock clearing corporations of the Clearing Members representing the exercising holder and the assigned writer.  If neither stock clearing corporation rejects the transaction by a time specified in their agreements with OCC, settlement is effected pursuant to the rules of those clearing corporations, and OCC has no further responsibility to either the exercising holder or the assigned writer.

In a few cases -- which usually occur because an underlying equity security is no longer eligible for clearance through a stock clearing corporation -- settlements calling for the delivery of that security are made directly between Clearing Members.  OCC's rules provide protect procedures for exercise settlements made directly between Clearing Members that involve the delivery of securities which either have been called for redemption, are due to expire or with respect to which a call or expiration date is impending, or are subject to an offer which will expire, if the expiration time (as defined in OCC's rules) is on or after the exercise settlement date for the option.  Under these protect procedures, the Clearing Member entitled to receive the securities may give a liability notice to the delivering Clearing Member by a specified cut-off time prior to the expiration time.  If a liability notice is so given and the securities are not delivered sufficiently in advance of the expiration time to permit the receiving Clearing Member to obtain their benefit, the delivering Clearing Member will be liable for any resulting damages.  If the failure to deliver was the fault of the Clearing Member's customer, the Clearing Member may (depending on its own procedures) pass that liability on to the customer.  Investors should be aware that correspondent clearing corporations may have protect procedures in respect of the settlements made through them.

At the date of this booklet, the regular exercise settlement date for physical delivery stock options is the fifth business day after exercise, but the SEC has adopted a rule that requires the regular settlement date to be the third business day after an exercise that takes place on or after June 1, 1995.  The regular exercise settlement dates for all other types of physical delivery options traded at the date of this booklet are described in the separate chapters of the booklet discussing those options.

At the date of this booklet, settlements of exercises of cash-settled options and foreign currency options are effected by Clearing Members through OCC.  Settlement of exercises of cash-settled options -- through the payment in cash of the cash settlement amount -- ordinarily takes place on the business day immediately following the day of exercise.  However, cash-settled capped options that have been automatically exercised on any trading day other than the one immediately prior to expiration are settled on the second business day after the automatic exercise is triggered.  The settlement of exercises of cash-settled options that have a settlement currency that is not U.S. dollars is discussed under "Settlement Currency" in Chapter VII.

OCC has authority to postpone settlement of any option on any type of underlying interest when OCC considers such action to be necessary in the public interest or to meet unusual conditions.

Each brokerage firm involved in an exercise or assignment settles with its own customer.  Neither OCC nor any options market has any responsibility to customers with respect to funds or securities that have been received by brokerage firms for their customers.  Investors may determine from their brokerage firms when and how settlement amounts will be credited or debited to their brokerage accounts.

In certain unusual circumstances, it might not be possible for uncovered call writers of physical delivery stock and stock index options to obtain the underlying equity securities in order to meet their settlement obligations following exercise.  This could happen, for example, in the event of a successful tender offer for all or substantially all of the outstanding shares of an underlying security or if trading in an underlying security were enjoined or suspended.  In situations of that type, OCC may impose special exercise settlement procedures.  These special procedures, applicable only to calls and only when an assigned writer is unable to obtain the underlying security, may involve the suspension of the settlement obligations of the holder and writer and/or the fixing of cash settlement prices in lieu of delivery of the underlying security.  In such circumstances, OCC might also prohibit the exercise of puts by holders who would be unable to deliver the underlying security on the exercise settlement date.  When special exercise settlement procedures are imposed, OCC will announce to its Clearing Members how settlements are to be handled.  Investors may obtain that information from their brokerage firms.


Tax Considerations, Transactions Costs and Margin Requirements

Options investing, like other forms of investing, involves tax considerations, transaction costs and margin requirements that can significantly affect the profit or loss results of buying and writing options.  These are only briefly mentioned in this chapter, but should be understood and taken into account by everyone considering transactions in options.

Notwithstanding the importance of tax considerations, transaction costs and margin requirements, for the sake of simplicity the examples in this booklet do not take these matters into account.  Nevertheless, it should be remembered that their impact may significantly reduce the opportunity for profit and the rate of return obtainable from particular options trading strategies; indeed, their effect may in some instances turn an apparent profit into a loss.


Tax Considerations

The tax consequences of an options transaction depend, in part, on the tax status of the investor and also may differ depending upon the type of underlying interest involved -- since the tax rules are not the same for each type of underlying interest -- and upon such factors as whether an option is exercised or is the subject of a closing transaction or is allowed to expire or whether an option that is written is covered or uncovered.  Some options markets have publications that deal specifically with the tax treatment of various options transactions.  These may be obtained from brokerage firms as well as the markets themselves.  Readers should also be aware that options transactions effected in foreign markets could subject the parties to tax liability under the laws of the country in which the foreign market is located.  Because of the importance of tax considerations to all options transactions, it cannot be emphasized too strongly that the reader considering options should consult with his tax adviser as to how taxes may affect the outcome of contemplated options transactions.


Transaction Costs

The transaction costs of options investing consist primarily of commissions (which are imposed in opening, closing, exercise and assignment transactions), but may also include margin and interest costs in particular transactions.  The impact of transaction costs on profitability is often greater for options transactions than for transactions in the underlying interests because these costs are often greater in relation to options premiums than in relation to the prices of underlying interests.  Transaction costs are especially significant in option strategies calling for multiple purchases and sales of options, such as spreads and straddles.  Transaction costs may be different for transactions effected in foreign options markets than for transactions effected in U.S. markets.  Readers should always discuss transaction costs with their brokerage firms before engaging in options transactions.


Margin Requirements

Writers of options, other than certain covered call option writers and certain writers of cash secured puts (discussed below), must comply with applicable margin requirements.

In the stock market, margin refers to buying stock or selling stock short on credit.  Margin customers are required to keep securities on deposit with their brokerage firms as collateral for their borrowings.  But options, unlike stock, cannot be bought on credit under current regulations.  In the options market, margin means the cash or securities required to be deposited by an option writer with his brokerage firm as collateral for the writer's obligation to buy or sell the underlying interest, or in the case of cash-settled options to pay the cash settlement amount, if assigned an exercise.  Minimum margin requirements are currently imposed by the Board of Governors of the Federal Reserve System, the options markets and other self-regulatory organizations, and higher margin requirements may be imposed -- either generally or in individual cases -- by the various brokerage firms.

Uncovered writers may have to meet calls for substantial additional margin in the event of adverse market movements.  Even if a writer has enough equity in his account to avoid a margin call, increased margin requirements on his option positions will make that equity unavailable for other purposes.

If a holder of a physical delivery call option exercises and wishes to purchase the underlying interest on credit, the holder may be required to deposit margin with the holder's brokerage firm.  Holders of physical delivery options on a foreign currency should be aware that, at the date of this booklet, foreign currency has no value for margin purposes except to the extent that credit has been extended on the same foreign currency.

Margin requirements are complex and are not the same for writers of options on different types of underlying interests.  Margin requirements are subject to change, and may vary from brokerage firm to brokerage firm.  Consequently, the examples in this booklet do not take margin requirements into account.  However, margin requirements can have an important effect on an option writer's risks and opportunities.

Persons considering writing options (whether alone or as part of options combinations, such as spreads or straddles) should determine the applicable margin requirements from their brokerage firms and be sure that they have sufficient liquid assets to meet those requirements in the event of adverse market movements.


Principal Risks of Options Positions

This chapter discusses the principal risks of holders and writers of options.  The risks discussed are those that are unique to being an option holder or writer.  Risks that relate to such matters as the trading of securities generally; the state of the economy; the supply and demand factors in the options markets and in other related markets; the factors affecting the values of the various underlying interests; the factors affecting the volatility, liquidity and efficiency of the options markets or of other markets or other factors that may affect the pricing of particular options; the quality or operations of the various options markets at any particular time; and the procedures of the various options markets and of brokers in transmitting orders and effecting executions are not within the scope of this booklet and are not discussed.  (See the discussion in Chapter XI as to the scope and limitations of this booklet.)

It should also be noted that new types of options and new options strategies are constantly being developed and that some of the risks of new options products and new options strategies do not become apparent until there has been significant experience in trading and using the new options and strategies.  Accordingly, readers should be aware that there is a risk in newness, particularly if the new option or strategy is complicated or complex, that cannot always be identified or described.

Readers should also be aware that not all options strategies will necessarily be suitable for them and that certain strategies may expose them to very significant potential losses.  For example, the risks associated with the writing of puts or uncovered calls expose investors to such potential losses, and this type of strategy is therefore not suitable for all investors.

Many of the risks are the same for options on all types of underlying interests, although some special risks may apply only to options on particular types of underlying interests.  The first three sections of this chapter describe risks that apply generally to options on all types of underlying interests.  They are followed by sections discussing the special risks associated with options on the particular types of underlying interests.


Risks of Option Holders

1.   An option holder runs the risk of losing the entire amount paid for the option in a relatively short period of time.  This risk reflects the nature of an option as a wasting asset which becomes worthless when it expires.  An option holder who neither sells his option in the secondary market nor exercises it prior to its expiration will necessarily lose his entire investment in the option.  (As noted in Chapter VIII, many brokerage firms have procedures for the exercise of options at expiration that are then in the money by a specified amount.)

The fact that options become valueless upon expiration means that an option holder must not only be right about the direction of an anticipated price change in the underlying interest, but he must also be right about when the price change will occur.  If the price of the underlying interest does not change in the anticipated direction before the option expires to an extent sufficient to cover the cost of the option, the investor may lose all or a significant part of his investment in the option.  This contrasts with an investor who purchases the underlying interest directly and may continue to hold his investment, notwithstanding its failure to change in price as anticipated, in the hope of waiting out an adverse price move and eventually realizing a profit.

