Characteristics and Risks of Standardized Options_OCR

8/8/2019 Characteristics and Risks of Standardized Options_OCR

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CHARACTERISTICS ANDRISKS OF

STANDARDIZED OPTIONS

TABLEOF CONTENTSCHAPTER I-INTRODUCTION . . . . . . . . . . . . .. 1

CHAPTER II-OPTIONS NOMENCLATURE. . . . .. 5

CHAPTER III-OPTIONS ON EQUITY SECURITIES 18Features of Stock Options . . . . . . . . . . . . . . . .. 18

CHAPTER IV-INDEX OPTIONS . . . . . . . . . . . .. 23

About Indexes 23Features of Index Options . . . . . . . . . . . . . . . .. 26

CHAPTER V-DEBT OPTIONS . . . . . . . . . . . . .. 29Rates, Yields and Prices of Debt Securities . . . . . .. 29TreasurySecurities . . . . . . . . . . . . . . . . . . . . .. 31Yield-Based Options . . . . . . . . . . . . . . . . . . . .. 32

CHAPTER VI-FOREIGN CURRENCY OPTIONS .. 35Market for Foreign Currencies . . . . . . . . . . . . . .. 36Special Characteristics of Foreign Currency Options. 37Special Features of Dollar-Denominated Foreign

Currency Options . . . . . . . . . . . . . . . . . . . .. 38Cross-Rate Foreign Currency Options . . . . . . . . .. 41Special Features of Cross-Rate Options . . . . . . . .. 42Cash-Settled Foreign Currency Options . . . . . . . .. 43

CHAPTER VII-FLEXIBLY STRUCTURED OPTIONS 45Special Features of Flexibly Structured Options . . .. 46

CHAPTER VIII-EXERCISE AND SETILEMENT . .. 49How to Exercise . . . . . . . . . . . . . . . . . . . . . .. 49Assignment . . . . . . . . . . . . . . . . . . . . . . . . .. 51Settlement. . . . . . . . . . . . . . . . . . . . . . . . . .. 51

CHAPTER IX-TAX CONSIDERATIONS,TRANSACTION COSTS AND MARGIN

REQUIREMENTS 54TaxConsiderations 54Transaction Costs . . . . . . . . .. 55Margin Requirements . . . . . . . . . . . . . . . . . . .. 55

CHAPTER X-PRINCIPAL RISKS OF OPTIONS

POSITIONS . . . . . . . . . . . . . . . . . . . . . . . .. 57Risks of Option Holders 58Risks of Option Writers . . . . . . . . . . . . . . . . . .. 62Other Risks . . . . . . . . . . . . . . . . . . . . . . . . .. 67Special Risks of Index Options .. . . . . . . . . . . .. 73Special Risks of Debt Options . . . . . . . . . . . . . .. 78Special Risks of Foreign Currency Options . . . . . .. 83Special Risks of Flexibly Structured Options .. . . .. 87

CHAPTER XI-SCOPE AND LIMITATIONS OF

THIS BOOKLET 89

SUPPLEMENTSDecember 1997 . . . . . . . . . . . . . . . . . . . . . .. 95March 2000 . . . . . . . . . . . . . . . . . . . . . . . . .. 96

January 2004 . . . . . . . . . . . . . . . . . . . . . . . .. 98March 2005 . . . . . . . . . . . . . . . . . . . . . . . . . . 100April 2007 . . . . . . . . . . . . . . . . . . . . . . . . . . . 106May 2007 . . . . . . . . . . . . . . . . . . . . . . . . . . . 111June 2007 . . . . . . . . . . . . . . . . . . . . . . . . . . . 120


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CHAPTER I

INTRODUCTION

This booklet relates solely to options issued by TheOptions Clearing Corporation ("OCC"), and all refer-

ences to "options" in this booklet are applicable onlyto such options. As of the date of this booklet, optionsare traded on the United States markets listed on theinside front cover page and on the European OptionsExchange in Amsterdam, The Netherlands. In the fu-ture, options may be traded on other markets within or

outside the United States. The markets on which op-tions are traded at any given time are referred to in thisbooklet as the "options markets."

OCC is a registered clearing agency, and each U.S.options market is a national securities exchange, thatis subject to regulation by the Securities and Exchange

Commission ("SEC") under the Securities ExchangeAct of 1934. Foreign options markets, and their mem-bers, are not generally subject to regulation by theSEC or to the requirements of the securities or otherlaws of the U.S. and may not be subject to the jurisdic-tion of U.S. courts.

What is an option? An option is the right either tobuy or to sell a specified amount or value of a particularunderlying interest at a fixed exercise price by exercis-ing the option before its specified expiration date. Anoption which gives a right toMis a call option, and anoption which gives a right to sell is a Q !:!! option. Calls

and puts are distinct types of options, and the buyingor selling of one type does not involve the other.

E X A M P L E : An option toM100 shares of com-mon stock of the 'A'{Z Corporation at a specified exer-cise price would be an 'A'{Z call option. An option tosell 100 shares of common stock of the 'A'{Z Corpora-

tion at a specified exercise price would be an 'A'{Z Q !:!!option.

There are two different kinds of options-physicaldelivery options and cash-settled options. A physicaldelivery option gives its owner the right to receivephysical delivery (if it is a call), or to make physicaldelivery (if it is a put), of the underlying interest whenthe option is exercised. A cash-settled option gives itsowner the right to receive a cash payment based on


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the difference between a determined value of the un-derlying interest at the time the option is exercised andthe fixed exercise price of the option. A cash-settledcall conveys the right to receive a cash payment if the

determined value of the underlying interest at exer-cise---this value is known as the exercise settlementvalue---exceeds the exercise pricedhhe option, and acash-settled Q !:! ! conveys the right to receive a cashpayment if the exercise settlement value is less thanthe exercise price of the option.

Each options market ~elects the underlying interestson which options are traded on that market Optionsare currently available covering four types of underly-ing interests: equity securities, stock indexes, govern~ment debt securities, and foreign currencies. Optionson other types of underlying interests may become

available in the future.

Most options have standardized terms-such as thenature and amount of the underlying interest, the expi-ration date, the exercfse price, whether the option is acall or a put, whether the option is a physical delivery

option or a cash-settled option, the manner in whichthe cash payment and the exercise settlement value ofa cash-settled option are determined, the multiplier ofa cash-settled option, the style of the option, whetherthe option has automatic exercise provisions, and ad-

justment provisions. These standardized terms aregenerally described in Chapter II. Each U.S. options

market publishes specification sheets setting forth theparticular standardized terms of the options traded onthat options market. (The options markets may alsoprovide for trading in options whose terms are not allfixed in advance. Rather, subject to certain limitations,the parties to transactions in these options maydesig-

nate certain of the terms. These flexibly structured op-tions are discussed in Chapter VII of this booklet.)

Options having the same standardized terms areidentical and comprise an options series. The stand-ardization of terms makes it more likely that there willbe asecondary market in which holders and writers ofoptions can close out their positions by offsetting salesand purchases. By selling an option of the same seriesas the one he bought, or buying an option of the sameseries as the one he wrote, an investor can close outhis position in that option at any time there is a func-tioning secondary options market in options of that

series.

IIIsome instances, options of the same series maybe traded on more than one options market at the

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same time. Options that are so traded are called multi-ply-traded options. Options traded on a U.S. optionsmarket may also be traded on a foreign options mar-ket. These options are referred to as internationally-

traded options. Multiply-traded and internationally-traded options can ordinarily be purchased and writ-ten, and positions in these options can ordinarily beliquidated in offsetting closing transactions, in any ofthe options markets in which the options are traded.However, because premiums are affected by market

forces, the premiums for identical mUltiply-traded orinternationally-traded options may not be the same inall markets at any given time.

