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From: [e-mail] (Christopher Lott)
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Subject: The Investment FAQ (part 5 of 20)
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Summary: Answers to frequently asked questions about investments.
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Archive-name: investment-faq/general/part5
Version: $Id: part05,v 1.61 2003/03/17 02:44:30 lott Exp lott $
Compiler: Christopher Lott

The Investment FAQ is a collection of frequently asked questions and
answers about investments and personal finance.  This is a plain-text
version of The Investment FAQ, part 5 of 20.  The web site
always has the latest version, including in-line links. Please browse
http://invest-faq.com/


Terms of Use

The following terms and conditions apply to the plain-text version of
The Investment FAQ that is posted regularly to various newsgroups.
Different terms and conditions apply to documents on The Investment
FAQ web site.

The Investment FAQ is copyright 2003 by Christopher Lott, and is
protected by copyright as a collective work and/or compilation,
pursuant to U.S. copyright laws, international conventions, and other
copyright laws.  The contents of The Investment FAQ are intended for
personal use, not for sale or other commercial redistribution.
The plain-text version of The Investment FAQ may be copied, stored,
made available on web sites, or distributed on electronic media
provided the following conditions are met:
    + The URL of The Investment FAQ home page is displayed prominently.
    + No fees or compensation are charged for this information,
      excluding charges for the media used to distribute it.
    + No advertisements appear on the same web page as this material.
    + Proper attribution is given to the authors of individual articles.
    + This copyright notice is included intact.


Disclaimers

Neither the compiler of nor contributors to The Investment FAQ make
any express or implied warranties (including, without limitation, any
warranty of merchantability or fitness for a particular purpose or
use) regarding the information supplied.  The Investment FAQ is
provided to the user "as is".  Neither the compiler nor contributors
warrant that The Investment FAQ will be error free. Neither the
compiler nor contributors will be liable to any user or anyone else
for any inaccuracy, error or omission, regardless of cause, in The
Investment FAQ or for any damages (whether direct or indirect,
consequential, punitive or exemplary) resulting therefrom.

Rules, regulations, laws, conditions, rates, and such information
discussed in this FAQ all change quite rapidly.  Information given
here was current at the time of writing but is almost guaranteed to be
out of date by the time you read it.  Mention of a product does not
constitute an endorsement. Answers to questions sometimes rely on
information given in other answers.  Readers outside the USA can reach
US-800 telephone numbers, for a charge, using a service such as MCI's
Call USA.  All prices are listed in US dollars unless otherwise
specified.

Please send comments and new submissions to the compiler.

--------------------Check http://invest-faq.com/ for updates------------------

Subject: Derivatives - Black-Scholes Option Pricing Model

Last-Revised: 5 Jan 2001
Contributed-By: Kevin Rubash (arr at bradley.edu)

The Black and Scholes Option Pricing Model is an approach for
calculating the value of a stock option.  This article presents some
detail about the pricing model.

The Black and Scholes Option Pricing Model didn't appear overnight, in
fact, Fisher Black started out working to create a valuation model for
stock warrants.  This work involved calculating a derivative to measure
how the discount rate of a warrant varies with time and stock price.
The result of this calculation held a striking resemblance to a
well-known heat transfer equation.  Soon after this discovery, Myron
Scholes joined Black and the result of their work is a startlingly
accurate option pricing model.  Black and Scholes can't take all credit
for their work, in fact their model is actually an improved version of a
previous model developed by A.  James Boness in his Ph.D.  dissertation
at the University of Chicago.  Black and Scholes' improvements on the
Boness model come in the form of a proof that the risk-free interest
rate is the correct discount factor, and with the absence of assumptions
regarding investor's risk preferences.

The model is expressed as the following formula.
C = S * N(d1) - K * (e ^ -rt) * N (d2)

       ln (S / K) + (r + (sigma) ^ 2 / 2) * t
d1 =   --------------------------------------
             sigma * sqrt(t)

d2 = d1 - sigma * sqrt(t)

Where:
C = theoretical call premium
S = current stock price
N = cumulative standard normal distribution
t = time until option expiration
r = risk-free interest rate
K = option strike price
e = the constant 2.7183..
sigma = standard deviation of stock returns (usually written as
lower-case 's')
ln() = natural logarithm of the argument
sqrt() = square root of the argument
^ means exponentiation (i.e., 2 ^ 3 = 8)
(boy, HTML just isn't much good for formulas!)

In order to understand the model itself, we divide it into two parts.
The first part, SN(d1), derives the expected benefit from acquiring a
stock outright.  This is found by multiplying stock price [S] by the
change in the call premium with respect to a change in the underlying
stock price [N(d1)].  The second part of the model, K(e^-rt)N(d2), gives
the present value of paying the exercise price on the expiration day.
The fair market value of the call option is then calculated by taking
the difference between these two parts.

The Black and Scholes Model makes the following assumptions.
  1. The stock pays no dividends during the option's life

     Most companies pay dividends to their share holders, so this might
     seem a serious limitation to the model considering the observation
     that higher dividend yields elicit lower call premiums.  A common
     way of adjusting the model for this situation is to subtract the
     discounted value of a future dividend from the stock price.


  2. European exercise terms are used

     European exercise terms dictate that the option can only be
     exercised on the expiration date.  American exercise term allow the
     option to be exercised at any time during the life of the option,
     making american options more valuable due to their greater
     flexibility.  This limitation is not a major concern because very
     few calls are ever exercised before the last few days of their
     life.  This is true because when you exercise a call early, you
     forfeit the remaining time value on the call and collect the
     intrinsic value.  Towards the end of the life of a call, the
     remaining time value is very small, but the intrinsic value is the
     same.