The significance of this risk to an option holder depends in large part upon the extent to which he utilizes the leverage of options to control a larger quantity of the underlying interest than he could have purchased directly with the same investment amount.  This is illustrated in the following example, which compares the consequences of three different approaches to investing the same amount of money in stock or options, with each approach involving a different degree of leverage.

EXAMPLE:  Assume that Investors A, B and C each have $5,000 to invest and that each anticipates an increase in the market price of XYZ stock, which is currently $50 a share.  Investor A invests his $5,000 in 100 shares of XYZ.  Investor B invests $500 in the purchase of an XYZ 50 call (covering 100 shares of XYZ at a premium of $5 a share) and invests the remaining $4,500 in a relatively risk-free investment such as Treasury bills.  (For purposes of this example, it is assumed that all of the calls are purchased when they have six months remaining until expiration, and that the risk-free investment bears interest at an annual rate of, say, 3.25%  -- which means that a $4,500 investment will earn approximately $73 in interest over six months.)  Investor C invests his entire $5,000 in 10 XYZ 50 calls.

If each option is held for six months and, if it is profitable, is either sold or exercised immediately before it expires, the following table illustrates the dollar and percentage profit or loss that each investor would realize on his $5,000 investment, depending upon the price of XYZ stock when the option expires.

							Investor A	Investor B	Investor C
Price of XYZ Stock at Expiration		Profit or Loss	%Return		Profit or Loss	%Return		Profit or Loss	%Return
62		+1200	+ 24%		+773	+15.5%		+7000	+140%
58		+ 800	+ 16%		+373	+ 7.5%		+3000	+ 60%
54		+ 400	+ 8%		- 27	- 0.5%		-1000	- 20%
50		0	0		-427	- 8.5%		-5000	- 100%
46		- 400	- 8%		-427	- 8.5%		-5000	- 100%
42		- 800	-16%		-427	- 8.5%		-5000	- 100%
38		-1200	-24%		-427	- 8.5%		-5000	- 100%
The table demonstrates how increased leverage results in greater profit potential on the upside and greater risk of loss on the downside.  Investor C, as the most leveraged investor, would realize the highest percentage return if the price of XYZ increased to 62, but would incur a 20% loss even if the price of XYZ increased to 54 (assuming he did not sell his options while they had significant remaining time value), and would lose all of his investment if the price of XYZ stayed at or below 50.

2.   The more an option is out of the money and the shorter the remaining time to expiration, the greater the risk that an option holder will lose all or part of his investment in the option.  The greater the price movement of the underlying interest necessary for the option to become profitable (that is, the more the option is out of the money when purchased and the greater the cost of the option) and the shorter the time within which this price movement must occur, the greater the likelihood that the option holder will realize a loss.  This does not necessarily mean that an option must be worthwhile to exercise in order for a holder to realize a profit.  Instead, it may be possible for the holder to realize a profit by selling an option prior to its expiration for more than its original cost even though the option never becomes worthwhile to exercise.  (The shorter the time remaining until expiration the less likely it is that this will be possible.)

3.   Prior to the period when a European-style option or a capped option is exercisable, the only means through which the holder can realize value from the option (unless the capped option is automatically exercised) is to sell it at its then market price in an available secondary market.  If a secondary market for such an option is not available during the time the option is not exercisable, it will not be possible for its holder to realize any value from the option at that time.

4.   The exercise provisions of an option may create certain risks for the option holders.  If the option does not have an automatic feature, a holder who wishes to exercise must assure that action is taken in a timely manner.  See the discussion of "How to Exercise" in Chapter VIII.

On the other hand, if the option has an automatic exercise feature -- such as one that will cause the option to be automatically exercised at the expiration if it is in the money by a specified amount -- the option may be exercised at a price at which the holder would not voluntarily choose to exercise in view of the transactions costs of exercise or other factors.  The transaction costs associated with the exercise could even exceed the cash settlement amount of the option, with the result that the holder would realize a net loss from the exercise.  Conversely, an option that has a cash settlement amount that is less than the threshold amount cannot be exercised even though the option holder's transaction costs may be low enough to permit the option to be exercised profitably.  In such a case, the option may expire unexercised.

The automatic exercise feature of capped options imposes a maximum value that a holder of these options can receive.  Even if the option holder expects the value of the underlying interest to continue to move in a favorable direction prior to its expiration, the automatic exercise feature will prevent the holder from realizing any gain from the option in excess of the cap interval times the multiplier for the option.

5.   The courts, the SEC, another regulatory agency, OCC or the options markets may impose exercise restrictions.  While an American-style option can normally be exercised at any time prior to its expiration, OCC and the options markets have authority to restrict the exercise of options at certain times in specified circumstances.  The options markets often exercise such authority with respect to an option in which trading has been halted.  If a restriction on exercise is imposed at a time when trading in the option has also been halted, holders of that option will be locked into their positions until either the exercise restriction or the trading halt has been lifted.

Exercise restrictions imposed by OCC and the options markets affecting cash-settled options generally cannot be continued in effect beyond the opening of business on the last trading day before their expiration.  Such exercise restrictions affecting physical delivery options generally cannot be continued beyond the opening of business on the tenth business day before their expiration, but with one important exception.  If OCC determines that the available supply of a security underlying a physical delivery option appears to be insufficient to permit delivery of the security by the writers of all outstanding calls in the event of exercise, or that foreign government restrictions would prevent or unduly burden the orderly settlement of exercises of foreign currency options, OCC may indefinitely prohibit the exercise of puts by holders who would be unable to deliver the underlying security.  The holder of such a put could lose his entire investment in the option if the prohibition remained in effect until the put's expiration and the holder was unable either to acquire the underlying interest or to sell his put in the market.  The put holder might be unable to do either because the very event that caused OCC to impose the exercise prohibition -- e.g., a suspension of trading in an underlying stock -- might not only make it difficult or impossible to obtain the underlying interest, but might also impair the market in options on that interest.

It is also possible that a court, the SEC or another regulatory agency having jurisdiction would impose a restriction which would have the effect of restricting the exercise of an option.  In such a case the option would not be exercisable until the restriction was terminated.  In the remote possibility that the restriction were to remain in effect until the expiration of the option -- which has never yet occurred -- the option would expire worthless, and the holder would lose the entire amount that he paid for the option.


Risks of Option Writers

1.   An option writer may be assigned an exercise at any time during the period the option is exercisable.  Starting with the day it is purchased, an American-style option is subject to being exercised by the option holder at any time until the option expires.  This means that the option writer is subject to being assigned an exercise at any time after he has written the option until the option expires or until he has closed out his position in a closing transaction.  By contrast, the writer of a European-style or capped option is subject to assignment only when the option is exercisable or, in the case of a capped option, when the automatic exercise value of the underlying interest hits the cap price.

An assigned writer may not receive notice of the assignment until one or more days after the assignment has been made by OCC.  Once an exercise has been assigned to a writer, the writer may no longer close out the assigned position in a closing purchase transaction, whether or not he has received notice of the assignment.  In that circumstance, an attempted closing purchase would be treated as an opening purchase transaction.

If an option that is exercisable is in the money, the option writer can anticipate that the option will be exercised, especially as expiration approaches.  Once he is assigned an exercise, the assigned writer must deliver (in the case of a call) or purchase (in the case of a put) the underlying interest (or pay the cash settlement amount in the case of an in the money cash-settled option).  The consequences of being assigned an exercise depend upon whether the writer of a call is covered or uncovered, as discussed below.

2.   The writer of a covered call forgoes the opportunity to benefit from an increase in the value of the underlying interest above the option price, but continues to bear the risk of a decline in the value of the underlying interest.  Unlike a holder of the underlying interest who has not written a call against it, the covered call writer has (in exchange for the premium) given up the opportunity to profit from an increase in the value of the underlying interest above the exercise price.  If he is assigned an exercise, the net proceeds that he realizes from the sale of the underlying interest pursuant to the exercise could be substantially below its prevailing market price.

EXAMPLE:  When XYZ stock was $50, the investor collected a $4 a share premium by writing an XYZ 50 delivery call.  As expiration approaches, the stock has risen to $58 and he is assigned an exercise.  His total return, in addition to any dividends received, will be the $50 exercise price he is paid for the stock plus the $4 premium collected when the option was written -- $4 a share less than the $58 he could have sold the stock for if he had not written the option.

On the other hand, if the value of the underlying interest declines substantially below the exercise price, the call is not likely to be exercised and, depending upon the price paid for the underlying interest, the covered call writer could have an unrealized loss on the underlying interest.  However, that loss will be wholly or partially offset by the premium he received when he wrote the option.

3.   The writer of an uncovered call is in an extremely risky position and may incur large losses if the value of the underlying interest increases above the exercise price.  The potential loss is unlimited for the writer of an uncovered call.  When a physical delivery uncovered call is assigned an exercise, the writer will have to purchase the underlying interest in order to satisfy his obligation on the call, and his loss will be the excess of the purchase price over the exercise price of the call reduced by the premium received for writing the call.  (In the case of a cash-settled option, the loss will be the cash settlement amount reduced by the premium.)  Anything that may cause the price of the underlying interest to rise dramatically, such as a strong market rally or the announcement of a tender offer for an underlying stock at a price that is substantially above the prevailing market price, can cause large losses for an uncovered call writer.