If an options market learns that a particular underly-ing interest no longer meets its requirements for op-tions trading oris not eligible for trading in all U.S.

jurisdictions, or if an options market decides to discon-tinue trading in a particular options series for anotherreason, the options market may stop introducing newoptions on that underlying interest and may in certaincircumstances impose restrictions on transactions thatopen new positions in options series that have been

previously introduced, although trading in the optionsseries will ordinarily continue on at least one optionsmarket until its expiration.

Options generally are traded on U.S. options mar-kets during normal day-time business hours of U.S.securities exchanges and for a short period afterward.

However, trading in options may not be confined tothose hours. Trading in evening and night tradingsessions occurs in options on foreign currencies andmay in the future occur in other types of options. More-over, when there are unusual market conditions, anoptions market may authorize trading to continue for a

substantially longer period than under normal condi-tions. Trading in an expiring option may close at anearlier time than trading in other options. Tradinghours for options are also subject to change from timeto time. Readers should ascertain the trading hours ofthe particular options they are interested in tradingfrom the options markets where those options aretraded. Readers should also be aware that trading inunderlying interests is not confined to normal ex-change trading hours. For example, underlying for-eign currencies and debt securities are traded ininternational markets on virtually an around-the-clockbasis, and underlying equity securities may be traded

in foreign markets when U.S. markets are closed andin some U.S. markets after the close of their normaltrading hours.

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Readers should be aware that this booklet has beenwritten to meet the requirements of an SEC rule that

requires the U.S. options markets to prepare, and bro-kerage firms to distribute,. a.l:)o,*let that briefly andgenerally describes tJ:1echaracteristics of options andthe risks to investors of maintaining positions in op-tions. Options are versatile instruments that can beused in a wide variety of investment strategies. They

give the investor the ability to create positions thatreflect the investor's opinion of an underlying interestand to select investmentstrategies1hat reflect the in-vestor's tolerance for risk. This booklet is not designedto describe the various potential benefits of options orhow investors may use options to enhance their invest-ment .strategies or to reduee risk. Numerous; otherpublloations, including some prepared bytheU,S. op-tions markets that are aVailable upon request, containdiscussions of the uses and potential benefits otop-tlonsand oHhe various',tradJngand investment strate-gies that can 00 employed with options. Readers whowish to balanee thegeneraldfscussion Of riskslhat is

contained in this booklet With a discussion ot.opnonsuses, benefits and strategies 'should consult one ormore of these other publications.

Readers should read and understand this booklet inits entirety, sInce a number of the separate chapterswill be relevant to every reader interested in buying orwriting options. Forexample,a reader Who is inter-ested in options on equity securities should fully readnot only Chapter Ill, but also should read Chapters II,VIII and IX, aswell as the discussion of risks in ChapterX. Readers should also be aware that, although thisbooklet seeks to describe the various characteristics of

options and the risks that are unique to being an inves-tor in options, there are many matters which are be-yond the scope of this booklet that are not discussed.Chapter XI contains a discussion of the scope andlimitations of trns booklet.

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CHAPTER"

OPTIONS NOMENCLATURE

This chapter contains a description Ofthe standard-

ized terms, and of some of the special vocabulary,applicable to options. Most of the nomenclature is thesame for options on the various types of underlyinginterests. Differences that are applicable to options ona particular underlying interest will be described in thechapter devoted to that underlying interest.

Certain terms-options, options markets, call op-tions, put options, physical delivery options, cash-set-tled options, options series, multiply-traded optionsand internationally-traded options-have been definedin Chapter I. Readers interested in those definitionsshould consult that chapter.

OPTION HOLDER; OPTION WRITER-The optionholder is the person who buys the right conveyed bythe option.

EXAMPLE: The holder of a physical delivery XYZcall option has the right to purchase shares of XYZ

Corporation stock at the specified exercise price uponexercise prior to the expiration of the option. Theholder of a physical delivery XYZ ~ option has theright to sell shares of XYZ Corporation at the specifiedexercise price upon exercise prior to the expiration ofthe option. The holder of a cash-settled option has the

right to receive an amount of cash equal to the cashsettlement amount (described below) upon exerciseprior to the expiration of the option.

The option writer is obligated-if and when assignedan exercise-to perform according to the terms of the

option. The option writer is sometimes referred to asthe option seller. An option writer who has been as-signed an exercise is known as an assigned writer.

EXAMPLE: If a physical delivery XYZ call option isexercised by the holder of the option, the assignedwriter must deliver the required number of shares of

XYZ common stock. He will be paid for the shares atthe specified exercise price regardless of their currentmarket price.

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If a physical delivery put option is exercised, theassigned writer must purchase the required number ofshares at the specified exercise price regardless of

their current market price. If a cash-settled option isexercised, the assigned writer must pay the cash set-tlement amount.

No certificates are issued to evidence options. In-vestors look to the confirmations and statements thatthey receive from their brokerage firms to confirm their

positions as option holders or writers. An optionholder looks to the system created by occ's rules,rather than to any particular option writer, for perform-anceof the option he owns. Similarly, option writersmust perform their obligations under the acc systemand are not obligated to any particular option holder.

Since every options transaction involves both a holderand a writer, it follows that the aggregate rights of op-tion holders under the system are matched by theaggregate obligations of option writers.

The acc system is designed so that the perform-

ance of all options is between acc and a group offirms called Clearing Members that carry the positionsof all option holders and option writers in their ac-counts at acc. To qualify as a Clearing Member, a firmmust meet acc's financial requirements. In addition,Clearing Members must provide acc with collateralfor the positions of option writers that they carry andmust contribute to Clearing Funds that protect accagainst a Clearing Member's failure. The ClearingMembers' guarantees of the performance of optionswriters' obligations, the financial strength of the Clear-ing Members, the collateral that they deposit, the obli-gations of correspondent clearing corporations, andthe Clearing Funds together make up the acc systembacking the performance of options. This system isdiscussed in more detail in the acc prospectus re-ferred to in paragraph 1 of Chapter XI.

EXERCISE PRICE-In the case of a physical delivery

option, the exercise price (which is sometimes calledthe "strike price") is the price at which the optionholder has the right either to purchase or to sell theunderlying interest.

E X A M P L E : A physical delivery XYZ 40 call optiongives the option holder the right to purchase 100shares of XYZstock at an exercise price of $40 a share.A physical delivery XYZ 40 put option gives the option

holderthe righrtosell1 00 shares of XYZ commonstock at an exercise price of $40 a share.

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The exercise price of a cash-settled option is thebase for the determination of the amount of cash, ifany, that the option holder is entitled to receive upon

exercise (see the discussion of "Cash SettlementAmount and Exercise Settlement Value" below).

Exercise prices for each options series are estab-lished by the options market on which that series istraded at the time trading in the series is introduced,and are generally set at levels above-and below thethen market value of the underlying interest. The op-tions markets generally have authority to introduce ad-ditional series of options with different exercise pricesbased on changes in the value of the underlying inter-est, or in response to investor interest, or in unusualmarket conditions, or in other circumstances.

EXPIRATION DATE-This is the date on which theoption expires. If an option has not been exercisedprior to its expiration, it ceases to exist-that is, theoption holder no longer has any rights, and the optionno longer has any value. The expiration dates for the

various options series are fixed by the options marketon which the series trades. Readers should learn theexpiration date of each option they wish to buy or write.

