Long-Term Options- Introduction

Long-Term Options

Introduction

Instead, the purpose of this is to highlight the fact that option premiums in general do not reflect the expected long-term growth rate of the underlying equities and to explain an investment strategy that can be used to take maximum advantage of this phenomenon. As I mentioned before, my own interest in this subject stems from the fact that I could no longer contribute additional funds to my retirement plan. As a long-term investor in the market, I had assembled a stock portfolio over many years, and I simply did not wish to raise cash by selling any of my winners. My few losers and laggards had long since been disposed of and the proceeds used to buy more shares of my better-performing stocks. I'm not a short-term, in-and-out investor, but I wanted to keep buying.

Options seemed the way to go, but as with stocks, purchasing calls requires money. What's more, options can only be paid for in cash, so going on margin and borrowing the funds from my broker was out of the question. My next thought was, if I'm going to raise cash, why not sell covered calls on my portfolio? I tried this a few times and promptly had some of my stocks called away from me when their share prices sharply increased as a result of takeover rumors or positive earnings surprises. I wasn't too happy about having to buy back shares using the little cash I had remaining to cover the gap between the exercise price received and the higher repurchase price. So much for covered calls.

By process of elimination, the only strategy remaining was selling puts. This method, you will recall, generates up-front money through the premiums received. Option premiums must be paid on the next business day and are available for reinvestment even faster than proceeds from the sale of stock (which settle within three business days). And because these funds represent premiums paid, not dollars borrowed, they are yours to keep. However, as the fine print in most travel ads states, "certain restrictions apply." Premiums have to stay in your account in case they are needed later in the event of assignment. But because they are in your account, you can use them to acquire additional equities. 

The problem with this approach, I soon discovered, is that applying it to standard options does not bring in much money, especially in relation to the risk assumed in potentially having the underlying stock assigned to you. You can certainly sell a put whose exercise price is well below the current stock price, thereby minimizing the risk of assignment, but doing this brings in a very small premium. A larger premium can be generated by selling a put with an exercise price much closer to or just below the current price, but this can entail significant risk of assignment. Substantial premiums seen on out-of-the-money* puts typically indicate highly volatile stocks or instances where the market (probably correctly) anticipates a sharp drop in the value of the underlying equity—situations that had no appeal to me whatsoever.

And if all that isn't enough, there is also the fact that dealing in standard options, with their quickly changing market values, typically requires substantial, if not full-time, commitment to the task. Most option traders I've met have had little time for anything else during their working days and have often spent a good deal of their evenings and weekends conducting research into what trades to enter and when to cover and get out. This kind of nerve-wracking, nail-biting, glued-to-the-console environment is not what I wanted either. It then occurred to me that there was a solution to this dilemma.

There does exist a class of options whose premiums are relatively large, which bear less risk than standard options, and which, because the underlying equities are comparatively stable, do not have to be monitored with anywhere near the same intensity as standard options. What distinguishes this class of options is their long-term expiration date, which permits the market price of the underlying equity plenty of time to recover should the overall market, industry sector, or the company itself encounter a temporary downturn or adverse conditions. It occurred to me that by selling puts on stronger, well-endowed firms whose intermediate- and long-term prospects are above average, it might be possible to achieve high returns without incurring undue risk.

LEAPS

The class of options that fits this description was actually created by the Chicago Board Options Exchange in 1990. Because standard options expire at most eight months after their inception, the CBOE introduced a new product for investors wishing to hedge common stock positions over a much longer time horizon. These options, called LEAPS (Long-term Equity AnticiPation Securities), are long-term options on common stocks of companies that are listed on securities exchanges or that trade over the counter. LEAPS expire on the Saturday following the third Friday in the month of January approximately two and a half years from the date of the initial listing. 

They roll into and become standard options after the May, June, or July expiration date corresponding to the expiration cycle of the underlying security. In most other ways, LEAPS are identical to standard options. Strike price intervals for LEAPS follow the same rules as standard options (i.e., they are $2.50 when the stock price of the underlying equity is between $5 and $25, $5 when the stock price is between $25 and $200, and $10 when the stock price is over $200). As for standard options, strike prices for LEAPS are adjusted for splits, major stock dividends, recapitalizations, and spin-offs when and if they occur during the life of the option. 