EXAMPLE:  An investor receives a premium of $4 a share for writing an uncovered XYZ 50 call option and the stock price jumps to $69 as the option approaches expiration.  If the investor liquidates his option position at, say, $19, in an offsetting closing purchase transaction, he will incur a loss of $1,500 (the $1,900 paid in the offsetting purchase transaction less the $400 option premium received when the option was written).

The writer of an uncovered call is in an extremely risky position and may incur large losses.  Moreover, as discussed in Chapter IX, a writer of uncovered calls must meet applicable margin requirements (which can rise substantially if the market moves adversely to the writer's position).  Uncovered call option writing is thus suitable only for the knowledgeable investor who understands the risks, has the financial capacity and willingness to incur potentially substantial losses, and has sufficient liquid assets to meet applicable margin requirements.

4.  As with writing uncovered calls, the risk of writing put options is substantial.  The writer of a put option bears a risk of loss if the value of the underlying interest declines below the exercise price, and such loss could be substantial if the decline is significant.   The writer of a put bears the risk of a decline in the price of the underlying interest -- potentially to zero.  A put writer of a physical delivery option who is assigned an exercise must purchase the underlying interest at the exercise price -- which could be substantially greater than the current market price of the underlying interest -- and a put writer of a cash-settled option must pay a cash settlement amount which reflects the decline in the value of the underlying interest below the exercise price.  Unless the put is a cash-secured put (discussed below), its writer is required to maintain margin with his brokerage firm.  Moreover, the writer's purchase of the underlying interest upon being assigned an exercise of a physical delivery option may result in an additional margin call.

A requisite for writing puts is an understanding of the risks, the financial capacity and willingness to incur potentially substantial losses, and the liquidity to meet margin requirements and to buy the underlying interest, or to pay the cash settlement amount, in the event the option is exercised.  A writer of an American-style put can be assigned an exercise at any time during the life of the option until such time as he enters into a closing transaction with respect to the option.  Since exercise will ordinarily occur only if the market price of the underlying interest is below the exercise price of the option, the put writer of a physical delivery option can expect to pay more for the underlying interest upon exercise than its then market value.

EXAMPLE:  At a time when XYZ stock is $50, an investor receives a $300 premium ($3 a share) by writing an XYZ 50 put.  Subsequently the stock price declines to $40 and he is assigned an exercise.  The investor must purchase the stock at $50.  Even though the $3 a share premium reduces his effective cost to $47, that is still substantially higher than the $40 market price of the stock.

The put writer's exposure to margin requirements can be eliminated if the put writer elects to deposit cash equal to the option exercise price with his brokerage firm.  Under this strategy, known as cash-secured put writing, the option writer is not subject to any additional margin requirements regardless of what happens to the market value of the underlying interest.  In the meantime, the option writer might earn interest by having the cash invested in a short-term debt instrument -- for example, in a Treasury bill.  However, a cash-secured put writer is still subject to a risk of loss if the value of the underlying interest declines.

EXAMPLE:  An investor receives a $500 premium for writing an XYZ 50 put option with six months remaining until expiration and deposits with his broker $5,000 invested in Treasury bills which, over the six month option life, will earn interest of $250.  If he has not been assigned an exercise by expiration, the investor will have a total return of $750 (option premium of $500 and interest of $250).  On the other hand, if the price of XYZ stock were to fall below $42-1/2 and the investor is then assigned an exercise, he would have a net loss -- that is, the market price of the XYZ stock he would be required to purchase would be below the exercise price by more than the combined premium income and interest earned.

5.   The risk of being an option writer may be reduced by the purchase of other options on the same underlying interest -- and thereby assuming a spread position -- or by acquiring other types of hedging positions in the options markets or other markets.  However, even where the writer has assumed a spread or other hedging position, the risks may still be significant.  See paragraph 1 under "Other Risks" below.

6.   The obligation of a writer of an uncovered call or of a put that is not cash-secured to meet applicable margin requirements creates additional risks.  If the value of the underlying interest moves against the writer's position, or if there is a significant change in the volatility or liquidity of the underlying interest, related interests, or the option, or if the writer's brokerage firm otherwise requires, the firm may request significant additional margin payments.  If those payments are not made, the firm may have the right to liquidate the options positions and other securities positions in the writer's account with little or no prior notice.

7.   Since the leverage inherent in an option can cause the impact of price changes in the underlying interest to be magnified in the price of the option, a writer of an option that is uncovered and unhedged may have a significantly greater risk than a short seller of the underlying interest.  This is illustrated by the table set forth in paragraph 2 under "Risks of Option Holders" above.  If an investor had sold short 100 shares of XYZ to Investor A in that table in order to receive $5,000 in proceeds, the investor would have lost $1,200 if the market price of XYZ had increased to 62.  On the other hand, if, in order to receive $5,000 in proceeds, the investor had written 10 XYZ 50 uncovered calls, he would have lost $7,000 if the market price of XYZ had increased to 62.

8.   The fact that an option writer may not receive immediate notification of an assignment creates a special risk for uncovered writers of physical delivery call stock options that are exercisable when the underlying security is the subject of a tender offer, exchange offer, or similar event.  A writer who fails to purchase the underlying security on or before the expiration date for the offer may learn after the expiration date that he has been assigned an exercise filed with OCC on or before that date.  At that point, neither the purchase of the underlying security for regular settlement nor the exercise of another option (e.g., the long leg of a spread) will enable the assigned writer to deliver the security on the settlement date for the option exercise (see "Settlement" in Chapter VIII).  If the assigned writer fails to make timely settlement, he may be liable for, among other things, the value of the offer (because his non-delivery may have prevented the exercising holder from making timely delivery of the security to the offeror).  This risk can be avoided only by purchasing the underlying security on or before the expiration date for the offer.  Occasionally, an offer will require that tendered securities be delivered in less than the normal settlement time for exchange transactions after the offer's expiration date.  In those cases, call writers will need to purchase the underlying equity security at an earlier point -- i.e., at least the number of days equal to the normal settlement time before the offeror's delivery deadline -- in order to protect themselves.

9.   Although the rules of the options markets establish exercise cut-off times by which exercise instructions of expiring options must be received by brokerage firms from their customers, OCC must accept all exercises which it receives before expiration -- even if those exercises are filed with OCC in violation of an options market's rules.  Accordingly, there is a risk that an option writer will be assigned an exercise that is made based on news that is published after the established exercise cut-off time and that the writer may not have an effective remedy to compensate for the violation of the options market's rules.

10.   If a trading market in an option should become unavailable, or if the writers of the option are otherwise unable to engage in closing transactions, the writers of that option would remain obligated until expiration or assignment.  See the discussions in paragraphs 2 and 3 under "Other Risks" below.

11.   A sudden development may cause a sharp upward or downward spike in the value of the interest underlying a capped option.  Such a spike could cause the capped option to be automatically exercised, and writers of the option to become obligated to pay the cash settlement amount, even if the effect of the development on the value of the underlying interest completely disappears on the day after the automatic exercise is triggered.


Other Risks

1.   Transactions that involve buying and writing multiple options in combination, or buying or writing options in combination with buying or selling short the underlying interests, present additional risks to investors.  Combination transactions, such as option spreads, are more complex than buying or writing a single option.  And it should be further noted that, as in any area of investing, a complexity not well understood is, in itself, a risk factor.  While this is not to suggest that combination strategies should not be considered, it is advisable, as is the case with all investments in options, to consult with someone who is experienced and knowledgeable with respect to the risks and potential rewards of combination transactions under various market circumstances.

The investor considering strategies involving combination transactions should recognize several other risk-related considerations in addition to those already mentioned:  the fact that it may at times be impossible simultaneously to execute transactions in all of the options involved in the combination, the difficulty that may be involved in attempting to execute simultaneously two or more buy or sell orders at the desired prices, the possibility that a loss could be incurred on both sides of a combination transaction, and the increased risk exposure that would result from the exercise or closing out of one side of the trade while the other side of the trade remains outstanding.  Also, the transaction costs of combination transactions can be especially significant, since separate costs are incurred on each component of the combination.  This can have the effect of requiring a substantial favorable price movement in the underlying interest before a profit can be realized.

Where a combination transaction involves the writing of an in the money American-style option, an investor must keep in mind the possibility of being assigned an exercise, which would eliminate that component of the transaction and could materially change the investor's risk position.

In the case of straddle writing, where the investor writes both a put and a call on the same underlying interest at the same exercise price in exchange for a combined premium on the two writing transactions, the potential risk is unlimited (except in the case of capped options).  To the extent that the price of the underlying interest is either below the exercise price by more than the combined premium, or above the exercise price by more than the combined premium, the writer of a straddle will incur a loss when one of the options is exercised.  Indeed, if the writer is assigned an exercise on one option position in the straddle and fails to close out the other position, subsequent fluctuations in the price of the underlying interest could cause the other option to be exercised as well, causing a loss on both writing positions.

Combinations involving different styles of options present added complexities.  For example, the assigned writer of an American-style option would be unable to cover by exercising a European-style or capped-style option that he holds unless the assignment happened to occur during the exercise period of that option.

Combination transactions involving all cash-settled options also pose the same risks that are discussed for index options under "Special Risks of Index Options" below.