STYLE OF OPTION-The style of an option refers towhen that option is exercisable. At the date of this

booklet there are three different styles of options--American-style, European-style and capped. Subjectto certain limitations prescribed in the rules of acc orthe options markets and subject to applicable law.these three styles are exercisable at the followingtimes:

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

A European-style option may be exercised onlyduring a specified period before the option expires.Every European-style option being traded at the

date of this booklet is exercisable only on its expira-tion date.

A capped option will be automatically exercisedprior to expiration if the options market on which theoption is trading determines that the value of the

underlying interest at a specified time on a tradingday "hits the cap price" for the option. Cappedoptions may also be exercised, like European-styleoptions, during a specified period before expiration.

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This period is the expiration date for all capped op-tions traded at the date ot.tnts booklet. The special

. terminology applicable to capped options is dis-

cussed at the end of this chapter.

European-style or capped options having an expira-tion period that is lonqeror shorter than their expirationdate may be introduced for trading in the future.

UNIT OF TRADING; CONTRACT SIZE-The unit of

trading (which is sonietimes referred to as the contractsize) of a physical delivery option is the amount of theunderlying interest that is subject to being purchasedor sold upon the exercise of a single option contract.For example, the unit o f trading for most options onequity securities is 100 shares. Thus, a physical deliv-

ery XYZ 50 call will give its holder the right upon exer-cise to purchase 100 shares of XYZ at $50 per share. Ifthe option is trading at a premium at,' say, $4 per share,

then the aggregate premium for a single option con-tract would be $400.

The contract size of a cash-settled option is deter-mined by the multiplier that is fixed by the optionsm arket on which the options series is traded. Themultiplier determines the aggregate value of eachpoint of the difference between the exercise price ofthe option and the exercise settlement va lue of theunderlying interest. For example, a multip lier of 100means that for each point by which a cash-settled op-tion is in the money upon exercise, there is a $100increase in the cash settlement amount. Similarly, if anoption with a multiplier of 100 is trading at a premium

of, say, $4, then the aggregate premium for a singleoption contract would be $400.

EXERCISE-If the holder of a physical delivery optionwishes to buy (in the case of a call) or sell ( in the caseof a put) the underlying interest at the exercise price--or, in the case of a cash-settled option, to receive thecash settlem ent am ount-his option m ust be exer-

cised. In order to exercise most options, option hold-ers m ust give exercise instructions to their brokeragefirm in accordance with the firm's procedures prior tothe firm's exercise cut-off time. The exercise process isdiscussed in Chapter VIII. Every option holder shouldunderstand this process and should learn his broker-

age firm's procedures concerning exercise, and its ex-ercise cut-6fftime, for each option he may buy.

Although an option holder must assure that action istaken to exercise most options, capped options and

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certain cash-settled options provide for automatic ex-ercise in specified circumstances: Other options hav-ing automatic exercise provisions maybe introduced

for trading in the future.

The rules of the options markets generally limit thetotal number of puts or calls on the same underlyinginterest that a single investor or group of investorsacting in concert may exercise during a specified time

period. Information concerning the exercise limits forparticular options is available from the options marketon which those options are traded or from brokeragefirms.

The right to exercise an option may be restricted in

certain circumstances. This is discussed under "Risksof Option Holders" in Chapter X.

When an option has been exercised, OCC will as-sign the exercise in accordance with its ru les to aClearing Member whose account with OCC reflects the

writing of an option of the same series. The ClearingMember may, in turn, assign this exercise to one of itscustomers who is a writer in accordance w ith the

Clearing Member's procedures, and the assignedwriter will then be obligated to perform the obligationsof the option-that is, to sell ( in the case of a physicaldelivery call) or buy (in the case of a physical deliveryput) the underlying interest at the exercise price, or, inthe case of a cash-settled option, to pay the cash set-tlement amount. The assignment process is dis-cussed further in Chapter VIII.

CASH SETTLEMENT AMOUNT, SETTLEMENTCURRENCY and EXERCISE SETTLEMENT

VALUE-The cash settlement amount is the amountof cash that the holder of a cash-settled option is enti-tled to receive upon exercise. It is the amount by whichthe exercise settlement value of the underlying interestof a cash-settled call exceeds the exercise price, or the

amount by which the exercise price of a cash-settledput exceeds the exercise settlement value of the un-derlying interest, multiplied by the multiplier for theoption.

E X AM P L E : Assume that a holder of a cash-set-

tled call on the X'fZ index that has an exercise price of80 exercises it when the exercise settlement value ofthe index is 85. If the multiplier for XYZ index options is100, the assigned writer would be obligated to pay,

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and the exercising holder would be.entitled to receive,a cash settlem ent am ount of $500 ($85 m inus $80multiplied by 100 = $500).

The currency in which the cash settlement amount ispayable is called the settlement currency. The settle-ment currency for all cash-settled options with stan-dardized term s that are trading at the date of thisbooklet is U.S. dollars. It is possible that another cur-rency will be the settlement currency for some optionsintroduced in the future.

The manner of. determining the exercise settlementvalue for a particular option series is fixed by the op-tions market on which the series is traded. The exer-cise settlement va lues for options on a particular

underlying interest traded in one options market willnot necessarily be determined in the same manner asthe exercise settlement values for options or futures onthe same underlying interest that may be traded inother markets.

Options markets may change the method of deter-mining exercise settlement values for particular op-tions series on specified days or on a ll days. Thesechanges may be made applicable to series outstand-ing at the t ime the changes become effective. Alterna-tively, an options market might phase in a change inthe method of determining exercise settlement valuesby opening new series of options identical to outstand-ing series in a ll respects other than the method forcalculating exercise settlement values. Such new se-ries would trade alongside the o ld series until bothseries expire, but the two series would not be inter-changeable. In the future, options markets may, sub-

ject to regulatory approval, introduce options whoseexercise settlement values may not exceed a specifiedmaximum amount.

ADJUSTMENT and ADJUSTMENT PANEL-Ad- justments may be made to some of the standardized

terms of outstanding options upon the occurrence ofcertain events. Adjustments that may be made to aparticular type of options are discussed in the chapterrelating to that type.

The determination of whether to adjust outstanding

options in response to a particular event, and, if so,what the adjustment should be, is made by a majorityvote of an adjustment panel. An adjustment panel foran options series consists of two representatives ofeach U.S. options market on which the series is traded

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and one representative of acc, who votes only tobreak a tie. Every determination by an adjustmentpanel is within its sale discretion and is binding on allinvestors.

PREMIUM-The premium is the price that the holderof an option ~ and the writer of an option receivesfor the rights conveyed by the option. 1tis the price setby the holder and writer, or their brokers, in a transac-tion in an options market where the option is traded. Itis not a standardized term of the option. The premiumdoes not constitute a "down-payment." It is simply

and entirely a nonrefundable payment in full-from theoption holder to the option writer-for the rights con-veyed by the option.