Like standard options, equity LEAPS generally may be exercised on any business day before the expiration date. Margin requirements for LEAPS follow the same rules as standard options. Uncovered put or call writers must deposit 100 percent of the option proceeds plus 20 percent of the aggregate contract value (the current price of the underlying equity multiplied by $100) minus the amount, if any, by which the LEAP option is out of the money. The minimum margin is 100 percent of the option proceeds plus 10 percent of the aggregate contract value. 

LEAP Premiums

Option premiums in general vary directly with the remaining time to expiration. As a result of their longer lives, LEAPS have premiums that can be considerably greater than those of their standard option counterparts. Each entry in the table is the theoretical premium corresponding to the expiration time in months shown in column 1 and the stock volatility, ranging from a fairly low level of 0.15 to a fairly high level of 0.65. Intel's stock, for example, has a volatility of about 0.35, so when the stock price reaches $100, an at-the-money put option should command a premium of $829.60 ($8.296 × 100 shares) with six months to expiration and a premium of $1,313.40 ($13.314 × 100 shares) with 24 months to expiration.

That is, if the stock price and strike price are both $50, the corresponding per share premiums are exactly half the amounts shown. The first question people often ask is why the at-the-money call premiums are so much greater than the corresponding put premiums for the same time horizon and volatility level. Note, for example, that for a stock with a volatility of 0.35 and an expiration date 30 months away, the put premium is $14.035 per share versus $27.964 for the call premium. Is this difference due to general inflation and/or the expected growth rate in the underlying equity?

The answer is no. The reason the call premiums are greater is that option pricing models assume that stock prices are just as likely to increase by, say, 10 percent as they are to decrease by 10 percent on any given day. On a cumulative basis, there is therefore no limit to how high prices can go up over time, but there is a definite lower limit (zero) to how low prices can go. It is this possibility of unrestricted price movement upward versus restricted price movement downward that explains why calls are more expensive than puts.

Commissions

There is another major advantage associated with LEAPS. Because of the inherently greater premium levels involved, the brokerage commissions charged are going to be a smaller percentage of the proceeds received. At a full-service firm, the brokerage commission to buy or sell a single option might be $45. In percentage terms, this amount is almost 12 percent of the premium for the one-month Intel option, but just 3.2 percent of the premium for the 30-month LEAP option. Commission costs per contract rapidly decrease at a full-service firm if more than one contract is involved and might range from $25 to $35 each for three contracts down to just $15 to $20 each for ten contracts.

At a discount broker's, the commission might be $20 each, but it is typically subject to a minimum fee of $40 and a maximum fee of $70 on transactions involving one to ten contracts. For online, deep-discount, and option-specialized brokers, the commission might be $15 each but is typically subject to a minimum fee of $35 and a maximum fee of $60 on transactions of one to ten contracts.

Table  European-Style At-the-Money Put Premiums as a Function of Time and Volatility

Although there can be significant differences in total commission costs between full-service brokers and other firms, I prefer to work with options-knowledgeable people at a full-service firm. I can readily do this because I am not a short-term investor, and the relatively small number of trades I do per year does not result in significant commissions in terms of absolute dollars. This is particularly true when one remembers that in selling options that subsequently expire worthless, only one commission is involved, not two.

Table  European-Style At-the-Money Call Premiums as a Function of Time and Volatility

LEAPS Available

LEAPS are currently traded on over 300 widely followed equities (as well as on numerous industry sector, domestic, and international indices). Shows the name of the underlying security, its stock symbol, the standard option symbol, the exchange code(s) showing where the option is traded, the options cycle governing when the LEAP option rolls over into a standard option, and the option symbol for the LEAPS expiring in the years 2001 and 2002. Omitted from the table are issues for which no new LEAPS will be listed as a result of mergers and acquisitions that have taken place.

Exchange Codes.

LEAPS are traded on one or more of four major exchanges,* as indicated by the following symbols:

A American Stock Exchange

C Chicago Board Options Exchange

P Pacific Stock Exchange

X Philadelphia Stock Exchange

Expiration Cycles.