2.   If a trading market in particular options were to become unavailable, investors in those options could no longer engage in closing transactions.  Moreover, even if the market were to remain available, there may be times when options prices will not maintain their customary or anticipated relationships to the prices of the underlying interests and related interests.  The options markets attempt to provide secondary markets in which holders and writers of options can close out their positions at any time prior to expiration -- by making offsetting sales or purchases  -- but there is no guarantee that such a market will at all times exist for every option.  Lack of investor interest, changes in volatility, or other factors or conditions might adversely affect the liquidity, efficiency, continuity or even the orderliness of the market for particular options.  Or an options market might permanently discontinue trading of a particular option or of options generally (although it has ordinarily been the practice, when an options market decides to discontinue trading of options on a particular underlying interest, to do so only after all outstanding series of those options have expired if the options are not traded on another options market).  A market could become temporarily unavailable if unusual events -- such as volume in excess of trading or clearing capability, computer malfunction, fire or natural disaster -- were to interrupt normal market operations.  As discussed in paragraph 3 below, an options market may also become unavailable in the event trading in the underlying interest is formally suspended or halted.  It is also possible that an options market will not open, or will delay opening, trading in certain options even though trading is taking place in the underlying security (or in the constituent securities of an underlying index).

In addition, an options market may at times determine to impose restrictions on particular types of options transactions, such as opening transactions or uncovered writing transactions.  For example, if an underlying interest ceases to meet qualifications imposed by the options market or OCC, new series of options on that interest may no longer be opened to replace expiring series, and opening transactions in existing series may be prohibited.

The accounts of options market makers and specialists are carried and guaranteed by a relatively few firms.  If one of these firms were to fail, be suspended by OCC, be restricted in its operations, determine or be required to discontinue or reduce its operations, or have a significant reduction in its capital, the markets for particular options, or even for all options, could be disrupted or possibly forced to discontinue trading.  Similarly, in the event an options specialist or a significant group of options market makers should fail or have a significant reduction in capital, the markets in the particular options in which the specialist or market makers traded could be adversely affected.  The suspension by OCC of any Clearing Member that maintains significant positions in a particular options series in its accounts could also disrupt the market for that options series.

An options market could also become unavailable because of its own financial problems.  For example, if an options market were to be declared bankrupt or if creditors were to take possession of its principal trading systems, it might be unable to continue to operate as an options market.

If a secondary market in a particular option were to become unavailable, a holder of that option would be able to realize his profits or limit his losses only by exercising at a time when the option is exercisable, and a writer of that option would remain subject to assignment until expiration.  However, as noted above in paragraph 5 under "Risks of Options Holders," an options market may also restrict exercises of that option.

3.   Disruptions in the markets for underlying interests could result in losses for options investors.  Each of the options markets has discretion to halt trading in an option in certain circumstances -- such as when the market determines that the halt would be advisable in maintaining a fair and orderly market in the option.  If trading is halted or suspended in one or more of the markets for an underlying interest, the trading of options on that interest may also be halted.  Similarly, if dissemination of the current level of an underlying index is interrupted, or if trading is interrupted in stocks accounting for a substantial portion of the value of an index, the trading of options on that index may be halted.  In addition, the rules of the options markets may require them to halt trading in particular types of options in certain circumstances.  At the date of this booklet, the U.S. options markets are required (1) to halt trading in all stock options and stock index options when trading in all stocks on the New York Stock Exchange ("NYSE") has been halted by the activation of "circuit breakers" by the NYSE, and (2) to halt trading in all stock options and stock index options for a specified period of time if the Dow Jones Industrial Average ("Average") is calculated at a value of 250 or more points below its closing value on the previous trading day, or for at least two hours if the Average is subsequently calculated on the same day at a value of 400 or more points below such closing value.  These requirements may be changed from time to time.

When trading in an option is halted or suspended, holders and writers of that option will be unable to close out their positions until trading resumes, and they may be faced with substantial losses if the value of the underlying interest moves adversely during that time.  For example, if a trading halt in an underlying stock is followed by the announcement of a tender offer at a substantial premium, and the stock reopens at a price reflecting the offer, uncovered call writers may sustain large losses.

Even if options trading is halted, holders of American-style options would still be able to exercise unless exercises were restricted.  (However, OCC or an options market may restrict the exercise of an option while trading in the option has been halted, and the restriction may remain in effect until shortly before expiration.  See paragraph 5 under "Risks of Option Holders" above.)  If the option is exercisable while trading has been halted in the underlying interest, option holders may have to decide whether to exercise without knowing the current market value of the underlying interest.  This risk can become especially important if an option is close to expiration, and failure to exercise will mean that the option will expire worthless.  If exercises do occur when trading of the underlying interest is halted, the party required to deliver the underlying interest may be unable to obtain it, which may necessitate a postponed settlement and/or the fixing of cash settlement prices (see Chapter VIII).

4.   All cash-settled options have certain special risks.  These risks, as they apply to cash-settled index options, are discussed under "Special Risks of Index Options" below.  That discussion is also applicable to other types of cash-settled options.

If a cash-settled option has a settlement currency other than U.S. dollars, holders and writers will be subject to the same kinds of risks with respect to the foreign currency and the settlement of an exercise as are discussed in paragraphs 1 through 9 under "Special Risks of Foreign Currency Options" below.

5.   Holders and writers of a capped option bear the risk that an automatic exercise value will be reported erroneously by the official reporting source.  As a consequence of the error, the options market on which the option is traded may not determine on a timely basis that the automatic exercise feature has been triggered.  In that event, the option will not be automatically exercised unless the options market determines on a subsequent trading day that the automatic exercise value for the option has hit the cap price.  Alternatively, the options market may determine on the basis of an erroneous report that the automatic exercise feature has been triggered.  If the options market makes such a determination and does not correct it on a timely basis, the option will be automatically exercised and the short positions of all writers will be assigned based on the erroneous report.

6.   The insolvency of a brokerage firm could present risks for that firm's customers, whether they are investors in options or in other securities.  If a brokerage firm or the OCC Clearing Member that carries the firm's accounts at OCC were to become insolvent, the firm's customers could have some or all of their options positions closed out without their consent.  Customers whose options positions were not closed out under these circumstances might experience delays or other difficulties in attempting to close out or exercise affected options positions.  Similarly, the insolvency of an associate clearing house could present risks for the customers of brokerage firms whose accounts are carried through that associate clearing house.

7.   Special risks are presented by internationally-traded options.  Because of time differences between the United States and various foreign countries, and because different holidays are observed in different countries, foreign options markets may be open for trading during hours or on days when U.S. markets are closed.  Investors buying or writing options in foreign markets at such times should understand that options premiums may not reflect current prices of the underlying interests in the United States.  For a discussion of risks pertaining to index options traded in foreign markets, see paragraph 13 under "Special Risks of Index Options" below.

8.   Although OCC's rules and procedures have been designed for the purpose, among others, of facilitating the prompt settlement of options transactions and exercises, there is a risk that OCC and its backup system will fail.  For example, if Clearing Member insolvencies are substantial or widespread, OCC's ability to honor all exercises could be impaired.  As noted in Chapter  XI, the prospectus of OCC relating to options is available from OCC or any of the U.S. options markets, and the registration statement of OCC, which includes OCC's financial statements, is available for inspection at OCC's office and may be obtained from the SEC.


Special Risks of Index Options

1.   Writers of cash-settled index call options cannot provide in advance for their potential settlement obligations by acquiring and holding the underlying interest.  A call writer can offset some of the risk of his writing position by holding a diversified portfolio of securities similar to those on which the underlying index is based.  However, except where the underlying index is a specialized one based on relatively few securities, most investors cannot, as a practical matter, acquire and hold a portfolio containing exactly the same securities in the same proportions as the underlying index.  Most writers of cash-settled index calls who also hold positions in securities will therefore bear the risk that the market prices of those securities will not increase as much as the index.

2.   Even if the writer of a cash-settled index call option could assemble a securities portfolio that exactly reproduced the composition of the underlying index, the writer still would not be fully covered from a risk standpoint because of the "timing risk" inherent in writing cash-settled options.  When a cash-settled index option is exercised, the amount of cash that the holder is entitled to receive is determined by the difference between the exercise price and the exercise settlement value, which is based on the prices of the constituent securities at a particular time on or in relation to the date on which the option is exercised.  As with most other kinds of options, the writer will not learn that he has been assigned until the next business day, at the earliest.  The time lag between exercise and notice of assignment poses no risk for the writer of a covered physical delivery call, because that writer's obligation is to deliver the underlying interest and not to pay its value as of a fixed time in the past.  So long as the writer of a physical delivery call already owns the underlying interest, he can satisfy his settlement obligations simply by delivering it, and the risk that its value may decline after the exercise date is borne by the exercising holder.  In contrast, even if the writer of a cash-settled index call holds securities that exactly match the composition of the underlying index, he will not be able to satisfy his assignment obligations by delivering those securities against payment of the exercise price.  Instead, he will be required to pay cash in an amount based on the exercise settlement value on the exercise date; and by the time he learns that he has been assigned, the index may have declined, with a corresponding decline in the value of the securities portfolio.  This "timing risk" is an inherent limitation on the ability of writers of cash-settled calls to cover their risk exposure by holding positions in the underlying interest.  This risk applies only to American-style options.  The writer of a European-style capped call that is exercisable only on the expiration date runs the risk of assignment only with respect to exercises filed on that day.  If the call is more than marginally in the money on the preceding trading day, the writer can ordinarily assume that it will be exercised and take market action to protect himself against a subsequent decline in the value of his position in the underlying interest.