  3. Markets are efficient

     This assumption suggests that people cannot consistently predict
     the direction of the market or an individual stock.  The market
     operates continuously with share prices following a continuous Itt
     process.  To understand what a continuous Itt process is, you must
     first know that a Markov process is "one where the observation in
     time period t depends only on the preceding observation." An Itt
     process is simply a Markov process in continuous time.  If you were
     to draw a continuous process you would do so without picking the
     pen up from the piece of paper.


  4. No commissions are charged

     Usually market participants do have to pay a commission to buy or
     sell options.  Even floor traders pay some kind of fee, but it is
     usually very small.  The fees that individual investors pay is more
     substantial and can often distort the output of the model.


  5. Interest rates remain constant and known

     The Black and Scholes model uses the risk-free rate to represent
     this constant and known rate.  In reality there is no such thing as
     the risk-free rate, but the discount rate on U.S.  Government
     Treasury Bills with 30 days left until maturity is usually used to
     represent it.  During periods of rapidly changing interest rates,
     these 30 day rates are often subject to change, thereby violating
     one of the assumptions of the model.


  6. Returns are lognormally distributed

     This assumption suggests, returns on the underlying stock are
     normally distributed, which is reasonable for most assets that
     offer options.

For more detail, visit Kevin Rubash's web page:
http://bradley.bradley.edu/~arr/bsm/model.html


--------------------Check http://invest-faq.com/ for updates------------------

Subject: Derivatives - Futures

Last-Revised: 30 Jan 2001
Contributed-By: Chris Lott ( contact me )

A futures contract is an agreement to buy (or sell) some commodity at a
fixed price on a fixed date.  In other words, it is a contract between
two parties; the holder of the future has not only the right but also
the obligation to buy (or sell) the specified commodity.  This differs
sharply from stock options, which carry the right but not the obligation
to buy or sell a stock.

These days, all details of a futures contract are standardized, except
for the price of course.  These details are the commodity, the quantity,
the quality, the delivery date, and whether the contract can be settled
in goods or in cash.  Futures contracts are traded on futures exchanges,
of which the U.S.  has eight.

Futures are commonly available in the following flavors (defined by the
underlying "cash" product):
   * Agricultural commodity futures
     A commodity future, for example an orange-juice future contract,
     gives you the right to take delivery of some huge amount of orange
     juice at a fixed price on some date.  Alternately, if you wrote
     (i.e., sold) the contract, you have the obligation to deliver that
     OJ to someone.
   * Foreign currency futures
     For example, on the Euro.
   * Stock index futures
     Since you can't really buy an index, these are settled in cash.
   * Interest rate futures (including deposit futures, bill futures and
     government bond futures)
     Again, since you cannot easily buy an interest rate, these are
     usually settled in cash as well.  Futures are explicitly designed
to allow the transfer of risk from those who want less risk to those who
are willing to take on some risk in exchange for compensation.  A
futures instrument accomplishes the transfer of risk by offering several
features:
   * Liquidity
   * Leverage (a small amount of money controls a much larger amount)
   * A high degree of correlation between changes in the futures price
     and changes in price of the underlying commodity.  In the case of
the commodity future, if I sell you a commodity future then I am
promising to deliver a fixed amount of the commodity to you at a given
price (fixed now) at a given date in the future.

Note that if the price of the future becomes very high relative to the
price of the commodity today, I can borrow money to buy the commodity
now and sell a futures contract (on margin).  If the difference in price
between the two is great enough then I will be able to repay the
interest and principal on the loan and still have some riskless profit;
i.e., a pure arbitrage.

Conversely, if the price of the future falls too far below that of the
commodity, then I can short-sell the commodity and purchase the future.
I can (predumably) borrow the commodity until the futures delivery date
and then cover my short when I take delivery of some of the commodity at
the futures delivery date.  I say presumably borrow the commodity since
this is the way bond futures are designed to work; I am not certain that
comodities can be borrowed.

Note that there are also options on futures! See the article on the
basics of stock options for more information on options.

Here are a few resources on futures.
   * The Futures FAQ has quite a bit of information.
     http://www.ilhawaii.net/~heinsite/FAQs/futuresfaq.html
   * The Futures Industry Association and the Futures Industry Institute
     offer many educational materials.
     http://www.fiafii.org
   * The Orion Futures Group offers a "Futures 101" primer.
     http://www.orionfutures.com/fut101.htm


--------------------Check http://invest-faq.com/ for updates------------------

Subject: Derivatives - Futures and Fair Value

Last-Revised: 11 Apr 2000
Contributed-By: Chris Lott ( contact me )

In the case of futures on equity indexes such as the S&P 500 contract,
it is possible to make a careful computation of how much a futures
contract should cost (in theory) based on the current market prices of
the stocks in the index, current interest rates, how long until the
contract expires, etc.  This computation yields a theoretical result
that is called the fair value of the contract.  If the contract trades
at prices that are far from the fair value, you can be fairly certain
that traders will buy or sell contracts appropriately to exploit the
differentce (also called arbitrage).  Much of this trading is initiated
by program traders; it gets restricted (curbed) when the markets have
risen or fallen far during the course of a day.