The premium is not fixed by the options markets orby acc. Premiums are subject to continuous changein response to market and economic forces, includingchanges in the trading conditions on the marketswhere the particular options are traded. The factorswhich may generally affect the pricing of an option

include such variables as the current value of the un-derlying interest and the relationship between that

value and the exercise price, the current values of re-lated interests (e.g., futures on the underlying interestor other interests related to the underlying interest), thestyle of the option, the individual estimates of market

participants of the future volatility of the underlyinginterest, the historical volatility of the underlying inter-est, the amount oftime remaining until expiration, cashdividends payable on the underlying stock (in the caseof stock and stock index options), current interestrates, current currency exchange rates (in the cases offoreign currency options and options whose premiumsor cash settlement amounts are payable in a foreigncurrency), the depth of the market for the option, theeffect of supply and demand in the options market aswell as in the markets for the underlying interest and forrelated interests, the information then available aboutcurrent prices and operations in the markets for the

underlying interest and related interests, the individualestimates of market participants of future develop-ments that might affect any of the foregoing, and otherfactors generally affecting the prices or volatility of op-tions, underlying interests, related interests or securi-ties generally. Also see the discussion below of

"Intrinsic Value and Time Value." Readers should notassume that options premiums will necessarily con-form or correlate with any theoretical options pricing

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formula, chart, last sale, or the prices of the underlyinginterest, related interests or other options at any partie-ulartime.

The currency in which the premium is payable iscalled the premium. currency. The premium currencyfor most options is U:S..dollars. ~9~ever, the premiumcurrency for cross-rate foreign currency options, whichare discussed in Chapter VI , is a foreign currency,andotheropiiclns with premiums payable in a foreign cur"

rency maybe introduced after the date oft~isbooklet.

OPENING TRANSACTION,T This is a purchase orsale transaction by which a person establishes or in-creases a position as either the holder or the writer ofan option.

CLOSING TRANSACTION-This is a transaction inwhich, at some point prior to expiration, the. optionholder makes an offsetting sale of an identical option,orthe option writer makes an offsetting purchase of anidentical option. A closing' transaction in an optionreduces or cancels out an investor's previous position

as the holder or the writer of that option.

EXA MPLE: In June an investor buys a Decemberx:fZ 50 call at an aggregate premium of $500. BySeptember the rnarkst price of the option has in-creased to $700. To seek to realize his $200 profit, the

investor can direct his broker to sell an offsetting De-cember x:fZ 50 call in a closing transaction. On theother hand, if by September the market price of theoption has decreased to $300, the investor might stilldecide to sell the option in a closing transaction,thereby limiting his loss to $200.

Although holders of American-style options have theright to exercise at any time before expiration, holdersfrequently elect to realizetheir profits or losses by mak-ing closing transactions because the transaction costsof the' closing transactions may be lower than thetransaction costs associated with exercises, and be-cause closing transactions may provide an opportu-nity for an option holder to realize the remaining timevalue (described below) of the option that would belost in an exercise. The limited period of exercisabilityof a European-style or capped option means that (ex-cept for the possibility of automatic exercise of a

capped option) the holder's only means of realizingprofit or loss on the option when the option is notexercisable is by selling the option in a closingtransaction.

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POSITION LIMITS-The rules of the options marketsgenerally limit the maximum number of options on thesame side of the market (i.e., calls held plus puts writ-

ten, or puts held plus calls' written) with respect to asingle underlying interest that may be carried in theaccounts of a single investor or group of investorsacting in concert. These limits-which are called posi-tion limits---differ for options on different underlying

interests. Information concerning the position limits for

particular options is available from the options marketon which those options are traded or from brokeragefirms.

COMBINATIONS; SPREADS and STRADDlES-Combination positions are 'positions in more than oneoption at the same time. Spreads and straddles are

two types of combination positions. A spread involvesbeing both the buyer and writer of the same type ofoption (puts or calls) on the same underlying interest,with the options having different exercise prices and/orexpiration dates. A straddle consists of purchasing orwriting both a put and a call on the same underlying

interest, with the options having the same exerciseprice and expiration date.

lONG and SHORT-The word long refers to a per-son's position as the holder of an option, and the wordshort refers to aperson's position as the writer of anoption.

COVE RED CAll WRITER-Ifthe writer of a physicaldelivery call option owns or acquires the amount of theunderlying interest that is deliverable upon exercise ofthe call, he is said to be a covered call writer.

E X A M P L E : An individual owns 100 shares of X'(Zcommon stock. If he writes one physical delivery X'(Z

call option-giving the call holder the right to purchase100 shares of the stock at a specified exercise price-this would be a covered call. If he writes two such X'(Z

calls, one would be covered and one would beuncovered.

The distinction between covered and uncovered callwriting positions is important since uncovered call writ-ing can involve substantially greater exposure to riskthan covered call writing. A call option writer who is nota covered writer may hold another option in a spread

position and thereby offset some or all of the risk of theoption he has written. However, the spread may notoffset all of the risk of the uncovered writing position.For example, if the long portion of the spread has a

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higher exercise price than the exercise price of theshort, or if the long has an earlier expiration date thanthe expiration date of the short, then the writer may stillbe exposed to significant risks from his uncovered writ-ing position.

AT THE MONEY-This term means that the currentmarket value of the underlying interest is the same asthe exercise price of the option.

IN THE M ONEY-A call o ption is said to be in themoney if the current market value of the underly inginterest is above the exercise price of the option. A putoption is said to be in the money if the current marketvalue of the underlying interest is below the exerciseprice of the option.

E X A M P L E : If the current market price of Y :Y Zstock is $43, an Y :Y Z 40 call would be in the money by$3.

OUT OF THE MONEY-If the exercise price of a callis above the current market value of the underly ing

interest, or if the exercise price of a put is below thecurrent market value of the underly inq interest, theoption is said to be out of the money by that amount.

E X A M P L E : With the current market price of Y :Y Zstock at $40, 'a call with an exercise price of $45 would

be o ut o f the m oney by $5-as would a put w ith anexercise price of $35.

INTRINSIC VALUE and TIME VA LU E-It is som e-times useful to consider the premium of an option asconsisting of two components: intrinsic value and timevalue. Intrinsic value reflects the amount, if any, bywhich an option is in the m oney. Time value iswhatever the premium of the option is in addition to itsintr insic value. An American-style option may ordina-rily be expected to trade for no less than its intrinsicvalue prior to its expiration, although occasionally anAmerican-style option will trade at less than its intrinsic

value. Because European-style and capped optionsare not exercisable at all times, they are more likelythan American-style options to trade at less than theirintrinsic value when they are not exercisable.

E X A M P L E OF A C A LL W IT H IN TR IN S IC

V A L U E : At a time when the current market price ofY :Y Z stock is $46 a share, an Y :Y Z 40 call would have anintrinsic value of $6 a share. If the market price of thestock were to decline to $44, the intrinsic value of the

14


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call would be only $4. Should the price of the stockdrop to $40 or below, the call would no longer have anyintrinsic value.

E X A M P L E OF A P U T W IT H IN TR IN S IC V A L UE :

At a time when the current market price of x:fZ stock is$46 a share, an x:fZ 50 put would have an intrinsicvalue of $4 a share. Were the market price of X'fZ stockto increase to $50 or above, the put would no longerhave any intrinsic value.

E X A M P L E OF T I M E V A L U E : At a time when themarket price of X'fZ stock is $40 a share, an x:fZ 40 callmay have a current market price of, say, $2 a share.This is entirely time value.

An option with intrinsic value may often have sometim e value as well-that is, the m arket price of theoption may be greater than its intrinsic value. Thiscould occur with an option of any style.

E X A M P L E : With the market price of x:fZ stock at

$45 a share, an X'fZ 40 call may have a current marketprice of $6 a share, reflecting an intrinsic value of $5 ashare and a time value of $1 a share.