3.   The timing risk discussed in the preceding paragraph makes spread positions and certain other multiple option strategies involving cash-settled American-style index options substantially riskier than similar strategies involving physical delivery options.  With physical delivery options, a person in a spread position can ordinarily satisfy his settlement obligations on the short leg of the spread merely by exercising the long leg if it is in the money.  That is, the cash or underlying interest that he obtains by exercising the long leg will ordinarily be sufficient to enable him to meet his settlement obligations on the short leg.  With cash-settled index options, however, an investor in a spread position runs the risk that by the time he receives notice of an exercise assignment on the option he has written, the index value will have changed such that exercising the long leg of the spread will not yield sufficient cash to satisfy his obligation on the exercise assignment.  Thus, an investor who holds a spread position in cash-settled index options and is assigned an exercise is at risk for any adverse movement in the prices of the constituent securities of the index after the time the exercise settlement value of the assigned short is determined unless the investor is able to exercise the long leg of the spread in time to receive that same exercise settlement value.  Other multiple options strategies involving cash-settled options can present similar risks.

4.   Readers intending to use index options to hedge against the market risk entailed in investing in individual securities should recognize the complexities of utilizing index options in this manner.  Market risk is the risk that factors affecting the stock market as a whole may have a similar effect on the price of a particular equity security.  Historically, some securities have tended to be highly sensitive to factors influencing the market generally; others less so.  As a result, different securities may be viewed as involving different levels of market risk.  In addition, a security's sensitivity to broad market influences may change over time, so that the same security may involve different levels of market risk at different times.

Investors using index options in this manner should also understand that they remain subject to company risk -- that is, the risk that factors affecting a particular company, such as its market position or the quality of its management, may cause its securities to perform differently than the market as a whole.

In addition, readers intending to utilize index options to hedge a diversified securities portfolio against market risk should understand that unless the securities in the portfolio exactly mirror the securities in an underlying index, the portfolio and the index may respond differently to a given market influence.  For this reason, the use of index options for hedging purposes involves special risks that are not present with "true" hedges -- i.e., hedges composed of options on the specific securities in the hedged position.  These risks are greatest when options on broad-based indexes are used to hedge a nondiversified securities position.  Except where the composition of the position to be hedged is very similar to that of an underlying index, index options may best be understood as a means of reducing some but not all of the risks of a securities portfolio position.

Readers should also be aware that it may not be possible to purchase or liquidate a portfolio of securities at prices that exactly converge with the prices used in determining the exercise settlement values of some index options.  For example, if the underlying index is comprised in whole or part of securities whose primary market is the NASDAQ stock market, an investor cannot be certain that he will be able to effect transactions in those securities at the opening or closing prices (as the case may be) used in determining the exercise settlement value.

5.   Just as holders and writers of stock options bear the risk that transactions in the underlying security may be erroneously reported, holders and writers of index options bear the risk that the reported current index level may be in error.  A person who buys or sells an index option at a premium based on an erroneously reported index level is bound by the trade and has no remedy under the rules of the options markets.  Similarly, persons who exercise cash-settled index options or are assigned exercises based on erroneously reported index levels will ordinarily be required to make settlement based on the exercise settlement value as initially reported by the official source of the index, even if a corrected value is subsequently announced.  References herein to index values "as initially reported" refer to the values initially reported by the source of the index as definitive, and not to any tentative or preliminary values that may be announced at an earlier time subject to adjustment.  In extraordinary circumstances (e.g., where an exercise settlement value as initially reported is obviously wrong and inconsistent with values previously reported, and a corrected value is promptly announced), OCC has discretion to direct that exercise settlements be based on a corrected exercise settlement value.  Ordinarily, however, the exercise settlement value as initially reported by the official source of the index will be conclusive for exercise settlement purposes.

6.   A holder of a cash-settled index option who exercises it before the exercise settlement value of the index for that day is available runs the risk that the level of the underlying index may subsequently change.  If such a change causes the exercised option to fall out of the money, the exercising holder will be required to pay the difference between the exercise settlement value and the exercise price of the option (times the applicable multiplier) to the assigned writer.

EXAMPLE:  A holder of an index put option that settles based on the closing prices of the constituent securities and that has an exercise price of 30 directs his broker to exercise at 10:00 A.M., when the level of the underlying index is 28.  If the underlying index stays at that level until the close of trading that day, the holder will be entitled to receive $200 in settlement (assuming a multiplier of 100).  If, however, the index level rises to 32 based on the closing prices of the constituent securities, the holder will be required to pay $200 to the assigned writer, thereby sustaining a $200 loss on the exercise.

A holder who plans to exercise a cash-settled index option that settles based on closing prices can minimize this risk by withholding exercise instructions until just before the daily exercise cut-off time fixed by his brokerage firm.  However, he may not be able to eliminate it entirely.  Daily exercise cut-off times for index options may be earlier than those fixed for other types of options and may occur before definitive exercise settlement values have been determined.  In the case of the exercise of a cash-settled index option that settles based on opening prices of the constituent securities, this risk applies if the holder submits exercise instructions before the definitive exercise settlement index value has been announced, which may be different from index levels that are initially disseminated at the time of the opening and which may not be available in some cases until several hours after the opening.

7.   Cash-settled index options whose exercise settlement values are based on the opening prices of the constituent securities are not traded on the last scheduled trading day for those securities prior to the option expiration date.  An option holder will be able to realize value from his option on that day only if the option is in the money and he exercises it.  A writer of this type of option who has not previously closed out his position will be unable to do so on that last trading day for the constituent securities and will be at risk of being assigned an exercise.

8.   Current index levels will ordinarily continue to be reported even when trading is delayed or interrupted in some or all of the constituent securities of the index or when the reporting of transactions in those securities has been delayed.  In that event, the reported index levels will be based on the most recent reported prices of the constituent securities -- whether or not those securities are being currently traded.  As a result, reported index levels may at times be based on non-current price information with respect to some or even all of the constituent securities of an index.  If this condition existed at the time of determining the exercise settlement value of an exercised option, that exercise would be settled on the basis of an index level that might not reflect current price information with respect to constituent securities accounting for a significant portion of the value of the index.  (Indeed, as noted in Chapter IV, an exercise settlement value that is based on the opening prices of the constituent securities may not coincide with, and may diverge substantially from, the index values that are reported at the time of the opening.)  Moreover, if the index underlay a capped index option, that option would or would not be automatically exercised based on an index level that might not reflect the true state of the market at the time.

9.   OCC has no authority, and the options markets on which capped index options are traded do not intend as of the date of this booklet, to restrict the automatic exercise of capped index options.  It is therefore possible that automatic exercise of a capped index option could occur on a day when OCC or an options market has imposed restrictions on the exercise of other styles of options on the same underlying index.  It is also possible that automatic exercise of a capped index option could occur on a day when the options market has suspended trading in the option.  Either of these possibilities could limit the ability of a writer to take action to limit the cost of being assigned an automatic exercise.

10.   The purchase and sale of index options in foreign markets at times when U.S. markets are closed may present special risks.  Although an underlying index may be based on securities primarily traded in U.S. markets, the index levels reported in foreign options markets at such times may be based on the trading of some or all of the constituent securities in foreign markets, and, in any case, option premiums in the foreign market will not reflect current prices of the constituent securities in U.S. markets.  In addition, if a cash-settled index option is exercised through the foreign office of a brokerage firm on a day when U.S. markets are closed, the exercise settlement value of the option will not be known until the time fixed for determining exercise settlement values on the next day on which U.S. markets are open.  The corresponding risks would apply to the trading in U.S. markets of options based on indexes of securities primarily traded in foreign markets.


Special Risks of Debt Options

1.   Many of the special risks associated with debt options result from the character of the markets in which the underlying debt securities are issued and traded and the distinctive characteristics of debt securities.  The vast majority of the trading activity in bonds and money market instruments takes place in a dealer market.  Dealers typically maintain markets in all outstanding issues of Treasury securities, but most of the activity tends to center on recently issued securities.  Liquidity is generally greater and quotations are generally tighter on recent issues than on older issues.

There are numerous dealers in all of the Treasury securities from which the yield on the options now traded is determined, but at the date of this booklet there is no comprehensive consolidation of bids and offers or public reporting of transaction prices in those securities such as exists in the markets for stocks.  While there is some dissemination of representative bids and offers, at the date of this booklet anyone interested in buying or selling a Treasury security usually must have his brokerage firm or bank contact one or more dealers individually to learn their current quotations.

The absence of last sale information and the limited availability of quotations for debt instruments can make it difficult for many investors to obtain timely, accurate data about the state of the market for the underlying debt securities.  At the same time, dealers in the underlying securities have access to private quotation networks that give actual current bids and offers of other dealers.  This information is not available to most investors.  As a result, these dealers may have a significant advantage over other participants in the debt options markets.

2.   Another important difference between the stock market and the market for Treasury securities is that stock quotations are generally keyed to a 100-share round lot while the basic unit of trading in the debt securities market typically involves much larger dollar amounts.  A round lot for most dealers in Treasury securities is, at a minimum, $1,000,000 of principal amount; and on Treasury bills it can be larger.  Most dealers are oriented toward doing business with large institutional customers or other dealers.  As a result, investors buying or selling debt securities in amounts smaller than round lots can expect to pay more and receive less than dealer quotations for round lot transactions.

The unit of trading for price-based debt options is likely to involve larger dollar amounts of the underlying debt security than is the case with stock options.  In general, this means that:  (a) premiums for such an option will tend to be higher than for a stock option, and (b) the increase or decrease in the price of an option that is associated with any given change in the price of the underlying security will tend to be larger for many such debt options.

If the unit of trading for a physical delivery price-based debt option is smaller than $1,000,000, investors who buy or write options covering principal amounts other than a multiple of $1,000,000 may be disadvantaged by having to deal in an odd-lot market for the underlying debt security at prices that are less favorable than for round lots.