Here are some resources about fair value of equity index futures.
   * An example from the Chicago Mercantile Exchange about calculating
     fair value:
     http://www.cme.com/market/equity/fairvalu.html
   * A long discussion (case study) about fair value, also from the
     Chicago Mercantile Exchange:
     http://www.cme.com/market/fairvalu.html
   * A few words from one of the program traders.
     http://www.programtrading.com/fvalue.htm


--------------------Check http://invest-faq.com/ for updates------------------

Subject: Derivatives - Stock Option Basics

Last-Revised: 26 May 1999
Contributed-By: Art Kamlet (artkamlet at aol.com), Bob Morris, Chris
Lott ( contact me ), Larry Kim (lek at cypress.com)

An option is a contract between a buyer and a seller.  The option is
connected to something, such as a listed stock, an exchange index,
futures contracts, or real estate.  For simplicity, this article will
discuss only options connected to listed stocks.

Just to be complete, note that there are two basic types of options, the
American and European.  An American (or American-style) option is an
option contract that can be exercised at any time between the date of
purchase and the expiration date.  Most exchange-traded options are
American-Style.  All stock options are American style.  A European (or
European-style) option is an option contract that can only be exercised
on the expiration date.  Futures contracts (i.e., options on
commodities; see the article elsewhere in this FAQ) are generally
European-style options.

Every stock option is designated by:
   * Name of the associated stock
   * Strike price
   * Expiration date
   * The premium paid for the option, plus brokers commission.

The two most popular types of options are Calls and Puts.  We'll cover
calls first.  In a nutshell, owning a call gives you the right (but not
the obligation) to purchase a stock at the strike price any time before
the option expires.  An option is worthless and useless after it
expires.

People also sell options without having owned them before.  This is
called "writing" options and explains (somewhat) the source of options,
since neither the company (behind the stock that's behind the option)
nor the options exchange issues options.  If you have written a call
(you are short a call), you have the obligation to sell shares at the
strike price any time before the expiration date if you get called .

Example: The Wall Street Journal might list an IBM Oct 90 Call at $2.00.
Translation: this is a call option.  The company associated with it is
IBM.  (See also the price of IBM stock on the NYSE.) The strike price is
90.  In other words, if you own this option, you can buy IBM at
US$90.00, even if it is then trading on the NYSE at $100.00.  If you
want to buy the option, it will cost you $2.00 (times the number of
shares) plus brokers commissions.  If you want to sell the option
(either because you bought it earlier, or would like to write the
option), you will get $2.00 (times the number of shares) less
commissions.  The option in this example expires on the Saturday
following the third Friday of October in the year it was purchased.

In general, options are written on blocks of 100s of shares.  So when
you buy "1" IBM Oct 90 Call at $2.00 you actually are buying a contract
to buy 100 shares of IBM at $90 per share ($9,000) on or before the
expiration date in October.  So you have to multiply the price of the
option by 100 in nearly all cases.  You will pay $200 plus commission to
buy this call.

If you wish to exercise your option you call your broker and say you
want to exercise your option.  Your broker will make the necessary
requests so that a person who wrote a call option will sell you 100
shares of IBM for $9,000 plus commission.  What actually happens is the
Chicago Board Options Exchange matches to a broker, and the broker
assigns to a specific account.

If you instead wish to sell (sell=write) that call option, you instruct
your broker that you wish to write 1 Call IBM Oct 90s, and the very next
day your account will be credited with $200 less commission.  If IBM
does not reach $90 before the call expires, you (the option writer) get
to keep that $200 (less commission).  If the stock does reach above $90,
you will probably be "called." If you are called you must deliver the
stock.  Your broker will sell IBM stock for $9000 (and charge
commission).  If you owned the stock, that's OK; your shares will simply
be sold.  If you did not own the stock your broker will buy the stock at
market price and immediately sell it at $9000.  You pay commissions each
way.

If you write a Call option and own the stock that's called "Covered Call
Writing." If you don't own the stock it's called "Naked Call Writing."
It is quite risky to write naked calls, since the price of the stock
could zoom up and you would have to buy it at the market price.  In
fact, some firms will disallow naked calls altogether for some or all
customers.  That is, they may require a certain level of experience (or
a big pile of cash).

When the strike price of a call is above the current market price of the
associated stock, the call is "out of the money," and when the strike
price of a call is below the current market price of the associated
stock, the call is "in the money." Note that not all options are
available at all prices: certain out-of-the-money options might not be
able to be bought or sold.

The other common option is the PUT.  Puts are almost the mirror-image of
calls.  Owning a put gives you the right (but not the obligation) to
sell a stock at the strike price any time before the option expires.  If
you have written a put (you are short a put), you have the obligation to
buy shares at the strike price any time before the expiration date if
you get get assigned .  Covered puts are a simple means of locking in
profits on the covered security, although there are also some tax
implications for this hedging move.  Check with a qualified expert.  A
put is "in the money" when the strike price is above the current market
price of the stock, and "out of the money" when the strike price is
below the current market price.

How do people trade these things? Options traders rarely exercise the
option and buy (or sell) the underlying security.  Instead, they buy
back the option (if they originally wrote a put) or sell the option (if
the originally bought a call).  This saves commissions and all that.
For example, you would buy a Feb 70 call today for $7 and, hopefully,
sell it tommorow for $8, rather than actually calling the option (giving
you the right to buy stock), buying the underlying stock, then turning
around and selling the stock again.  Paying commissions on those two
stock trades gets expensive.