An option's time value is influenced by several fac-tors (as discussed above under "Premium"), including

the length of time remaining until expiration. An optionis a "wasting" asset; if it is not sold or exercised prior toits expiration, it will become worthless. As a conse-quence, all else remaining the same, the t ime value ofan option usually decreases as the option approachesexpiration, and this decrease accelerates as the time to

expiration shortens. However, there may be occasionswhen the market price of an option may be lower thanthe market price of another option that has less timeremaining to expiration but that is similar in all otherrespects.

An American-style option's time value is also influ-enced by the amount the option is in the money or outof the money. An option normally has very little timevalue if it Js substantia lly in the money. Although anoption that is substantially out of the money has onlytime value, the amount of that time value is normally

less than the t ime value of an option having the sameunderlying interest and expiration that is at the money.

Another factor influencing the time value of an optionis the volatility of the underlying interest. All else being

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the same, options on more volatile interests commandhigher premiums than options on less volatileinterests.

Time value is also influenced by the current cost of

money. Increases in prevailing interest rates tend tocause higher premiums for calls and lower premiumsfor puts, and decreases in prevailing interest rates tendto cause lower premiums for calls and higher premi-ums for puts.

The following is a description of the terminology ap-plicable to capped options:

CAP INTERVAL-The cap interval is a constant es-tablished by the options market on which a series ofcapped options is traded. The exercise price for a

capped-style option plus the cap interval (in the caseof a call), or minus the cap interval (in the case of aput), equals the cap price for the option. For example,if a capped call option with an exercise price of 360 hasa cap interval of 30, then the cap price at which theoption will be automatically exercised would be 390.

CAP PRICE-The cap price is the level that the auto-matic exercise value of a capped option must reach inorder for the option to be automatically exercised. Thecap price of a call option is above, and of a put optionbelow, the exercise price of the option.

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

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

AUTOMATIC EXERCISE VALUE-The automaticexercise value of a capped option is the price orlevel ofthe underlying interest determined in a manner fixedby the options market on which the option is traded foreach trading day as of a specified time of that day.

EXAMPLE: A 310 XYZ capped put index optionhas a cap interval of 20, and therefore has a cap priceof 290. Assume that the options market on which theoption is traded has specified the close of trading oneach trading day as the time for determining the auto-matic exercise value on the XYZ index, and that the

index level reaches a low of 289 during a particulartrading day, but is at 291 at the close. The automatic

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exerc ise value has not reached the cap price, and theautomatic exercise feature o f the option is no t trig -gered, because the index level was not at or below the

cap price a t the time of day specified tjJ the optionsmarket for determin ing the aut()m~tig .,~~~}s~ value ..t 'r', """" ~, .

CASH SETTLEM~NT ~OUKT\ . , I h l s J S :th.~,~~amount that the holder of a dash - s e t t l e d cappeCl optionis entitled to receive upon the exerc ise ofthe option. Inthe case of a capped option that has, been. automatl-

cally exercised, the cash settlement amOunt is equal tothe cap interval times the m ultiplier for t~ option. evenif the a utoma tic exe rcise va lue on the. day tha t theautomatic exerc ise feature is triggered~ceeds (in thecase of a ca ll) or is less than (in the. case of a put) the

cap price. If the capped option is voluntar ily exercised

a t exp ira tion, the ca sh se ttlemen t a mount is de te r-mined in the same manner as for, other s ty les at cash-sett led options.

EXAMPLE: A ~60 ABC cappec;j !faU index option

has a cap interval of 30 and a !J1ultip iier of 100 -. The

automatic exerc ise value of the A E , J Q index is 396 on apart icular t rading day. The call option is automaticallyexercised , and the cash settlement amount is $3000(equa l to the cap in terval o f:30times the multip lier o f100).

EXAMPLE: A 360 ABC capped ca ll index option

has a cap in te rva l o f 30 and a multip lie r o f 100. Thea utom atic. exercise va lue of the A BC index neverequals or eXceeds the cap pr ice of 390 during the l ife ofthe option,' and the exercise se ttlement value o f theoption is 367 on the fina l trading day. Upon exerc ise of

the'option,the holderis 'entitled to receive a cash set-

tlamentarnolin t o f $700 (equa l to the mUltip lier o f 100times the d ifference between the exerc ise settlement

value of 367 and the exerc ise price of 360).

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-. .---

~TER'"

ClPTIONSONEQUITY SECURITIES

~~""-"",*",~f-"'''').~~~~~M


21/129

EXAMPLE: An XYZ 40 call g ives the buyer theright to purchase 100 shares of XYZstock at'Q ~t1c$fOf$40 per share, or a total price of $4,000. ' ..,r ,

~( . . .

In the future, stock options may, with regulatory ap-proval, be introduced that have exercisef>rittl'.jn aforeign currency.

Adjustments may be made to certain of UJe,stan-dardized terms of outstanding stock options when cer-.

tain events occur, such as a stock djvideri.ct,. s~pckdistribution, stock split, reverse stock split; righ~'offe'r~'.ing, distribution, reorganization, recapitalization,reclassification in respect of an underlying security, ora merger, consolidation, dissolution or liquiclatICm ofthe issuer of the underlying security. In the following

discussion, there is a brief description of anumRer. ofgeneral adjustment rules applicable to stock optionsthat are in effect at the date of this booklet. Such rules

may be changed from time to time with f@Qulatoryapproval. An adjustment panel has the authority to

make such exceptions as it determines to be aporopri-ate to any of the general adjustment rules.

As a general rule, no adjustment is made for ordi-nary cash dividends or distributions.' A cash dividendor distribution by most issuers will generally beconsld-ered "ordinary" unless it exceeds 10% of the aggre-gate market value of the ul1derlying security

outstanding. The options markets are considering anamendment to the general rule~ which, i f adopted andapproved by the regulators, would provide that a:cashdividend or distribution by an issuer that is a closed-end investment company may not be considered to be"ordinary" if it exceeds 5% of such aggregate market

value. Determinations whether to adjust for cash divi-dends or distributions in excess of those amounts aremade on a case-by-case basis.

Because stock options are not generally adjusted forordinary cash dividends and distributions, coveredwriters of calls are entitled to retain dividends and dis-tributionsearned on the underlying securities duringthe time prior to exercise. However, a call holder be-comes entitled to the dividend if he exercises the op-tion prior to the ex-dividend date even though theassigned writer may not be notified that he was as-signed an exercise until after the ex-date. Because call

holders may seek to "capture" an impending dividendby exercising, a call writer's chances of being assignedan exercise may increase as the ex-date for a dividendon the underlying security approaches.

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"sa g~eral rule, stock dividends, stock distribu-tioosaoo stock splits can result in an adjustment in thenumber of underlying shares or the exercise price, orboth.

'EXAMPLE: An investor bought an XYZ 60 op-tion-either a call or a put-and XYZ Corporation sub-sequently effected a 3 for 2 stock distribution. Insteadof covering 100 shares of stock at an exercise price of$60 a share, each outstanding option could be ad-

justed to cover 150 shares at an exercise price of $40per share.

However, when a stock distribution results in theissuance of one or more whole shares of stock for eachoutstanding share-such as a 2 for 1 stock split-as a

general rule the number of underlying shares is notadjusted. Instead, the number of outstanding optionsis proportionately increased and the exercise price isproportionately decreased.

E X A M P L E : Before a 2 for 1 stock split, an investorholds an option on 100 shares of XYZ stock with an

.' exercise price of $60. After adjustment for the split, hewill hold two XYZ options, each on 100 shares and withan exercise price of $30.