3.    In the event of a shortage of the underlying debt security deliverable on exercise of a physical delivery price-based debt option, OCC has the authority to permit other generally comparable securities to be delivered in fulfillment of the delivery obligation.  If OCC exercises its authority to allow such other securities to be delivered, it may also adjust the exercise prices of the affected options by setting different prices at which otherwise non-eligible securities may be delivered.  As an alternative to permitting such substitute deliveries, OCC may impose special exercise settlement procedures similar to those applicable to stock options, including the fixing of a cash settlement price payable by writers who would otherwise be unable to meet their delivery obligations (see "Settlement" in Chapter VIII), and/or prohibit the exercise of puts by holders who would be unable to meet the resulting settlement obligations (see paragraph 5 under "Risks of Option Holders" above).

4.   The hours of trading for debt options may not conform to the hours during which the debt securities are traded.  To the extent that the options markets close before the markets for the underlying or other related instruments, significant price and rate movements can take place in the underlying markets that may not be reflected in the options markets.  The possibility of such movements should be taken into account in relating closing prices in the options markets to those in the underlying markets.  In addition, there is a risk that debt options may be exercised on the basis of price movements in the underlying security after the close of trading in the options markets when writers are no longer able to close out their short positions.

5.   Because exercises of yield-based options are settled in cash, option writers cannot fully provide in advance for their potential settlement obligations by acquiring and holding the Treasury security from which the underlying yield is determined.  A writer of a yield-based option can theoretically offset most of the risk of his writing position by acquiring Treasury securities of the designated maturity period on which the underlying yield is based.  Offsetting risk in this way may be difficult to do in practice, however.  While it is possible at any given time to calculate the principal amount of Treasury securities needed to assure that the risk of the option position is offset, such calculations are based upon complex mathematical relationships.  Moreover, the principal amount of Treasury securities needed to assure that the risk of an options position is fully offset will generally not remain constant throughout the life of the option, but instead will fluctuate as a result of changes in yields and remaining time to maturity.  For a given percentage change in yield, this fluctuation will be greater for securities of longer maturity periods than for securities of shorter maturity periods.  Furthermore, there can be no assurance that an option writer will be able to sell the Treasury securities that he holds at the option's expiration at the same average yield that is used in calculating the exercise settlement value of the option.  Prices, and therefore yields, could differ from dealer to dealer.  Moreover, when dealer quotations are averaged in obtaining a yield, they may result in a value which varies from the value that would be obtained by averaging yields representing actual transactions for the same securities during the same time period.

6.   Investors in yield-based debt options run the risk that reported yields may be in error.  The values disseminated by the designated reporting authority of the options markets during trading and for exercise settlement purposes will ordinarily be averages or medians of dealer quotations or prices, and it is possible that errors could be made in the gathering or averaging of these values.  A person who buys or sells an option at a premium based on an erroneous reported yield value is bound by the trade and has no remedy under the rules of the options markets.  Similarly, persons who exercise options or are assigned exercises based on erroneous reported yields will ordinarily be required to make settlement based on the value as initially reported by the reporting authority, even if a corrected value is subsequently announced.  In extraordinary circumstances (e.g., where a value as initially reported is obviously wrong and inconsistent with values previously reported, and a corrected value is promptly announced), OCC may direct that exercise settlements be based on a corrected value.  Ordinarily, however, the value as initially reported by the official source will be conclusive for exercise settlement purposes.

7.   A holder of a yield-based option who exercises it before the exercise settlement value of the underlying yield is available runs the risk that the level of the underlying yield may subsequently change.  If such a change causes the exercised option to fall out of the money, the exercising holder will be required to pay the difference between the exercise settlement value and the exercise price of the option (times the applicable multiplier) to the assigned writer.  A holder who plans to exercise an option may be able to minimize this risk by withholding exercise instructions until just before the exercise cut-off time fixed by his brokerage firm.  However, he may not be able to eliminate the risk entirely.  Exercise cut-off times for yield-based options may occur before definitive exercise settlement values are announced.  Because exercise cut-off times may vary from brokerage firm to brokerage firm, and there may be different exercise cut-off times for different yield-based options, option holders who anticipate exercising should determine the applicable cut-off times from their brokers.

8.   If for any reason there are no quotations available for the Treasury security from which underlying yields of a yield-based option are determined, trading in the option may be halted.  If trading is not halted, reported yields may be based on non-current price information for the Treasury security.

9.   If OCC determines that the exercise settlement value of the underlying yield for any series of yield-based options is unreported or otherwise unavailable for purposes of calculating the cash-settlement amount of such series, OCC has the authority to suspend the settlement obligations of the exercising and assigned Clearing Members of options of such series or to fix the cash settlement amount for exercised options of such series based on the best information available to OCC, or to do both.  Accordingly, there is a risk to both holders and writers of such options that the settlement of exercised options may be postponed and may be based on a determination by OCC rather than by the pricing actions of the market for the Treasury security from which the underlying yield is determined.


Special Risks of Foreign Currency Options

1.   The value of any currency, including U.S. dollars as well as foreign currencies, may be affected by complex political and economic factors applicable to the country issuing that currency.  The price of a foreign currency option is dependent upon the value of the underlying foreign currency relative to the trading currency as well as the value of both currencies relative to other currencies generally.  Fluctuations in the value of the trading currency -- whether it is the U.S. dollar (in the case of a dollar-denominated option) or a foreign currency (in the case of a cross-rate option) -- will affect exchange rates and the prices of foreign currency options, even in the case of an otherwise stable underlying foreign currency.  Conversely, fluctuations in the value of an underlying foreign currency will affect exchange rates and the prices of foreign currency options even if the value of the trading currency remains relatively constant.  Investors should consider factors affecting the economies and currency values of both the country of origin for the trading currency and the country of origin for the underlying currency.  Although these same considerations apply to dollar-denominated options and cross-rate options, cross-rate options involve factors affecting the economies of at least two foreign countries and may involve consideration by U.S. investors of factors affecting the U.S. economy as well.  Accordingly, a U.S. investor in cross-rate options may need to consider a broader range of economic developments than a U.S. investor in dollar-denominated foreign currency options.

2.   Even though the intrinsic value of an option is determined by the value of the underlying currency relative to the trading currency, investors who intend to convert gains or losses into U.S. dollars or other currencies may be particularly affected by changes in the exchange rates between their "home" currency and either the trading or the underlying currency.

EXAMPLE:  Assume that an investor purchases a yen-denominated, at-the-money call option on British pounds by converting U.S. dollars to Japanese yen.  The British pound then appreciates relative to the yen, and at expiration the exercise price is more favorable than the then current exchange rate between yen and pounds.  The investor could realize a gain in yen by converting dollars to yen in order to purchase pounds at the exercise price and then reselling the pounds for yen at the current exchange rate.  If the amount of that gain exceeds the premium that the investor paid for the option, the investor will realize a gain in yen on his investment in the option.  However, if the yen has depreciated relative to the dollar since the investor purchased the option, the gain may be reduced or even converted to a loss when the yen are converted back to dollars.  This is so because, although the yen received upon the sale of the pounds may exceed the exercise price plus the premium paid in yen, there is no guarantee that, when the yen are converted back to dollars at the current rate, the dollars received will exceed the exercise price plus the premium paid in dollars.  If the investor converts the pounds directly into dollars rather than to yen and then to dollars, the result would be the same since the amount of the dollars received would be expected to be approximately the same, ignoring any difference in transaction costs and any timing differences in the two-step process.

Similar considerations will apply if the investor liquidates his investment in a cross-rate option by selling it rather than by exercising it.

EXAMPLE:  Assume in the previous example that the premium value of the call option has increased permitting the investor to liquidate his investment in the option by selling it for more yen than he paid for it.  If the exchange rate between the U.S. dollar and the Japanese yen has not changed, the investor should be able to convert the yen received on the sale of the option to a U.S. dollar amount greater than his original investment.  If, on the other hand, the yen has declined in value relative to the U.S. dollar, the investor's gain in yen may be reduced or converted to a loss when the premium received on the sale of the option is converted to dollars.

3.   The exchange rates of foreign currencies (and therefore the prices of foreign currency options) could be significantly affected, fixed or supported directly or indirectly by government actions.  Government actions could increase risks to investors in both dollar-denominated and cross-rate options if exchange rates were not free to fluctuate in response to other market forces.  Investors in options involving currencies of countries that participate in the European Monetary System ("EMS") should note that, as of the date of this booklet, exchange rates among EMS currencies are subject to exchange rate agreements and intervention mechanisms of the EMS.  The monetary authorities of other countries may also intervene, either independently or in concert with others, to attempt to affect the exchange rates between their currencies and other currencies.

4.   Because foreign currency transactions occurring in the interbank market involve substantially larger amounts than those likely to be involved in the exercise of individual foreign currency option contracts, investors who buy or write foreign currency options may be disadvantaged by having to deal in an odd lot market for the underlying foreign currencies at prices that are less favorable than for round lots.  Because this price differential may be considerable, it should be taken into account when assessing the profitability of a foreign currency option transaction that will involve the exchange of one currency for another.

5.   There is no systematic reporting of last sale information for foreign currencies.  There is reasonably current, representative bid and offer information available on any market where foreign currency options are traded, in certain brokers' offices, in bank foreign currency trading offices, and to others who wish to subscribe for this information.  There is, however, no regulatory requirement that those quotations be firm or be revised on a timely basis.  The absence of last sale information and the limited availability of quotations to individual investors may make it difficult for many investors to obtain timely, accurate data about the state of the underlying market.  In addition, the quotation information that is available is representative of very large round lot transactions in the interbank market and does not reflect exchange rates for smaller odd lot transactions.  Since the relatively small amount of currency underlying a single foreign currency option would be treated as an odd lot in the interbank market, available pricing information from that market may not necessarily reflect prices pertinent to a single foreign currency option contract.