Although options offically expire on the Saturday immediately following
the third Friday of the expiration month, for most mortals, that means
the option expires the third Friday, since your friendly neighborhood
broker or internet trading company won't talk to you on Saturday.  The
broker-broker settlements are done effective Saturday.  Another way to
look at the one day difference is this: unlike shares of stock which
have a 3-day settlement interval, options settle the next day.  In order
to settle on the expiration date (Saturday), you have to exercise or
trade the option by Friday.  While most trades consider only weekdays as
business days, the Saturday following the third Friday is a business day
for expiring options.

The expiration of options contributes to the once-per-quarter
"triple-witching day," the day on which three derivative instruments all
expire on the same day.  Stock index futures, stock index options and
options on individual stocks all expire on this day, and because of
this, trading volume is usually especially high on the stock exchanges
that day.  In 1987, the expiration of key index contracts was changed
from the close of trading on that day to the open of trading on that
day, which helped reduce the volatility of the markets somewhat by
giving specialists more time to match orders.

You will frequently hear about both volume and open interest in
reference to options (really any derivative contract).  Volume is quite
simply the number of contracts traded on a given day.  The open interest
is slightly more complicated.  The open interest figure for a given
option is the number of contracts outstanding at a given time.  The open
interest increases (you might say that an open interest is created) when
trader A opens a new position by buying an option from trader B who did
not previously hold a position in that option (B wrote the option, or in
the lingo, was "short" the option).  When trader A closes out the
position by selling the option, the open interest either remain the same
or go down.  If A sells to someone who did not have a position before,
or was already long, the open interest does not change.  If A sells to
someone who had a short position, the open interest decreases by one.

For anyone who is curious, the financial theoreticians have defined the
following relationship for the price of puts and calls.  The Put-Call
parity theorem says:
P = C - S + E + D
where
P = price of put
C = price of call
S = stock price
E = present value of exercise price
D = present value of dividends


The ordinary investor will occasionally see a violation of put-call
parity.  This is not an instant buying opportunity, it's a reason to
check your quotes for timeliness, because at least one of them is out of
date.

My personal advice for new options people is to begin by writing covered
call options for stocks currently trading below the strike price of the
option; in jargon, to begin by writing out-of-the-money covered calls.

The following web resources may also help.

   * For the last word on options, contact The Options Clearing
     Corporation (CCC) at 1-800-OPTIONS and request their free booklet
     "Characteristics and Risks of Listed Options." This 94-page
     publications will give you all the details about options on equity
     securities, index options, debt options, foreign currency options,
     principal risks of options positions, and much more.  The booklet
     is published jointly by the American Stock Exchange, The Chicago
     Board Options Exchange, The Pacific Exchange, and The Philadelphia
     Stock Exchange.  It's available on the web at:
     http://www.optionsclearing.com/publications/riskstoc.htm
   * The Chicago Board Options Exchange (CBOE) maintains a web site with
     extensive information about equity and index options.  Visit them
     at:
     http://www.cboe.com
   * The Orion Futures Group offers an "Options 101" primer.
     http://www.orionfutures.com/opts.htm


--------------------Check http://invest-faq.com/ for updates------------------

Subject: Derivatives - Stock Option Covered Calls

Last-Revised: 17 July 2000
Contributed-By: Chris Lott ( contact me ), Art Kamlet (artkamlet at
aol.com), John Marucco

A covered call is a stock call option that is written (i.e., created and
sold) by a person who also owns a sufficient number of shares of the
stock to cover the option if necessary.  In most cases this means that
the call writer owns at least 100 shares of the stock for every call
written on that stock.

The call option, as explained in the article on option basics , grants
the holder the right to buy a security at a specific price.  The writer
of the call option receives a premium and agrees to deliver shares
(possibly from his or her holdings, but this is not required) if the
option is called.  Because the call writer can deliver the shares from
his or her holdings, the writer is covered: there is no risk to the call
writer of being forced to buy and subsequently deliver shares of the
stock at a huge premium due to some fantastic takeover offer (or
whatever event that drives up the price).

Note the difference between selling something in an opening transaction
and selling something in a closing transaction.  When you sell a call
you already own, you are selling to close a position.  When you sell a
call you do not own (whether it is covered by a stock position or not),
you are selling to open the option position; i.e., you are writing the
call.  You might compare this with selling stock short, where you are
selling to open a position.

A call writer is covered in the broker's opinion if the broker has on
deposit in the call writer's option account the number of shares needed
to cover the call.  The call writer might have shares in his or her safe
deposit box, or in another broker's account, or in that same broker's
cash account -- this makes the investor covered, but not as far as the
broker is concerned.  So the call writer might consider himself covered,
but what will happen if the call is exercised and the shares are not in
the appropriate account? Quite simply, the broker will think the call is
naked, and will immediately purchase shares to cover.  That costs the
call writer commissions -- and the writer will still own the shares that
were supposed to cover the call!

A call is also considered covered if the call writer has an escrow
receipt for the stock, owns a call on the same stock with a lower strike
price (a spread), or has cash equal to the market value of the stock.
But a person who writes a covered call and doesn't have the sahres in
the brokerage account might be well advised to check with his or her
broker to make sure the broker knows all the details about how the call
is covered.

While the covered-call writer has no risk of losing huge amounts of
money, there is an attendant risk of missing out on large gains.  This
is pretty simple: if a stock has a large run-up in price, and calls are
nearing expiration with a strike price that is even slightly in the
money, those calls will be exercised before they expire.  I.e., the
covered call writer will be forced to deliver shares (known as having
the shares "called away").