These are the January, February, and March cycles that control how and when each LEAP option rolls over into a standard option. It is important to note that the trading symbol for a LEAP option will change when it does roll over and become a standard option, and quote requests, statements, trades, close-outs and exercise instructions should reflect this. In Table, the numerical codes used for the expiration cycles are:

1 January Sequential

2 February Sequential

3 March Sequential

The expiration cycle of a given class of options also tells you the specific month that the corresponding LEAP is due to open for trading. For example, Intel is cycle 1, so the next set of Intel LEAPS is supposed to open right after the May expiration. Boeing is cycle 2, so the next set of Boeing LEAPS is supposed to open right after the June expiration. And Pfizer is cycle 3, so the next set of Pfizer LEAPS is supposed to open right after the July expiration.

LEAP Symbols.

To facilitate trading, LEAPS are symbolized by a four- to six-character trading symbol made up of a root symbol designating the underlying equity, a single character designating the expiration month, and a single letter designating the strike price involved. Because LEAPS expire only in January, the code letter for the expiration month is always A for calls and M for puts. The root symbols for the underlying equity began with the letter V for the January 1999 LEAPS and the letter L for the January 2000 LEAPS, and begin with the letter Z for the January 2001 LEAPS and the letter W for the January 2002 LEAPS. This V/L/Z/W sequence of initial letters is repeated every four years, so the letter V will likely be assigned as the starting letter for the year 2003 LEAPS.

As each LEAP option rolls over into a standard option approximately a half year prior to expiration, the root symbol portion of the trading code is changed to that of the standard option. Because of conflicts that frequently arise with existing trading symbols of stocks and standard options, there is often no consistency in the designations of LEAP root symbols. Note too that although the LEAP root symbols are three letters long, in some instances they consist of just two letters. A dash indicates that there was no LEAP option offered for that year on a particular security, often because of a pending merger or acquisition.

It is frequently the case that as a result of a wide fluctuation in stock price (as well as mergers, acquisitions, and stock splits), there is going to be more than one LEAP root symbol for a given stock and expiration year. For example, the January 2001 LEAPS for Yahoo have the root YZY for strikes between $22.5 and $35; ZYH for strikes $37.50 through $85; ZGH for strikes $90 through $135; ZYO for strikes $150 through $200; and ZYM for strikes between $210 and $250. The only sure way to determine the correct root symbol for a given LEAP option series is to consult an online table showing the specific LEAPS available, such as the one maintained by the Chicago Board Options Exchange. Or you can call the CBOE directly at 800-OPTIONS (678-4667).

Position Limits.

Not shown in Table because of rapidly changing conditions is the maximum number of open contracts that are permitted on any option class. As opposed to stocks, whose outstanding shares often number in the hundreds of millions, the maximum number of open option contracts (including LEAPS and standard options) permitted on the underlying equity is heavily limited. These limits are set in accordance with the number of outstanding shares and the trading volume of the underlying equity.

The larger, more frequently traded stocks are assigned initial position limits of 75,000 contracts, while less active issues are assigned initial position limits of either 60,000, 31,500, 22,500, or as few as 13,500 contracts for the smallest of traded issues. As a result of stock splits, mergers, acquisitions, and other factors, these limits are periodically adjusted. Position limits are imposed by the various options exchanges to prevent any person or entity from controlling the market on a given issue. Because every option contract has both a buyer and a seller, the open contract count is the sum of the number of opening calls bought and the number of opening puts sold, so as not to double count.

Using Options to Buy Stocks

There's no way around it, buying stocks takes money. But by now you've guessed where the money for buying stocks can come from: not out of your pocket but from the premiums accumulated from the sales of the LEAP puts. As described in the preface, the purpose of my selling LEAP puts was not just to enhance the cash flow and dividend yield of my stock portfolio. Rather, it was to furnish the funds with which to continue stock acquisition.

Table  LEAPS Available August 1999

Table  LEAPS Available August 1999

Table  LEAPS Available August 1999

 Table  LEAPS Available August 1999

Table  LEAPS Available August 1999 

Table  LEAPS Available August 1999

Table  LEAPS Available August 1999

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THE OPTIONS COURSE- Processing Your Trade

THE OPTIONS COURSE

Processing Your Trade

Most investors never realize the number of steps required for a trade to occur and the incredible speed involved. Technology has made this process almost unnoticeable to the average investor. When you contact your stock or futures broker, you begin a process that, in many cases, can be completed in 10 seconds or less, depending on the type of trade you want to execute. There are various types of orders that are placed between customers and brokerage firms. The faster technology becomes, the faster a trader’s order gets filled. Let’s take a closer look at what happens when you place an order.