The quotation information available to investors may be from sources that are different from those used to calculate the exercise settlement value of cash-settled foreign currency options.  An investor who attempts to realize the intrinsic value of such an option through an exercise rather than by selling the option in a closing transaction runs the risk that the exercise settlement value may be less than appears from the information then available to him.

6.   Foreign governmental restrictions or taxes could result in adverse changes in the cost of acquiring or disposing of foreign currencies.  If OCC determines that such restrictions or taxes would prevent the orderly settlement of delivery foreign currency option exercises or would impose undue burdens on parties to exercise settlements, it has authority to impose special exercise settlement procedures, which could adversely affect some investors.

7.   The interbank market in foreign currencies is a global, around-the-clock market.  Therefore, the hours of trading for foreign currency options do not conform to the hours during which the underlying currencies are traded.  To the extent that the options markets are closed while the market for the underlying currencies remains open, significant price and rate movements may take place in the underlying markets that cannot be reflected in the options markets.  The possibility of such movements should be taken into account in relating closing prices in the options markets to those in the underlying markets.  In addition, this creates a risk that foreign currency options may be exercised on the basis of price movements in the underlying currency after the close of trading in the options markets, when writers are no longer able to close out their short positions.

8.   Since exercise settlement of physical delivery foreign currency options -- whether they are dollar-denominated or cross-rate options -- occurs within the country issuing the underlying foreign currency, investors must accept or make delivery of the trading and underlying foreign currencies through their brokerage firms in conformity with any U.S. or foreign restrictions or regulations regarding the maintenance of foreign banking arrangements by U.S. residents, and may be required to pay any fees, taxes or charges associated with such deliveries.

9.   Exercise settlement of physical delivery foreign currency options -- whether they are dollar-denominated or cross-rate options -- is made through OCC's correspondent banks in the country of origin.  Investors may be exposed to losses in the event that a correspondent bank should fail during the settlement process.

10.   As in the case of other cash-settled options, writers of cash-settled foreign currency call options cannot fully provide in advance for their potential settlement obligations by acquiring and holding the underlying interest.  Although a call writer may hold the quantity of the currency underlying the option, there is no assurance that if he is assigned an exercise he will be able to sell such currency at the exercise settlement value.

11.   If a cash-settled foreign currency option is exercised based upon a reported exercise settlement value that is in error, the holder and the writer will ordinarily be obligated to make settlement based on the exercise settlement value as originally reported, even if the value is subsequently revised or determined to have been inaccurate.  In extraordinary circumstances (e.g., where the value as initially reported is obviously wrong and inconsistent with other available price information and a corrected value is promptly announced), OCC has discretion to direct that the exercise settlement be based on the corrected value.

12.   If cash-settled foreign currency options expire on a trading day -- as is the case with the cash-settled options traded at the date of this booklet -- there will ordinarily be an abbreviated trading session in those options on the morning of their expiration date.  If the opening of the options market should be delayed for any reason on that day, there may be no trading at all that day in those options.  Accordingly, holders and writers who wait until the last trading day to close out their positions in closing transactions in those options run a risk that they may be unable to do so.

13.   If OCC determines that the exercise settlement value for any cash-settled foreign currency option is unavailable for purposes of calculating the cash settlement amount, OCC has the authority to suspend the settlement obligations of the exercising holder and assigned writer of such option or to fix the cash settlement amount based on the best information available to OCC, or to do both.  Accordingly, there is a risk to both holders and writers that the settlement of exercised cash-settled foreign currency options may be postponed and may be based on a determination by OCC rather than by the procedures specified by the options market on which the options are traded.


Special Risks of Flexibly Structured Options

In addition to the risks discussed above, the following special risks are applicable to flexibly structured options.

1.   Because flexibly structured options have variable terms that are fixed by the parties, there are no pre-established series of flexibly structured options.  Rather, many different series of flexibly structured options may be created and outstanding at any given time as a result of the various designations of variable terms that are made in different transactions.  Secondary trading interest in flexibly structured options may therefore be spread over a larger number of series than the trading interest in other options, the trading interest in any particular series of flexibly structured options may be very limited, the secondary markets in flexibly structured options may be less deep, liquid and continuous than the markets in other options on the same underlying interests, and the premiums for flexibly structured options may not correlate with premiums for such other options.

2.   OCC may base its calculations of the margin requirements of OCC's Clearing Members for positions in a series of flexibly structured options on an estimate derived from data and factors OCC deems pertinent in respect of quotations and transactions in that options series and in other options series.  Alternatively, OCC may fix such margin requirements at a level it deems necessary to protect the respective interests of OCC, the Clearing Members and the public.  As a result, the Clearing Member's margin requirements for positions in flexibly structured options may differ from -- and may be significantly greater than -- the margin requirements applicable to similar positions in other options on the same underlying interest.  Such differences may cause Clearing Members to require customers that maintain positions in flexibly structured options to deposit more margin for flexibly structured options positions than for positions in other options.  To the extent OCC's estimate of the current value of a flexibly structured option is used in the determinations of the margin requirements of the Board of Governors of the Federal Reserve System, the options markets and other self-regulatory organizations, it may also cause such margin requirements to be greater than they would be for other options.


Scope and Limitations of this Booklet

Readers should be aware of the scope and limitations of this booklet set forth below:

1.   This booklet has been prepared by the U.S. options markets for distribution pursuant to the requirements of SEC Rule 9b-1 under the Securities Exchange Act of 1934 and the rules of the U.S. options markets.  This booklet is not intended to meet other requirements which may be in effect in any jurisdiction and should not be relied upon for that purpose.

Under the applicable SEC regulatory scheme for options, this booklet is not a prospectus.  Nothing in this booklet should be construed as furnishing investment advice or as being a recommendation, solicitation or offer to buy or sell any option or any other security.  A prospectus of OCC relating to options is available without charge upon request addressed to OCC, One Financial Place, 440 S. LaSalle Street, 24th Floor, Chicago, Illinois 60605, or any of the U.S. options markets.  The OCC registration statement relating to options, which includes the OCC prospectus and the financial statements of OCC, is available for inspection at the offices of OCC, and copies may be obtained from the SEC, Room 1024, 450 5th Street, N.W., Washington, D.C. 20549, upon payment of the fees prescribed by the SEC.  Additional information concerning OCC -- but not the options markets -- is included in the OCC prospectus and registration statement.

2.   Only the U.S. options markets on which an option is authorized to be traded are responsible for the statements in this booklet concerning that option.

3.   The options markets do not intend this booklet to be incorporated by reference into the OCC prospectus or into any other publication that may be prepared or distributed by OCC, an options market or any other person (other than a document that has been specifically designated to be a supplement to this booklet and that has been filed with the SEC pursuant to Rule 9b-1). The fact that another document states that this booklet is available, or states from whom this booklet may be obtained, or recommends that this booklet be read and understood, does not mean that this booklet has been incorporated by reference into that other document.

4.   No other publication is incorporated by reference into this booklet.  The fact that this booklet refers to information that may be available in other publications does not mean that any of those other publications has been incorporated into this booklet.

5.   This booklet does not attempt to present a complete description of all of the provisions governing options.  These are set forth in applicable laws, in the rules and regulations of the SEC and other regulatory agencies, and in the rules, interpretations, policies and procedures (collectively called "rules") of OCC, the options markets and the foreign clearing houses that act as "associate clearing houses" of OCC that may be in force from time to time.

This booklet also does not attempt to describe either the rules that govern the structure or conduct of options trading or the forms and procedures for trading in the various options markets.  These matters differ from one options market to another, and they may change from time to time. As examples, the various options markets may utilize different market-making systems (with some markets using a specialist system, others a competing market-maker system, and others a combination of the two), order routing systems, and automatic order execution systems.  Moreover, as advances are made in computer technology, the trading and market-making systems and the other trading procedures of the options markets are likely to evolve and change -- or even be radically different from what they now are.

At particular times -- such as when unusual conditions or circumstances exist, which for example may occur on and after days on which there have been substantial or volatile price movements in the securities markets generally or in the markets for underlying or related interests  -- the options markets may have authority under their rules to modify the application of some or all of their trading rules and procedures or to take such actions as they may deem appropriate in the circumstances.  Such actions could include, among other things, changing the manner in which trading in particular options is conducted, extending trading hours for particular options, halting trading in particular options, restricting the types of orders that may be employed, and modifying or eliminating the bid/asked differential at which market-makers or specialists may quote.  The taking of such actions by an options market often is promptly disclosed to the trading crowd in that options market, to representatives of brokerage firms that are members of the options market, and/or to price vendors, but the actions may be taken without public notice, and there can be no assurance that disclosure will be made in a manner that will permit investors to learn of the actions in a timely way.

OCC and the options markets have broad discretion under their rules to take a variety of actions in particular circumstances, and readers should not assume that any organization will exercise its discretion in a particular way in any particular circumstance.  A statement in this booklet to the effect that OCC or an options market has authority or discretion to take a particular action does not mean that it will necessarily take that action.  To the contrary, it should be understood from such a statement that the organization also has authority not to take that action.  Moreover, it should be understood that OCC and the options markets have broad discretion in the manner in which they interpret their own rules.