An adjustment panel may make an exception to thegeneral rule to adjust for stock dividends. For exam-

ple, in cases where the issuer of the underlying secur-ity announces or exhibits a policy of declaring regularstock dividends that do not individually exceed 10% ofthe amount of the underlying security outstanding, anadjustment panel may determine to treat the stock divi-dends as though they were ordinary cash dividends

and to make no adjustment for them.

As a general rule, adjustments in exercise prices arerounded to the nearest 1/8 of a dollar, and adjustmentsin the number of underlying shares are rounded downto eliminate fractional shares. In the latter case, the

exercise pricemay be further adjusted to compensatefor the elimination of the fractional shares.

Distributions of property other than the underlyingsecurity may require different adjustments. For exam-ple, outstanding options might be adjusted to include

the distributed property.

E X A M P L E : If XYZ"spins off' its subsidiary ABCby distributing to its stockholders 2.5 shares of ABC

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stock for each share of XYZstock, outstanding 'X'{Zoptions might be adjusted to require delivery of 100shares of 'X'{Z stock plus 250 shares of ABC stock.

Alternatively, the exercise prices of outstanding op-tions might be reduced by the value, on a per-sharebasis, of the distributed property, as determined by theadjustment panel.

Events other than distributions may also result in

adjustments. If a ll of the outstanding shares of anunderlying security are acquired in a merger or consol-idation, outstanding options will as a general rule beadjusted to require delivery of the cash, securities, orother property payable to holders of the underly ingsecurity as a result of the acquisition.

E X A M P L E : If 'X'{Z is acquired by POR in a mergerwhere each holder of 'X'{Z stock receives $50 plus 1/2share of POR stock for each share of 'X'{Z stock held,'X'{Zoptions might be adjusted to call for the delivery of$5,000 in cash and 50 shares of POR stock instead of100 shares of XYZ stock.

When an underlying security is wholly or partiallyconverted into a debt security or a preferred stock,options that have been adjusted to call for delivery ofthe debt security or preferred stock may, as a generalrule, be further adjusted to call for any securities dis-

tributed as interest or dividends on such debt securityor preferred stock.

When an underlying security is converted into a rightto receive a fixed amount of cash, options on thatsecurity will generally be adjusted to require the deliv-

ery upon exercise of a fixed amount of cash, and trad-ing in the options will ordinarily cease w hen the mergerbecomes effective. As a result, after such an adjust-ment is made all options on that security that are not inthe m oney will become worthless and all that are in themoney wil l have no t ime value.

As a general rule, adjustments are not made fortender offers or exchange offers, whether by the issueror a third party, and whether for cash, securities (in-c luding issuer securities), or o ther property. Thispresents a r isk for wr iters of put options, because asuccessful tender offer or exchange offer (whether by

the issuer or by a third party) may have a significanteffect on the market value of the security that the putwriters would be obligated to purchase if the put op-tions are exercised after the expiration of the offer.

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As a general rule. adjustments will not be made toreflect changes in the capital structure of the issuerwhere all of the underlying securities outstanding inthe hands of the public (other than dissenters' shares)

are not changed into another security, cash or otherproperty.

As a general rule, an adjustment that is made in anoption will become effective on the ex-dateestablishedby the primary market for trading in the underlyingsecurity.

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C H A P T E R I V

INDEX OPTIONS

A BO UT I ND EX E S

As referred to in this booklet, an index is a measureof the prices of a group of securities" or other-interests.Although indexes have been developed to cover avari-ety of interests, such as stocks and other'equity securi-ties, debt securities and foreign currencles,and evento measure the cost of living, indexes on equity securi-

ties (which are called stock indexes) are among themost familiar, and they are the only indexes that under-lie options trading at the date of th is booklet. Thefollowing discussion refers only to" stoc:kindexes andstock index options.

Stock indexes are compijeg, ~fld;published by vari-ous sources, including, securities markets. An indexmay be designed to be representative of the stockmarket of a particular nation as a whole, of securitiestraded in a particular market, of a broad market sector(e.g., industrials) , or of a particular industry (e.g., elec-tronics). An index may be based on the prices of all, or

only a sample, of the securities whose prices it is in-tended to represent. Indexes may be based on securi-ties traded primarily in U.S. markets, securities tradedprimarily in a foreign market, or a combination of secu-rities whose primary markets are in various countries.

A stock index, like a cost of l iving index, is ordinarilyexpressed in relation to a "base" established when theindex was originated.

E X A M P L E : On the starting or "base" date for anew value-weighted index, the total market values ofthe component securities (market price t imes number

of shares outstanding) is $50 billion. The publisher ofthe index will a~sign, an arb itrary index level-say1DO-to that base value. If the total market value of thecomponent stocks increases by 2% the next day (i.e.,to $51 billion), the index level would rise to 102 (102%of the base level of 100).

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

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The base may be adjusted from time to time to re-flect such events as capitalization changes affectingthe constituent securities ofthe index (e.g., issuance ofnew shares) or to maintain continuity when securities

are added to or dropped from the index. These adjust-ments are generally designed so that the index levelwill change only as a result of price changes of constit-uent securities during trading.

Securities may be dropped from an index because

of events such as mergers and liquidations or becausea particular security is no longer thought to be repre-sentatlve of the types of stocks constituting the index.Securities may also be added to an index from time totime. Adjustments in the base level of an index, addi-tions and deletions of constituent securities, and simi-

lar changes are within the discretion of the publisher ofthe index and will not ordinarily cause any adjustmentin the terms of outstanding index options. However, anadjustmentpallel has authority to make adjustments ifthe publisher of the underlying index makes a changein the index's composition or method of calculation

that in the paneT'sdetermination, may cause signifi-cant discontinuity in the index level.

Different stock indexes are calculated in differentways. Accbrdingly, even where indexes are based onidentical securities, they may measure the relevantmarket differently because of differences in methods ofcalculation. Often the market prices of the securities inthe index group are "capitalization weighted." That is,in calculating the index value, the market price of eachconstituent security is multiplied by the number ofshares outstanding. Because of this method of calcu-lation, changes in the prices of the securities of larger

corporations will generally have a greater influence onthe level of a capitalization weighted index than pricechanges affecting smaller corporations.

Other methods may be used to calculate stock in-dexes. For example, in one method known as "equal-

dollar weighting," the index is established by estab-lishing an aggregate market value for every constituentsecurity of the index and then determining the numberof shares of each security by dividing such aggregatemarket value by the then current market price of thesecurity. The base level of the index is established by

dividing the total market value of all constituent securi-ties by a fixed index divisor. Thereafter, the number ofshares of the constituent securities and the index divi-sor are adjusted at periodic intervals in order to have

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each constituent security continue to represent an.ap-proximately equal dollar value in the indeJ(without dis-torting the level of the index.

Another method of calculation is simply to add upthe prices of the securities in the index and divide bythe number of securities in the index, disregardingnumbers of shares outstanding. Another method mea-sures daily percentage movements of prices by aver-aging the percentaqe price changes of all securities

included in the index.

Investors should keep in mind that an index canrespond only to reported price movements in its con-stituent securities. An index will therefore reflect thestock market as a whole, or particular market seg-

ments, only to the extent that the securities in the indexare being traded, the prices of those trades are beingpromptly reported, and the market prices of those se-curities, as measured by the index, reflect price move-ments in the relevant markets. The index level will beaffected by all of the factors that may at the time affect

prices in the relevant markets for the constituent secu-rities of the index, including, among other things, appli-cable laws, regulations and trading rules, the market-making and order processing systems of those mar-kets, the liquidity and efficiency of those markets, andthe prices and price behavior of'Mures contracts on

that index or a related index..