EXCHANGES

Stocks, futures, and options are traded on organized exchanges throughout the world, 24 hours a day. These exchanges establish rules and procedures that foster a safe and fair method of determining the price of a security. They also provide an arena for the trading of securities. Over the years, the various exchanges have had to update themselves with the ever increasing demands made by huge increases in trading volume. The New York Stock Exchange (NYSE)—probably the best known of the exchanges—not too long ago traded 100 million shares as a high. Today we see 700, 800, 900 million, and even 1 billion shares trading in a day.

Stocks, futures, and options exchanges are businesses. They provide the public with a place to trade. Each exchange has a unique personality and competes with other exchanges for business. This competitiveness keeps the exchanges on their toes. Exchanges sell memberships on the exchange floor to brokerage firms and specialists. They must be able to react to the demands of the marketplace with innovative products, services, and technological innovations. If everyone does his or her job, then you won’t even know where your trade was executed. In addition, exchanges all over the world are linked together regardless of different time zones. 

Prices shift as trading ends in one time zone, moving activity to the next. This global dynamic explains why shares close at one price and open the next day at a completely different price at the same exchange. With the increased use of electronic trading in global markets, these price movements are more unpredictable than ever before. The primary U.S. stock exchanges are the New York Stock Exchange, the American Stock Exchange (Amex), and Nasdaq. There is a host of others that do not get as much publicity as the big three. However, each exchange certainly produces its share of activity. 

These include the Pacific Exchange in San Francisco, the Chicago Stock Exchange, the Boston Stock Exchange, and the Philadelphia Stock Exchange. The major international exchanges are in Tokyo, London, Frankfurt, Johannesburg, Sydney, Hong Kong, and Singapore. The primary commodities exchanges include: Chicago Mercantile Exchange (CME); Chicago Board of Trade (CBOT); New York Mercantile Exchange (NYMEX); COMEX (New York); Kansas City Board of Trade; Coffee, Cocoa and Sugar Exchange (New York); and the Commodity Exchange (CEC). 

The Commodity Futures Trading Commission (CFTC) and the National Futures Association (NFA) currently regulate the nation’s commodity futures industry. Created by the Commodity Futures Trading Commission Act of 1974, the CFTC has five futures markets commissioners who are appointed by the U.S. President and subject to Senate approval. The rules of the SEC and the CFTC differ in some areas, but their goals remain similar. They are both charged with ensuring the open and efficient operation of exchanges.

EXPLORING THE FOREX

The term FOREX is derived from “foreign exchange” and is the largest financial market in the world. Unlike most markets, the FOREX market is open 24 hours per day and has an estimated 1.2 trillion in turnover every day. The FOREX market does not have a fixed exchange. It is primarily traded through banks, brokers, dealers, financial institutions, and private individuals. A common term in the FOREX arena you will run into is “Interbank.” Originally this was just banks and large institutions exchanging information about the current rate at which their clients or themselves were prepared to buy or sell a currency. 

Now it means anyone who is prepared to buy or sell a currency. It could be two individuals or your local travel agent offering to exchange euros for U.S. dollars. However, you will find that most of the brokers and banks use centralized feeds to ensure the reliability of a quote. The quotes for bid (buy) and offer (sell) will all be from reliable sources. These quotes are normally made up of the top 300 or so large institutions. This ensures that if they place an order on your behalf that the institutions they have placed the order with are capable of fulfilling the order. Just as with other securities on other exchanges, you will see two numbers. The first number is called the bid and the second number is called the ask. 

For example, using the euro against the U.S. dollar you might see 0.9550/0.9955. The first number is the bid price and is the price at which traders are prepared to buy euros against the U.S. dollar. Spot or cash market FOREX is traditionally traded in lots, also referred to as contracts. The standard size for a lot is $100,000. In the past few years, a mini-lot size has been introduced of $10,000 and this again may change in the years to come. They are measured in pips, which is the smallest increment of that currency. To take advantage of these tiny increments it is desirable to trade large amounts of a particular currency in order to see any significant profit or loss.

Leverage financed with credit, such as that purchased on a margin account, is very common in FOREX. A margined account is a leverageable account in which FOREX can be purchased for a combination of cash or collateral depending what your broker will accept. The loan in the margined account is collateralized by your initial margin or deposit. If the value of the trade drops sufficiently, the broker will ask you to either put in more cash, sell a portion of your position, or even close your position. Margin rules may be regulated in some countries, but margin requirements and interest vary among broker/dealers; so always check with the company you are dealing with to ensure you understand its policy.