If the call writer does not want the shares to get called away, he or
she can buy back the option if it hasn't been exercised yet.  And then
the call writer can roll up (higher strike price) or roll over (same
strike price, later expiration date), or roll up and over.  Of course
the shares could be bought on the open market and delivered, but that
would get expensive.

If you write a covered call and are concerned about indicating specific
shares to be delivered in case you are called, it may be possible to
have your broker write a note on the call to specify a vs date.  The
call confirmation might read: "Covered vs.  Purchase 4/12/97." In other
words the decision on which shares you are covering is made at the time
you write the call.  This should be more than enough to prove your
intent.  What your individual broker or brokerage service will do for
you is a business matter between them and you.

My personal advice for new options people is to begin by writing covered
call options for stocks currently trading below the strike price of the
option; in jargon, to begin by writing out-of-the-money covered calls.

For comprehensive information about covered calls, try this site:
http://www.coveredcalls.com


--------------------Check http://invest-faq.com/ for updates------------------

Subject: Derivatives - Stock Option Covered Puts

Last-Revised: 30 May 2002
Contributed-By: Art Kamlet (artkamlet at aol.com), Chris Lott ( contact
me )

A covered put is a stock put option that is written (i.e., created and
sold) by a person who also is short (i.e., has borrowed and sold) a
sufficient number of shares of the stock to cover the option if
necessary.  In most cases this means that the put writer is short at
least 100 shares of the stock for every put written on that stock.

The put option, as explained in the article on option basics , grants
the holder the right to sell a security at a specific price.  The writer
of the put option receives a premium and agrees to buy shares if the
option is exercised.  For an explanation of what it mans to borrow and
sell shares, please see the FAQ article on selling short .

Note the difference between selling something in an opening transaction
and selling something in a closing transaction.  When you sell a put you
already own, you are selling to close a position.  When you sell a put
you do not own, you are selling to open a position.  So when you sell a
put in an opening transaction (you give an instruction to your broker
"Sell 1 put to open"), that is known as writing the put.  You might
compare this with selling stock short, where you are selling to open a
position.

If you write a naked put, and the stock price goes way way down, you
have incurred a significant loss because you must buy the stock at the
strike price, which (in this example) is well above the current price.

If you write a covered put, that is you hold a short postion on the
underlying stock, then past the strike price the put is covered.  For
every dollar the stock price goes down, the cost to you of getting put
(i.e., of buying the shares because the option gets exercised) is
exactly offset by the decrease in the stock you hold short.  In other
words, for the covered put writer, the shares s/he is put balance the
shares s/he will have to deliver to close out the short position in
those shares, so it balances out pretty well.  The put is covered.

Like the covered call, the covered put does not do a thing to protect
you against the rise (in this case) in price of the underlying stock you
hold short.  But if the price of the stock rises, the put itself is
safe.  So the put writer is covered from loss due to the put.

While the covered-put writer has no risk of losing huge amounts of
money, there is an attendant risk of missing out on large gains.  This
is pretty simple: if a stock has a large fall in price, and puts are
nearing expiration with a strike price that is even slightly in the
money, those puts will be exercised before they expire.  I.e., the
covered put writer will be forced to buy shares (known as "being put").


--------------------Check http://invest-faq.com/ for updates------------------

Subject: Derivatives - Stock Option Ordering

Last-Revised: 25 Jan 96
Contributed-By: Hubert Lee (optionfool at aol.com)

When you are dealing in options, order entry is a critical factor in
getting good fills.  Mis-spoken words during order entry can lead to
serious money errors.  This article discusses how to place your order
properly, and focuses on the simplest type of order, the straight buy or
sell.

There is a set sequence of wording that Wall Street professionals use
among themselves to avoid errors.  Orders are always "read" in this
fashion.  Clerks are trained from day one to listen for and repeat for
verification the orders in the same way.  If you, the public customer,
adopt the same lingo, you'll be way ahead of the game.  In addition to
preventing errors in your account, you will win the respect of your
broker as a savvy, street-wise trader.  Here is the "floor-ready"
sequence:

After identifying yourself and declaring an intent to place an order,
clearly say the following:
[For a one-sided order (simple buy or sell)]
"Buy 10 Calls XYZ February 50's at 1 1/2 to open, for the day"

Always start with whether it is a buy or sell.  When you do so, the
clerk will reach for the appropriate ticket.

Next comes the number of contracts.  Remember, to determine the money
amount of the trade, you multiply this number of contracts by 100 and
then by the price of the option.  In the above example, 10 x 100 x 1 1/2
= $1,500.  Don't ever mention the equivalent number of underlying
shares.  One client of mine used to always order 1000 contracts when he
really meant to buy 10 options (equivalent to 1000 shares of stock).

Thirdly, you name the stock.  Call it by name first and then state the
symbol if you know it.  Be aware of similar sounding letters.  B, T, D,
E etc., can all sound alike in a noisy brokerage office.  Over The
Counter stocks can have really strange option symbols.

The month of expiration comes next.  Again, be careful.  September and
December can sound alike.  Floor lingo uses colorful nicknames to
differentiate.  The "Labor Day" 50s are Sept options while the
"Christmas" 50s are the December series.  But don't get carried away
with trying to use the slang.  Don't ever use it to show off to a clerk.
Simply use it for accuracy (e.g.  "the December as in Christmas 50s").

Then comes the strike price.  Read it plainly and clearly.  15 and 50
sound alike as does 50 and 60.