Certain trading strategies involving purchases andsales of index options, index futures, options on indexfutures or portfolios of certain of the securities in anindex can affect the value of the index, the prices of the

index Mures, and, therefore, the prices of index op-tions. These transactions and the resulting impactmay occur at any time-and may accompany signifi-cant changes in the prices or volatilities of the stockand derivative markets-including at or shortly beforean expiration. For example, traders holding positions

in expiring index options or futures contracts hedgedby positions in securities included in the index mayattempt to liquidate their securities positions at or nearthe time for determining the final exercise settlementvalue of the options or futures contracts. The resultingorders to liquidate these securities might result in sig-nificant changes in the level of the index. Index optionsinvestors should be aware of the potential impact thatthese trading strategies can have on index levels at ornear expiration, and the possibility that the values ofindex option positions will be affected accordingly.

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Readers who intend to trade index options shouldfamiliarize themselves with the basic features of theunderlying indexes, including the general methods ofcalculation. Readers who are attempting to follow a

precise and sophisticated strategy involving index op-tions may wish to inform themselves about the exactmethod for calculating each index involved. Informa-tion regarding the method of calculation of any indexon which options are traded, including informationconcerning the standards used in adjusting the index,

adding or deleting securities, and making similarchanges, is generally available from the options mar-ket where the options are traded.

The value level of every index underlying an op-tion-including the exercise settlement value-is the

value of the index as reported by the reporting author-ity designated by the options market where the optionis traded as the official source for determining thatindex's value. Unless acc directs otherwise, everyvalue as initially reported by the reporting authority isconclusively presumed to be accurate and deemed to

be final for the purpose of calculating the cash settle-ment amount, even ifthe value is subsequently revisedor determined to have been inaccurate.

Most indexes on which options are traded are up-dated during the trading day, and updated index levelsare disseminated at frequent intervals. Investors maydetermine current index levels from their brokeragefirms; in addition, the closing levels of many underlyingstock indexes are published in daily newspapers suchas "The Wall Street Journal." However, an index op-tion may be traded in the options markets at a timewhen some, or even a substantial portion, of the con-

stituent securities of the underlying index are not trad-ing or when there is a lag in the reporting of prices insome or all of the constituent securities. In those cir-cumstances, the current reported index level will bebased on non-current information, since its calculationwill be based on the last reported prices for all constitu-

ent securities even though trading or price reporting insome of those securities is not current.

FEATURES OF INDEX OPTIONS

All index options that are traded at the date of this

booklet are cash-settled. Cash-settled index optionsdo not relate to a particular number of shares. Rather,the "size" of a cash-settled index option contract isdetermined by the multiplier of the option. If the option

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market on which an option series is traded shoulddecrease the multiplier for the series, an adjustmentpanel may adjust outstanding options of that series.

The exercise pric~sand premiums of the index op-tions that are traded at the date of th is booklet areexpressed in L!.S. dollars ... SUbject to regulatory ap-proval, trading in index options whose exercise pricesor premiums are expressed in a foreign currency maybe introduced in the future. The total exercise price for

a single option is the stated exercise price multipliedby the multiplier.

Premiums for index options are expressed in pointsand fractions of points. Eachpoint of premium of theoptions trading at the date of this booklet representsan amount equal to one U.S. dollar. In order to deter-

mine the aggregate premium for a single index option,the quoted premium must be multiplied by themultiplier.

EXAMPLE: An investor purchases a December110 index call at 2%. The multiplier for that option is100. The aggregate dollar amount of the premium is$212.50 ($21/8time~ 100 = $212.50). Had the optionsmarket used a multiplier of 200, a premium of 21/8would have meant an aggregate premium of $425.00.

The exercise settlement values of stock index op-tions are determined by their reporting authorities in a

variety of ways. The exercise settlement values ofsome index options are based on the reported level ofthe index derived from the last reported prices of theconstituent securities of the index at the closing on theday of exercise. The exercise settlement values ofother options are based on the reported level of the

index derived from the opening prices of the constitu-ent securities on the day of exercise. If an option isexercised on a day that is not scheduled as a tradingday for the constituent securities of the index, the exer-cise settlement value is based on the reported level ofthe index derived from the opening or closing prices

(depending on the options series) of the constituentsecurities on the last prior day that is scheduled as atrading day. If a particular constituent security doesnot open for trading on the day the exercise settlementvalue is determined, the last reported price of that se-curity is used. Other means for determining the exer-cise settlement values of some index options serieshave been, and may continue to be, established. Forexample, the exercise settlement values for options onan index of foreign securities may be fixed in relation toa value fixed by a foreign exchange.

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Investors should be aware that the exercise settle-ment value of an index option that is derived from theopening prices of the constituent securities may not ber~ported for several hours following the opening oftrading in those securities. A number of updated indexlevelsmay be reported at and after the opening beforethe exercise settlement value is reported, and therecould be a substantial divergence between those re-ported index levels and the reported exercise settle-ment value,

Investors should also be aware that there is no sin-gle opening or closing price for securities primarilytraded in the NASDAQ stock market. A price of aNASDAQ security that is used in determining the levelOna particular day of an index that includes the secur-ityVilll not necessarily be the price at which a majorityof opening or closing trades in that security were ef-fected on that day.

The principal risks of holders and writers of indexoptions are discussed in Chapter X. Readers inter-ested in Duying or writing index options should care-fully read that chapter, particularly the discussionsunder the headings' "Risks of Option Holders," "Risksof Option Writers," "Other Risj


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CHAPTER V

DEBT OPTIONS

Two kinds of debt options have been approved for

trading at the date of this booklet." One kind, calledprice-based options, are options which give their hold-ers the right either to purchase or sell a specified un-

derlying debt security or to receive a cash settlementpayment based on the value of an underlying debt

security (depending on whether the options are physi-

cal delivery or cash-settled options). The other kind,called yield-based options, are options that are cash-settled based on the difference between the exercise

price and the value of an underlying yield. The distinc-

tions between price-based and yield-based options

are fundamental and should be understood by readers

interested in investing in debt options.

At the date of this booklet, only yield-based options

are being traded. Although price-based options have

traded in the past and may be traded in the future, noprice-based option is traded at the date ofthis booklet.

The principal risks of holders and writers of debtoptions are d iscussed in Chapter X, Readers in ter-

ested in buying or writing debt options should not only

read this chapter but should also carefully read C hap-

ter X, particularly the discussions under the headings"Risks of Option Holders," "Risks of Option Buyers,""Other Risks," and "Special Risks of Debt Options."

RATES, YIELDS AND PRICES OF

DEBT SECURITIES

To understand debt options, an investor should un-derstand the relationship between the rates or yields,

which are different ways of expressing return on debtsecurities, and prices of debt securities. (Coupon inter-

est rates of a debt security express return as a percent-age of the principal amount (par value) of the security.

Yields express return (or projected return) as a per-centage of the amount invested.) This relationship,

s imply stated, is that prices of debt securities moveinversely to changes in rates. D eclining rates, whether

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on long-term bonds or money market instruments, will

generally cause prices of outstanding debt securities

to increase. Conversely, rising rates across a particu-

lar maturity spectrum will generally cause the prices ofoutstanding debt securities of that maturity to decline.