Although the movement today is toward all transactions eventually finishing with a profit or loss in U.S. dollars, it is important to realize that your profit or loss may not actually be in U.S. dollars. This trend toward U.S. dollars is more pronounced in the United States, as you would expect. Most U.S.-based traders assume they will see their balance at the end of each day in U.S. dollars Preferably you want a company that is regulated in the country in which it operates, is insured or bonded, and has an excellent track record. As a rule of thumb, nearly all countries have some kind of regulatory authority that will be able to advise you. 

Most of the regulatory authorities will have a list of brokers who fall within their jurisdiction and may provide you with a list. They probably will not tell you who to use but at least if the list came from them, you can have some confidence in those companies. Just as with a bank, you are entitled to interest on the money you have on deposit. Some brokers may stipulate that interest is payable only on accounts over a certain amount, but the trend today is that you will earn interest on any amount you have that is not being used to cover your margin. Your broker is probably not the most competitive place to earn interest, but that should not be the point of having your money with them in the first place. 

Payment on the portion of your account that is not being used, and segregation of funds all go to show the reputability of the company you are dealing with. Policies that are implemented by governments and central banks can play a major role in the FOREX market. Central banks can play an important part in controlling the country’s money supply to ensure financial stability. A large part of FOREX turnover is from banks. Large banks can literally trade billions of dollars daily. This can take the form of a service to their customers, or they themselves might speculate on the FOREX market.

The FOREX market can be extremely liquid, which is why it can be desirable to trade. Hedge funds have increasingly allocated portions of their portfolios to speculate on the FOREX market. Another advantage hedge funds can utilize is a much higher degree of leverage than would typically be found in the equity markets. The FOREX market mainstay is that of international trade. Many companies have to import or export goods to different countries all around the world. Payment for these goods and services may be made and received in different currencies. Many billions of dollars are exchanged daily to facilitate trade. The timing of those transactions can dramatically affect a company’s balance sheet.

Although you may not think it, the man in the street also plays a part in today’s FOREX world. Every time he goes on holiday overseas he normally needs to purchase that country’s currency and again change it back into his own currency once he returns. Unwittingly, he is in fact trading currencies. He may also purchase goods and services while overseas and his credit card company has to convert those sales back into his base currency in order to charge him. The key impression I would like to leave you with about the FOREX is that it is more than the combined turnover of all the world’s stock markets on any given day. This makes it a very liquid market and thus an extremely attractive market to trade.

HISTORY OF OPTIONS

Stock options have been trading on organized exchanges for more than 30 years. In 1973, the first U.S. options exchange was founded and call options on 16 securities started trading. A few years later, put options began trading. A decade later, index options appeared on the scene. Today, five exchanges are active in trading options, and annual options trading volumes continue to set records. Indeed, over the course of 30 years, from the early 1970s until now, a great deal has changed in the world of options trading. What was once the domain of mostly sophisticated professional investors has turned into a vibrant and dynamic marketplace for investors of all shapes and sizes.

The history of organized options trading dates back to the founding of the Chicago Board Options Exchange (CBOE) in 1973. By the end of that year, options had traded on a total of 32 different issues and a little over 1 million contracts traded hands. In 1975, the Securities and Exchange Commission (SEC) approved the Options Clearing Corporation (OCC), which is still the clearing agent for all U.S.-based options exchanges. As clearing agent, the OCC facilitates the execution of options trades by transferring funds, assigning deliveries, and guaranteeing the performance of all obligations. The Securities and Exchange Commission approved the OCC roughly two years after the founding of the first U.S.based options exchange.

The early 1970s also witnessed other important events related to options trading. For instance, in 1973, Fischer Black and Myron Scholes prepared a research paper that outlined an analytic model that would determine the fair market value of call options. Their findings were published in the Journal of Political Economy and the model became known as the Black-Scholes option pricing model. Today it is still the option pricing model most widely used by traders. As more investors began to embrace the use of stock options, other exchanges started trading these investment vehicles. 