Name the limit price or whether it is a market order.  Qualify it if it
is something other than a limit or market order.  For example, 1 1/2
Stop.  Pet peeve of many clerks: Don't say "or better" when entering a
plain limit order.  That is assumed in the definition of a limit order.
"Or better" is a designation reserved for a specific instance where one
names a price higher than the current market bid-ask as the top price to
be paid.  For instance, an OEX call is 1 1/2 to 1 5/8 while you are
watching the President on CNN.  He hints at a budget resolution and you
jump on the phone.  You want to buy the calls but not with a market
order.  Instead, you give the floor some room with an "1 7/8 or better
order".  Clerks use this tag as a courtesy to each other to let them
know they realize the current market is actually below the limit price.
This saves them a confirming phone call.

Next is the position of the trade, that is, to Open or to Close.  This
is the least understood facet.  It has nothing to do with the opening
bell or closing bell.  It tells the firm if you are establishing a new
position (opening) or offsetting an existing one (closing).  Don't just
think that by saying "Buy", your firm knows you are opening a new
position.  Remember, options can be shorted.  One can buy to open or to
close.  Likewise, one can sell to open or to close.

If your order has any restrictions, place them here at the end.
Examples are All or None, Fill or Kill, Immediate or Cancel, Minimum of
15 (or whatever you want).  Remember, restricted order have no standing.
Unrestricted orders have execution priority.

Finally, state if the order is a day order or Good Till Canceled.  If
you don't say, the broker will assume it to be a day order only, but the
client should mention it as a courtesy.

Very Important: Your clerk will read the order back to you in the same
way for verification.  LISTEN CAREFULLY.  If you don't catch an error at
this point, they can stick you with the trade.

Proper order entry can mean the difference between a successful
execution and a missed fill or a poor price.  Doing it the right way can
save you precious seconds.  Further, it will mean a better relationship
with your broker.  The representative will act differently when he sees
a customer who knows what he is doing.  The measure of respect given to
someone who knows how to give an order properly is considerable.  After
all, you've just proven that you "speak" his language.

This article is Copyright 1996 by Hubert Lee.  For more insights from
Hubert Lee, visit his site:
http://www.optionfool.com


--------------------Check http://invest-faq.com/ for updates------------------

Subject: Derivatives - Stock Option Splits

Last-Revised: 23 Apr 1998
Contributed-By: Art Kamlet (artkamlet at aol.com)

When a stock splits, call and put options are adjusted accordingly.  In
almost every case the Options Clearing Corporation (OCC) has provided
rules and procedures so options investors are "made whole" when stocks
split.  This makes sense since the OCC wishes to maintain a relatively
stable and dependable market in options, not a market in which options
holders are left holding the bag every time that a company decides to
split, spin off parts of itself, or go private.

A stock split may involve a simple, integral split such as 2:1 or 3:1,
it may entail a slightly more complex (non-integral) split such as 3:2,
or it may be a reverse split such as 4:1.  When it is an integral split,
the option splits the same way, and likewise the strike price.  All
other splits usually result in an "adjustment" to the option.

The difference between a split and an adjusted option, depends on
whether the stock splits an integral number of times -- say 2 for 1, in
which case you get twice as many of those options for half the strike
price.  But if XYZ company splits 3 for 2, your XYZ 60s will be adjusted
so they cover 150 shares at 40.

It's worth reading the article in this FAQ on stock splits , which
explains that the owner of record on close of business of the record
date will get the split shares, and -- and -- that anyone purchasing at
the pre-split price between that time and the actual split buys or sells
shares with a "due bill" attached.

Now what about the options trader during this interval? He or she does
have to be slightly cautious, and know if he is buying options on the
pre-split or the post-split version; the options symbol is immediately
changed once the split is announced.  The options trader and the options
broker need to be aware of the old and the new symbol for the option,
and know which they are about to trade.  In almost every case I have
ever seen, when you look at the price of the option it is very obvious
if you are looking at options for the pre or post-split shares.

Now it's time for some examples.
   * Example: XYZ Splits 2:1
     The XYZ March 60 call splits so the holder now holds 2 March 30
     calls.
   * Example: XYZ Splits 3:2
     The XYZ March 60 call is adjusted so that the holder now holds one
     March $40 call covering 150 shares of XYZ.  (The call symbol is
     adjusted as well.)
   * Example: XYZ declares a 5% stock dividend.
     Generally a stock dividend of 10% or less is called a stock
     dividend and does not result in any options adjustments, while
     larger stock dividends are called stock splits and do result in
     options splits or readjustments.  (The 2:1 split is really a 100%
     stock dividend, a 3:2 split is a 50% dividend, and so on.)
   * Example: ABC declares a 1:5 reverse split
     The ABC March 10 call is adjusted so the holder now holds one ABC
     March 50 call covering 20 shares.

Spin-offs and buy-outs are handled similarly:
   * Example: WXY spins off 1 share of QXR for every share of WXY held.
     Immediately after the spinoff, new WXY trades for 60 and QXR trades
     for $40.  The old WXY March 100 call is adjusted so the holder now
     holds one call for 100 sh WXY @ 60 plus 100 sh WXY at 40.


   * Example: XYZ is bought out by a company for $75 in cash, to holders
     of record as of March 3.
     Holders of XYZ 70 call options will have their option adjusted to
     require delivery of $75 in cash, payment to be made on the
     distribution date of the $75 to stockholders.