OCC and the options markets have no duty to enforce, or to oversee the  enforcement of, each other's rules.  OCC and each U.S. options market has a general statutory obligation to enforce compliance with its own rules by its own members.  However, there can be no assurance that all such rules will always be complied with by members, since frequently the only means of enforcing compliance with rules is to impose disciplinary sanctions after the fact on those who have violated them.

Readers desiring information concerning the rules of OCC or any of the options markets as to the terms of options, the manner in which options are traded or in which a market functions, the trading hours of a particular options market, or other related matters, or information concerning any of the other matters referred to herein, may obtain the information from the relevant organization.  Information concerning a foreign options market or associate clearing house is generally available from that organization.

6.   The U.S. options markets have rules applicable to the handling of customer accounts and the execution of buy and sell orders that impose special requirements with respect to approval of customer accounts for options trading and recommendations of particular option transactions.  This booklet does not attempt to describe those requirements, the laws and rules governing brokerage firms and other securities professionals, or the agreements, procedures and internal rules of brokerage firms that are applicable to the approval and opening of customer accounts, the handling and execution of orders, the transmission to brokerage firms of instructions to exercise or not to exercise options, the manner or time in which writers of options are notified by their brokerage firms that options have been assigned an exercise, the handling of customers' funds, securities and accounts, the safeguarding of customers' positions in options, or other matters relating to the handling of options transactions by brokerage firms.  Readers should consult with their own brokerage firms for information concerning such matters.

7.   This booklet does not attempt to describe the risks to investors that may be associated with the way trading is conducted in any particular options market or in any market for an underlying or related interest.  The reader should not assume that either the options markets or the markets for underlying or related interests will be efficient, liquid, continuous and orderly in all circumstances or that they will be or remain open at all times.  Even on relatively normal days, there will be variances in the market-making performance of specialists and market makers in the various markets which derive primarily from differences in individual skills, capital, willingness to accept risk, ability to hedge risk, trading strategies, and market-making obligations, and these variances are likely to be exacerbated during times of greatly increased volume or volatility.  Although specialists and market makers in some markets have certain obligations to assist in the maintenance, so far as is practicable, of a fair and orderly market, traditional indicators of orderliness are difficult to apply to the trading of derivative products such as options and there is a risk that the market-making system of a particular market will not operate effectively, efficiently or in an orderly manner at particular times.  The nature and scope of that risk are not among the types of risk discussed further in this booklet.

It is also possible that the systems of an options market, or of a market for an underlying or related interest, may fail or may not work effectively or efficiently at times.  During the past few years, for example, the operations of various U.S. markets have been disrupted by earthquake, flood, fire, electricity outages, and computer failure.  Moreover, no system can be expected to work perfectly at all times.  The options markets may rely on manual methods to record trade information, and errors or omissions can occur in their reports of price, volume and other information, and these can be expected to be exacerbated on days of significant volume or volatility.

It is also beyond the scope of this booklet to discuss the risks that may result to investors from the use by market participants of options pricing theories.  There are a number of publications that are commercially available which discuss such theories.

8.   This booklet does not attempt to describe risks that may be inherent in an investment in the underlying interest.  It is obvious that the investment potential of an option can be dependent on the performance of the underlying interest and that investors in options are therefore subject to the risks that may affect the value of that interest.  For example, one of the risks undertaken by a purchaser of a call option (or a writer of a put option) on XYZ stock is that XYZ may decline in price during the life of the option.  The risk of this decline is dependent on the risks that may affect the economy or the stock market generally or XYZ specifically.  Similarly, the holder of a dollar-denominated option on a foreign currency is subject to the risk factors affecting the relative values of the U.S. dollar and the foreign currency.  A discussion of these types of risks is beyond the scope of this booklet.

9.   This booklet does not attempt to describe systemic risks that could affect the options markets and the investors in those markets.  The options markets, like all securities markets, are interrelated with, and frequently interdependent upon, other aspects of national and international financial and capital systems and upon the national and world economy.  Any disturbance or crisis of one part of these interrelated systems could severely disrupt or even threaten the performance of the options markets or of OCC.  Bank failures, payments breakdowns, large and sudden economic shocks, the failure of a large securities firm, market or clearing organization, or other such events could cause other failures on a widespread basis and could affect the liquidity and solvency of the participants in the options markets.  The specific causes of systemic failure or disruption are not easy to predict, and a discussion of them is beyond the scope of this booklet.

10.   All examples in this booklet are based on hypothetical values that are not necessarily indicative of the prices in an actual transaction.  Readers should not assume that options will necessarily be priced in accordance with any example in this booklet or in accordance with any pricing formula or model.  As noted in the discussion of "Premium" in Chapter II, option premiums are not fixed by OCC or any of the options markets.

11.   The examples in this booklet do not include tax consequences, commissions or other transaction costs, nor do they include the impact of applicable margin requirements.  As discussed in Chapter IX, these items can be very significant and should be taken into account by all investors.


November 8, 1995 Supplement to Characteristics and Risks of Standardized Options

The following supplements material in Chapter VIII of the February 1994 edition of Characteristics and Risks of Standardized Options under the captions "How to Exercise" and "Assignment" in respect of certain flexibly structured foreign currency options:

If the expiration date of an option falls on a day on which an options market is open for trading in that option, a brokerage firm's last cut-off time for accepting exercise instructions prior to the option's expiration may be on the expiration date.

OCC has modified procedures for the assignment of exercises of certain flexibly structured foreign currency options. Under the modified procedures, OCC assigns exercises in a series of the options to each Clearing Member account in approximately the same proportion that the number of short positions of that series carried in the account bears to the total number of short options positions of that series. (A description of the modified procedures is available from OCC on request.) The rules of the options market on which such options are traded may either require or permit their member firms to allocate assignments among customers using a similar proportional method. As a result, there is a substantial likelihood that an investor who has a short position in a series of options for which the modified procedures are applicable will be assigned exercises with respect to at least a part of that position whenever options of that series are exercised. Investors should determine from their brokerage firms which flexibly structured foreign currency options are subject to the firm's proportional method of allocation and how that method works.


October, 1996 Supplement to Characteristics and Risks of Standardized Options

To accommodate the introduction of flexibly structured stock options (and the possible future introduction of other European-style stock options) and to reflect the current rules of the options markets on which flexibly structured stock options are traded, the February 1994 edition of the booklet entitled Characteristics and Risks of Standardized Options (the "options booklet") is amended as follows:

1.  The second full paragraph after the example on page 21 of the options booklet is amended to read:

When an underlying security is converted into a right to receive a fixed amount of cash, options on that security will generally be adjusted to require the delivery upon exercise of a fixed amount of cash, and trading in the options will ordinarily cease when the conversion becomes effective.  As a result, after such an adjustment is made all options on that security that are not in the money will become worthless and all that are in the money will have no time value. If the option is European-style (as may be the case for a flexibly structured stock option designated as a European-style option), the expiration date of the option will ordinarily be accelerated to fall on or shortly after the date on which the conversion of the underlying security to a right to receive cash occurs.  Holders of an in the money option whose expiration date is accelerated must be prepared to exercise that option prior to the accelerated exercise cut off time in order to prevent the option from expiring unexercised.  Writers of European-style options whose expiration date is subject to being accelerated bear the risk that, in the event of such an acceleration, they may be assigned an exercise notice and be required to perform their obligations as writers prior to the original expiration date.  When the expiration date of a European-style option is accelerated, no adjustment will be made to reflect the accelerated expiration date.  There is no assurance that the exercise settlement date for an accelerated option will coincide with the date that the cash payment to the holders of the underlying security becomes available from the issuer of the underlying security.  Covered writers of an accelerated option may therefore be required to pay the cash amount in respect of the option before they receive the cash payment on the underlying security.

2.  The following paragraph is added to the description of flexibly structured options on page 46 of the options booklet, following the second paragraph under the caption "Special Features of Flexibly Structured Options":

The parties to an opening transaction in a flexibly structured call option on an individual stock may fix the exercise price of the option only at a price that would qualify under the rules of the options market where the opening transaction occurs as the exercise price of a series of non-flexibly structured options on the same stock, and that is evenly divisible by the applicable minimal exercise price interval on that market.  For example, for a flexibly structured call option on a stock for which the minimum exercise price interval is $5, the exercise price may be designated as $25, $30, $35, $40, etc. This restriction does not apply to the exercise prices of flexibly structured stock put options.  Investors considering strategies involving combinations of flexibly structured put and call stock options should therefore be aware of this difference between the two types of options.

3.  The third and fourth sentences of the paragraph under "Exercises and Settlements" on page 47 of the options booklet are amended to read:

However, unlike most other options, flexibly structured index options that are in the money on the expiration date may be exercised automatically.  In the future it may be provided that flexibly structured index options will be exercised automatically only if they are in the money by a specified amount.


Copyright Notice - Copyright Notice
Copyright Notice

AMERICAN STOCK EXCHANGE, INC.

86 Trinity  Place

New York, New York 10006

---------------

CHICAGO BOARD OPTIONS EXCHANGE, INCORPORATED

400 South LaSalle Street

Chicago, Illinois 60605

---------------

PACIFIC STOCK EXCHANGE, INCORPORATED

301 Pine Street

San Francisco, California 94104

---------------

PHILADELPHIA STOCK EXCHANGE, INC.

1900 Market Street

Philadelphia, Pennsylvania 19103

©1996 American Stock Exchange Inc., Chicago Board Options Exchange, Incorporated, Pacific Stock Exchange, Incorporated and Philadelphia Stock Exchange, Inc.


Some indexes reflect values of companies, rather than securities, by taking into account both the prices of constituent securities and the number of those securities outstanding.