In 1975, both the Philadelphia Stock Exchange (PHLX) and the American Stock Exchange (AMEX) began trading stock options. In 1976, the Pacific Stock Exchange (PCX) entered the options-trading scene. All three became members of the OCC, and all three still trade options today. In addition, in 1977, the SEC permitted the trading of put options for the first time. In 1975, 18 million option contracts were traded. By 1978, the number had soared to nearly 60 million. The 1980s also saw an explosion in the use of options, which eventually peaked with the great stock market crash of 1987. The Chicago Board Options Exchange launched the first cash-based index in the early 1980s. 

In 1983, the exchange began trading options on the S&P 100 index (OEX). The OEX was the first index to have listed options. In 1986, the CBOE Volatility Index (VIX) became the market’s first real-time volatility index. VIX was based on the option prices of the OEX. In 2003, it was modified and is now based on S&P 500 Index (SPX) options. The early 1980s saw a growing interest in both stock and index options. From 1980 until 1987, annual options volume rose from just under 100 million contracts to just over 300 million. 

After the market crash in October 1987, however, investor enthusiasm for options trading waned and less than 200 million contracts traded in the year 1991, or roughly two-thirds of the peak levels witnessed in 1987. Throughout most of the 1990s, trading activity in the options market improved. In 1990, long-term equity anticipation securities (LEAPS) were introduced. The OCC and the options exchanges created the Options Industry Council (OIC) in 1992. The OIC is a nonprofit association created to educate the investing public and brokers about the benefits and risks of exchange-traded options. 

In 1998, the options industry celebrated its 25th anniversary. In 1999, the American Stock Exchange began trading options on the Nasdaq 100 QQQ (QQQ)—an exchange-traded fund that is among the most actively traded in the marketplace today. That same year, total options volume surpassed one-half million contracts for the first time ever. In the year 2000, a new options exchange arrived on the scene. On May 26, 2000, the International Securities Exchange (ISE) opened for business. It was the first new U.S. exchange in 27 years. In addition, ISE became the first all-electronic U.S. options exchange. 

In 2001, the options exchanges converted prices from fractions to decimals. In 2003, more than 900 million contracts traded, nearly four times greater than 10 years before. Therefore, despite the three-year downturn in the U.S. stock market, options trading continued to grow. On February 6, 2004, the Boston Options Exchange (BOX) made its debut as the sixth options exchange and began trading a handful of options contracts. The exchange was the second all-electronic exchange and is already another key player in the burgeoning options market.

EVOLUTION OF THE CHICAGO BOARD OPTIONS EXCHANGE

The CBOE has had quite an impact on the financial world over the past 31 years. Formed on April 26, 1973, the CBOE changed this country’s and the world’s approach to the markets forever. This new organization introduced the trading universe to standardized options contracts. The contract represented 100 shares of stocks with expiration dates attached using various months as their basis. Today the CBOE is the largest options exchange in the United States, trading more than half of all U.S. options and accounting for over 90 percent of all index trading. To get to this point, the CBOE has been through many changes and has had a very interesting historical time line.

When the Chicago Board of Trade first opened the CBOE, it traded only call options on 16 equities. After four years of operation, put options were finally offered. This caused quite an explosion in option trading activity in 1977 and moved the SEC to bring to a halt any further options expansion until a formal review could take place. The review, which was designed to protect the customer, lasted until March of 1980. From there the CBOE quickly added option coverage to include 120 equities. Later in that same year (1980) the CBOE and the Midwest Stock Exchange merged their options operations.

In March 1983, one of the biggest developments in the CBOE’s history took place. This involved introducing the trading public to options on broad-based stock indexes. The impact was enormous, with the first such index traded being the Standard & Poor’s 100 Index (OEX). This proved to be a very active index, trading an average of more than 130,000 contracts per day in 1983. This surge in trading volume prompted the CBOE to move into its own facilities in 1984, leaving the CBOT behind. The move allowed the CBOE to implement key trading floor technologies enhancing customer service. 

The major innovation was what was known as the Retail Automatic Execution System that facilitated the filling of customer orders at the current bid or ask and reported back all within a matter of seconds. The CBOE launched the Options Institute in 1985 to educate its major customers such as retail account executives and institutional money managers. In 1989 options on Treasury securities were introduced. The option values were pegged to changes in the U.S. Treasury yield curve. In 1990, the needs of the conservative options investor were addressed by introducing long-term equity anticipation securities (LEAPS) to the trading public. 