Note: Short holders of the call options find themselves in the same
unenviable position that short sellers of the stock do.  In this sense,
the options clearing corporation's rules place the options holders in a
similar risk position, modulo the leverage of options, that is shared by
shareholders.

The Options Clearing Corporation's Adjustment Panel has authority to
deviate from these guidelines and to rule on unusual events.  More
information concerning options is available from the Options Clearing
Corporation (800-OPTIONS) and may be available from your broker in a
pamphlet "Characteristics and Risks of Standardized Options."


--------------------Check http://invest-faq.com/ for updates------------------

Subject: Derivatives - Stock Option Symbols

Last-Revised: 21 Oct 1997
Contributed-By: Chris Lott ( contact me )

The following symbols are used for the expiration month and price of
listed stock options.

Month Call Put
Jan A M
Feb B N
Mar C O
Apr D P
May E Q
Jun F R
Jul G S
Aug H T
Sep I U
Oct J V
Nov K W
Dec L X


Price Code Price
A x05
U 7.5
B x10
V 12.5
C x15
W 17.5
D x20
X 22.5
E x25
F x30
G x35
H x40
I x45
J x50
K x55
L x60
M x65
N x70
O x75
P x80
Q x85
R x90
S x95
T x00


The table above does not illustrate the important fact that price code
"A", just to pick one example, could mean any of the following strike
prices: $5, $105, $205, etc.  This is not so much of a problem with
stocks, because they usually split to stay in the $0-$100 range most of
the time.

However, this is particularly confusing in the case of a security like
the S&P 100 index, OEX, for which you might find listings of more than
100 different options spread over several hundred dollars of strike
price range.  The OEX is priced in the hundreds of dollars and sometimes
swings wildly.  To resolve the multiple-of-$100 ambiguity in the strike
price codes, the CBOE uses new "root symbols" such as OEW to cover a
specific $100 range on the S&P 100 index.  This is very confusing until
you see what's going on.


--------------------Check http://invest-faq.com/ for updates------------------

Subject: Derivatives - LEAPs

Last-Revised: 30 Dec 1996
Contributed-By: Chris Lott ( contact me )

A Long-term Equity AnticiPation Security, or "LEAP", is essentially an
option with a much longer term than traditional stock or index options.
Like options, a stock-related LEAP may be a call or a put, meaning that
the owner has the right to purchase or sell shares of the stock at a
given price on or before some set, future date.  Unlike options, the
given date may be up to 2.5 years away.  LEAP symbols are three
alphabetic characters; those expiring in 1998 begin with W, 1999 with V.

LEAP is a registered trademark of the Chicago Board Options Exchange.
Visit their web site for more information: http://www.cboe.com/


--------------------Check http://invest-faq.com/ for updates------------------

Subject: Education Savings Plans - Section 529 Plans

Last-Revised: 25 Jan 2003
Contributed-By: Chris Lott ( contact me )

Tax law changes made in 2001 introduced a college savings plan commonly
called a "529 plan" (named after their section in the Internal Revenue
Code).  These plans allow people to save for college expenses.

There are actually two types of 529 plans being offered by different
states.  One kind is a pre-paid tuition plan; the other is a more
general savings vehicle.  Participants in pre-paid plans are usually
strongly encouraged to use their credits at certain state schools, and
might not get full benefits if they choose an out-of-state school.
Participants in 529 savings plans can use their funds for any accredited
institution in any state.

Funds in the account, as in an IRA, grow free of taxes.  Contribution
limits are high; each state sets its own limits.  Very few states impose
any income limits (meaning that if you make too much money, you cannot
contribute to one of these plans).  Anyone can contribute: parents,
grandparents, etc.

Different versions of 529 plans are offered in all 50 states, and there
is no restriction on state residency to use a state's plan.  So for
example, if you live in Maine, you could invest in Hawaii's 529 plan.
However, the benefits may differ depending on the state where you live.
So if you are the Maine resident who is considering the Hawaii plan, you
should certainly ask about the Maine plan's benefits.

Many state plans offer significant benefits to state residents.  A
resident may pay a lower management fee than an out-of-state plan
member.  A state resident may be able to deduct 529 contributions from
his or her state taxable income, which reduces the amount of state
income tax due to their state.  Note that companies marketing plans from
other states may conveniently "gloss over" these benefits.

One feature of these plans that makes them most attractive to many
people is the amount of control that the donor retains over the funds.
Unlike gifts made under a Uniform Gifts to Minors Act or a Coverdell
Education Savings Account, where the minor owns the funds, the intended
beneficiary of a 529 plan has no right to the money.  In fact, many
states allow the donor to revoke the donation and get the money back
(although subject to various taxes and penalties).

A common complaint about 529 plans is the lack of choice in the
investments available for participants.  State plans are usually managed
by some large financial institution.  That institution may choose to
offer only load funds or other investments that charge fees higher than
the fees on comparable investments available outside the 529 plans.
Further, many plans restrict how often funds can be moved among the
investment choices, usually only once a year.

Withdrawals that are used to pay qualified expenses, including tuition,
fees, and certain other expenses are free of tax on any earnings.  If
the money is withdrawn for any other purpose, both state and federal
income tax is due on any earnings, and further Uncle Sam demands a 10%
penalty on those earnings.  (Of course tax law can change at any time;
the tax-free withdrawal provision is currently set to expire in 2010.)

These plans are suitable for many families but certainly not all.  The
implications for financial aid computations are not clear and vary with
each educational institution.  It's probably safe to say that if you
have enough income that you will never qualify for financial aid, then a
529 plan is exactly right for you.

If you have determined that a 529 plan is right for you, your job is not
done yet.  Because there are so many plans out there, and so many sales
pitches from brokers and other financial institutions, choosing one can
be exceedingly difficult.  Some items to research about these plans and
alternatives include the contribution limits (how much can you stash
away), the advantages you may attain, the range of investment choices,
and (last but certainly not least) the fees demanded by the account
custodian.  You can draw parallels to the big debate over load versus
non-load mutual funds without really trying.

Here are a few web resources on 529 plans:
   * Joe Hurley runs Saving For College LLC, a comprehensive guide to
     529 plans on the web.
     http://www.savingforcollege.com
   * The Motley Fool offers a comparison of Section 529 plans against
     Coverdell Educational Savings Plans.
     http://www.fool.com/csc/compare.htm


--------------------Check http://invest-faq.com/ for updates------------------

Subject: Education Savings Plans - Coverdell

Last-Revised: 25 Jan 2003
Contributed-By: Chris Lott ( contact me )

A Coverdell Education Savings Account (ESA), formerly known as an
Education IRA, is a vehicle that assists with saving for education
expenses.  This article describes the provisions of the US tax code for
educational IRAs as of mid 2001, including the changes made by the
Economic Recovery and Tax Relief Reconciliation Act of 2001.

Funds in an ESA can be used to pay for elementary and secondary
education expenses, college or university expenses, private school
tuition, etc.  I am told that the educational institution must be
accredited (which in this case means the school can participate in
various financial aid programs), but it does not have to be in the
United States.  In other words, it appears that it's legal to pay
tuition at a foreign school using funds from an ESA as long as the
school is accredited.

An ESA may be established for any person who is under 18 years of age.
Contributions to this account are limited to $2,000 in 2002.  Once the
beneficiary reaches 18, then no further funds may be contributed.
Annual contributions must be made by April 15th of the following year
(previously they had to be made by December 31st of the same year).

Although anyone may contribute to a minor's ESA, contributions are not
tax deductible, and further, contributions may only be made by taxpayers
who fall under the limits for adjusted gross income.  As with many
provisions in the tax code, the limits are phased; the ranges are
95-110K for single filers and 150-160K for joint filers.  Also,
contributions are not permitted if contributions are made to a state
tuition program on behalf of the beneficiary.

The major benefit of this savings vehicle is that the funds grow free of
all taxes.  Distributions that are taken for the purpose of paying
qualified educational expenses are not subject to tax, thus saving the
beneficiary of paying tax on the fund's growth.  Distributions that are
used for anything other than qualified educational expenses are treated
as taxable income and further are subject to a 10% penalty, unless a
permitted exception applies.

If the beneficiary reaches age 30 and there are still funds in his or
her ESA, they must either be distributed (incurring tax and penalties)
or rolled over to benefit another family member.

On a related note, changes made in 1997 to the tax code also permit
withdrawals of funds from both traditional IRAs and Roth IRAs for paying
qualified educational expenses.  Basically, the change established an
exception so you can avoid the 10% penalty on distributions taken before
age 59 1/2 if they are for educational expenses.

It is possible to roll over funds from an ESA to a (new as of 2002) 529
plan.  A roll-over from an ESA plan to a 529 plan is free of tax and
penalty as it is completed within 60 days and the account beneficiary is
the same.

The rules for ESAs changed in mid 2001 in the following ways:
   * The contribution limit rises from $500 to $2,000 in 2002.
   * Starting in 2002, funds can be used to pay for elementary and
     secondary education, not just college/university, including private
     schools.
   * Income limits on those who can fund an ESA rise: married filers
     will be limited starting at $190,000 starting in 2002.


--------------------Check http://invest-faq.com/ for updates------------------

Subject: Exchanges - The American Stock Exchange

Last-Revised: 19 Jan 2000
Contributed-By: Chris Lott ( contact me )

The American Stock Exchange (AMEX) lists over 700 companies and is the
world's second largest auction-marketplace.  Like the NYSE (the largest
auction marketplace), the AMEX uses an agency auction market system
which is designed to allow the public to meet the public as much as
possible.  In other words, a specialist helps maintain liquidity.

Regular listing requirements for the AMEX include pre-tax income of
$750,000 in the latest fiscal year or 2 of most recent 3 years, a market
value of public float of at least $3,000,000, a minimum price of $3, and
a minimum stockholder's equity of $4,000,000.

In 1998, a merger between the NASD and the AMEX resulted in the
Nasdaq-Amex Market Group.

For more information, visit their home page: http://www.amex.com


--------------------Check http://invest-faq.com/ for updates------------------

Subject: Exchanges - The Chicago Board Options Exchange

Last-Revised: 19 Jan 2000
Contributed-By: Chris Lott ( contact me )

The Chicago Board Options Exchange (CBOE) was created by the Chicago
Board of Trade in 1973.  The CBOE essentially defined for the first time
standard, listed stock options and established fair and orderly markets
in stock option trading.  As of this writing, the CBOE lists options on
over 1,200 widely held stocks.  In addition to stock options, the CBOE
lists stock index options (e.g., the S&P 100 Index Option, abbreviated
OEX), interest rate options, long-term options called LEAPS, and sector
index options.  Trading happens via a market-maker system.  For more
information, visit the home page: http://www.cboe.com


--------------------Check http://invest-faq.com/ for updates------------------

Compilation Copyright (c) 2003 by Christopher Lott.