LEAPS allow investors to create positions that have up to three years until expiration, which makes them particularly attractive to the traditional buy-and-hold investor. In 1992 the CBOE expanded its coverage to include various sectors and foreign markets. This new development helped customers to better hedge their exposure to these areas as well as allowing investors to participate in different market spaces and the continued globalization of the markets. The growth continued in 1997, adding another cash-settled index based on the Dow Jones Industrial Average, which quickly became the CBOE’s most popular new product. 

At the same time options on the Dow Jones Transportation Average and Dow Jones Utility Average were introduced. Of course, there are indeed other option exchanges that do exist in the United States such as the American Stock Exchange, the Philadelphia Stock Exchange, and the Pacific Exchange. However, by far the CBOE is the options-trading king when one just looks at sheer volume. Going forward, the CBOE will continue to innovate and bring even more products to the investment community, especially given the continued and growing popularity of options.

STOCK AND STOCK OPTION ORDERS

If you are trading the stock market, you begin by placing an order with your broker, who passes it along to a floor broker, who then takes it to the appropriate specialist. At this time, the floor broker may or may not find another floor broker who wants to buy or sell your order. If your broker cannot fill your order, it is left with the specialist who keeps a list of all the unfilled orders, matching them up as prices fluctuate. In this way, specialists are brokers to the floor brokers and receive a commission for every transaction they carry out. Groups of specialists trading similar markets are located near one another. These areas are referred to as trading pits.

Once your order has been filled, the floor trader contacts your broker, who in turn contacts you to confirm that your order has been placed. The amazing part of this process is that a market order—one that is to be executed immediately—can take only seconds to complete. Today, electronic exchanges like the International Securities Exchange handle a large number of options orders and offer an electronic platform to match option buyers and sellers.

Your broker, as your intermediary, is paid a commission for his or her efforts. Each completed trade costs $10 on the low end and $100 or more on the high end. Stock commissions may also be based on a percentage value of the securities bought or sold. Remember, your broker should be in the business of looking after your interests, not generating commissions for the broker’s own pockets. Since your chief concern as a trader should be to get the transactions executed as you desire and at the best price possible, choosing the right broker is essential to your success.

Let’s review the stock market order process. The seven steps are:

1. You call your broker.

2. The broker writes your order.

3. Broker transmits your order to an exchange.

4. Floor broker tries to immediately fill your order or takes it to a specialist.

5. A specialist matches your order.

• If your order is placed as a market order, you get an (almost) immediate fill.

• If placed as a limit order, you have to wait until you get the price you want.

6. Confirmation is sent back to the broker.

7. Broker contacts you to confirm that your order has been executed.

This is the process for most transactions. In addition to the specialists, there are also market makers who are there to create liquidity and narrow the spread. Market makers trade for themselves or for a firm. Once an order “hits the floor,” the market makers can participate with the other players on a competitive basis. Stock orders are handled in a similar manner. For example, orders for a stock trading on the New York Stock Exchange or the American Stock Exchange are routed to the floor electronically or to a floor broker by phone. In contrast, Nasdaq—also referred to as the over-the-counter (OTC) market—is an electronic computerized matching system that lists more than 5,000 companies, including a large number of high-tech firms. 

Brokers can trade directly from their offices using telephones and continuously revised computerized prices. Since they completely bypass the floor traders, they get to keep more of their commissions. There are no specialists, either—but there are market makers. Their role is to bid and offer certain shares they specialize in, thereby creating liquidity. They make their money on the spread—the difference between the bid price and the offer price—as well as on longer-term plays. This difference may be only $0.25 or less. However, when you trade a large number of shares this adds up very quickly.

FUTURES (COMMODITY) ORDERS

Futures contracts are traded at commodity exchanges. The exchanges are divided into trading pits that are sometimes subdivided into sections of smaller commodities. Individual trades are recorded on trading cards that are turned in to the pit recorder, who time-stamps and keys the transaction into a computer. Some exchanges prefer the use of handheld computers that instantly record the transactions.

Orders are filled using an open-outcry system in which the buyers (who make bids) and the sellers (who make offers, otherwise known as the ask) come together to execute trades. For example, in the gold market, if gold is trading at $300 per ounce, you may get a price of $299.50 to $300.50. This means that you would be buying the gold futures contract at $300.50 and you would be selling at $299.50. You may ask, “Why can’t I buy for the lower price and sell for the higher price?” You can try, but the trade will probably not be executed. The floor traders make their living off this spread. They won’t want to give it up to you.

Let’s review the futures market order process. The six steps are:

1. Call your commodity broker (or call direct to the trading floor for large accounts).

2. The broker writes an order ticket or sends your order via computer or calls the trading floor.

3. Floor broker will bid or offer.

4. When your order is matched, the fill is signaled to the desk.

5. The desk calls your broker.

6. Broker contacts you to confirm trade execution.

Floor traders primarily make their money on the bid/ask spread. They are the ones who spend (in many cases) thousands of dollars each month for the privilege of being on the floor of the exchange (or hundreds of thousands to buy a seat). They can either lease the seats—gaining the right to trade as an exchange member—or purchase the seats. In addition, they spend each and every day creating liquidity for the investor who is not trading on the exchange floor. 

For this they want something in return—the right to make money on the spread. The money to be made on the spread comes from the difference between the bid and offer price. In the gold example, the reward is $1.00 ($300.50 – $299.50 = $1.00). In addition, being right where the action is allows them to see the order flow. Order flow is the buying and selling happening around them. They can spot when large traders are trading. This does give them an advantage, but there are negatives. These include the following five aspects:

1. High monthly expenses.

2. The need to always be in the market to cover costs.

3. Sometimes getting caught up in emotion, not fact.

4. Missed opportunities in other markets.

5. Very physically and mentally demanding work.

You probably have watched scenes of the trading pits on television or in movies. You see lots of people yelling and screaming. Is this the way it really is? Yes, when there is action in the market, it can be extremely volatile. If it is slow, people will read newspapers or just stay away. I do suggest that you visit a commodity exchange if you get the chance. It is very exciting and enlightening to experience what really goes on there. Commodity exchanges have to provide safeguards for the public trader. 

For every buyer there is a matching seller. Clearing firms—where the funds are held—must guarantee that each person trading through them has the available funds to meet that trader’s financial obligations, or they are responsible for the integrity of the transaction. This system of checks and balances has never failed, no matter how crazy the markets have become. Public investors can feel secure that they will not lose their money due to the system failing.

PLACING AN ORDER

One of the most stressful functions of the new trader is actually to place that first trade. Picking up the phone or turning to the broker’s web site is, without a doubt, a time of considerable angst. After all, you are trying something totally new. There is seemingly an endless number of choices, you are on your own, and, if you mess it up, it could conceivably cost you a lot of money—your money.

As you gain experience, you will settle into a style of order placing that works for you and your broker, often forgetting that there are many other ways that might possibly solve a particular problem. This section covers the basics of how to place a trade, as well as some of the available options that even the more experienced trader may have forgotten.

To place a trade, you need to communicate several specifics to your broker. The following list is designed to introduce you to these specifics, although in no particular order. This list can be applied to a single asset trade (stock, call, or put), but will work just as well for any of the Optionetics-style combination (or hedge) trades. You will need to provide your broker with seven items of information:

1. Whether you want to buy (go long) or sell (go short) the security.

2. The underlying stock (and possibly ticker symbol).

3. The actual investment vehicle (stock, call, or put).

4. For an option, the particular month and strike (and possibly the appropriate symbol).

5. The number of shares or contracts.

6. The type of trade (market, limit—and if so, what limit).

7. Whether you are “opening” a position (initially setting up the position—long or short) or you are “closing” a position (selling an existing long position or buying back an existing short position).

Some brokers and most web sites require you to provide the exact ticker symbol for your transaction. Other brokers will accept an order using a plain English description of your transaction. Personally, I much prefer to give the plain English description, as then I am exactly sure of what I am saying. Using the coded description  is just too easy to mess up, especially for a beginning trader or a semiactive trader (one who “remembers” the code from last week or month). 

For instance, “AEQFI” and “AEQRI” appear to be almost identical (at least with my handwriting!) and in fact are both options for Adobe Systems, ADBE. However, the “FI” is the descriptor for the June 45 call, while the “RI” is the descriptor for the June 45 put—both fine options, but hardly interchangeable. If you are using a broker that cannot look up the symbols (or remember them—they, after all, do this many, many times per day), then be very careful that you in fact have the correct symbol—it is your money that is on the line.

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