EXAMPLE: A 3D-year Treasury bond pays inter-

est at a 12% coupon rate, The only time prior to matur-

ity that investors wilrpay a.price of 100 (that is, 100% of

par value) for the bond is when the prevailing yield onsuch long-term Tre~ury bonds is exactly 12%. Should

rates move higher tQ. say, 14% for such Treasury

bonds, the price of an outstanding 12% bond would

have to decline to about 86 in order for the bond to

yield 14%. If rates on such bonds subsequently de-

cline to 10%, the price of the12"A>bond could be ex-

pected to rise substantially, above par, since it would

yield 10% at a price q1120.

Price-based call options become more valuable as

the prices of the underlying debt securities increase,and price-based puts become more valuable as the

prices of the underlying pebt securities decline. The

relationship between. interest rate changes, prices, and

the value of price-based debt options can be ex-

pressed as follows:

Interest Rates (Yields) t = Prices ~

Call tPut +

Call +Put t

Interest Rates (Yields) ~ = Prices t

In contrast, the exercise settlement value of a yield-based option is based on the difference between the

value of an underlying yield and the exercise price of

the option. Since the underlying yields of yield-based

options will increase as interest rates increase, and

vice-versa, it follows that yield-based calls become

more valuable as yields rise (i.e.! as the prices of thedebt securities from which the underlying yield is de-

rived decline), and puts become more valuable as

yields decline (and prices of such securities increase).

These relationships can be expressed as follows:

Call+

Put t

Call tPut +

Interest Rates (Yields) + Prices t

Interest Rates (Yields) t Prices +

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TREASURY SECURITIES

The underlying debt securities of price-based op-

tions and the debt securities from which the underlying

yields of yield-based options are derived are all Trea-

sury securities-e.g., 30-year Treasury bonds, 10-year

Treasury notes, 5-year Treasury notes and Treasury

bills.

Treasury bonds and notes are direct obligations of

the United States that pay a fixed rate of interest semi-

annually. Bonds are issued for maturities of more than

ten years (although many issues are callable prior to

maturity). Notes are issued for maturities of one to ten

years, and are non-callable. New issues of bonds and

notes are sold periodically by the Treasury, usually on

an auction basis. The auction price is established by

bidding and may be above or below par value. Occa-

sionally the Treasury will "reopen" an outstanding is-

sue by auctioning additional principal amounts.

Government securities dealers make secondary mar-

kets in virtually all outstanding issues, but market activ-

ity and liquidity tend to center on the most recently

auctioned issues.

Unlike Treasury bonds and notes, Treasury bills do

not pay interest. Instead, the Treasury sells bill~at a

discount from their principal amount (par value). Theinvestment return consists of the difference between

the discounted purchase price and the principal

amount payable at maturity. Treasury bills are issued

in m,aturities of13,26 or 52 weeks.

R~turn on Treasury bills is commonly expressed interms of a discount rate which represents an annuali-

zation (based on a 360-day year) of the percentage

discount at which the bills are sold.

EXA MPLE: If a 13-week (91-day) Treasury bill

with a principal amount of $1,000,000 is sold for$970,000, the actual discount would be $30,000 or 3%

and the discount rate would be approximately 11.9%

(360/91 times 3%).

Bills are auctioned by the Treasury on a regular ba-

sis, typically at weekly intervals for 13-week and 26-week bills and every four weeks for 52-week bills.

While dealers maintain secondary markets in all out-

standing Treasury bills, activity tends to center in the

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most recently auctioned issues. These are commonlyreferred to as the "current" 13-week, 26-week, and

"year" bills, respectively.

YIELD-BASED. QPTIONS ;~'t~-,-;

4. No other publication is incorporated by referenceinto this booklet. The fact that this booklet refers toinformation that may be available in other publicationsdoes not mean ,thatany ofthose other publications has

been incorporated into this booklet.

5, This booldet does not attempt to present a com-plete description of all of the provisions governing op-tions. These .are set forth in applicable laws, in therulesa,nd,tegulations of the SEC and other regulatory

agencie~. and in the rules, interpretations, policies andproC8d~ (collectively called "rules") of ace, theoptions markets and the foreign clearing houses thatact as "associate clearing houses" of ace that maybe ,ri'forcefmm time to time.

," " .

Thisbooklet also does not attempt to describe either

therulestt!iatgovern the structure or conduct of op-tions tradingorthe.rorms and procedures for trading in

the varibus options markets. These matters differ fromone options market to another, and they may changefrom time to time. ,As examples, the various optionsmarkets may utilize different market-making systems

(with some markets using a specialist system, others acompeting market-maker system,and others a combi-nation of the two), order routing systems, and auto-

matic order execution systems. Moreover, asadvances are made incomputertechnology, the trad-ing and market-making systems and the other trading

procedures of the options markets are likely to evolveand change-or even be radically different from whatthey now are.

At particular times-such as when unusual condi-tions or circumstances exist, which for example mayoccur on and after days on which there have been

substantial or volatile price movements in the securi-ties markets generally or in the markets for underlyingor related interests-the options markets may haveauthority under their rules to modify the application ofsome or all of their trading rules and procedures or to

take such actions as thlilYmay deem appropriate in the

circumstances, Such actions could include, amongother things, changing the manner in which trading inparticular. options i s conducted, extending tradinghours for particulal'options, halting tradingfn particular

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options, restricting the types of orders that may beemployed, and modifying or eliminating the bid/askeddifferential at which market-makers or specialists mayquote. The taking of such actions by an options mar-ket often is promptly disclosed to the trading crowd in

that options market, to representatives of brokeragefirms that are members of the options market, and/or toprice vendors, but the actions may be taken withoutpublic notice, and there can be no assurance that dis-closure will be made in a manner that will permit inves-tors to learn of the actions in a timely way.

acc and the options markets have broad discretionunder their rules to take a variety of actions in particularcircumstances, and readers should not assume thatany organization will exercise its discretion in a particu-lar way in any particular circumstance. A statement inthis booklet to the effect that

accor an options market

has authority or discretion to take a particular actiondoes not mean that it will necessarily take that action.To the contrary, it should be understood from such astatement that the organization also has authority notto take that action. Moreover, it should be understoodthat acc and the options markets have broad discre-tion in the manner in which they interpret their ownrules.

acc and the options markets have no duty to en-force, or to oversee the enforcement of, each other'srules. acc and each U.S. options market has a gen-eral statutory obligation to enforce compliance with itsown rules by its own members. However, there can beno assurance that all such rules will always be com-plied with by members, since frequently the onlymeans of enforcing compliance with rules is to imposedisciplinary sanctions after the fact on those who haveviolated them.

Readers desiring information concerning the rules ofacc or any of the options markets as to the terms ofoptions, the manner in which options are traded or inwhich a market functions, the trading hours of a partic-ular options market, or other related matters, or infor-

mation concerning any of the other matters referred toherein, may obtain the information from the relevantorganization. Information concerning a foreign op-tions market or associate clearing house is generallyavailable from that organization.

6. The U.S. options markets have rules applicable tothe handling of customer accounts and the execution

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of buy and sell orders that impose special require-ments with,re$psd to approval of customer accountsfOt optiOnStrading arrd recommendations of particular

optiorwhnsaetions;- This booklet does not attempt todescribe 1t\Ose. requirements, the laws and rules gov-

eIl'J'Ilng'brokerage firms and other securities profes-sion~lIs,'Qnheagreements, procedures and internalrtllesof brOkerage firms that are applicable to the ap-prbVal'sndopenlng of customer accounts, the han-dliNg Qndexecution of orders, the transmission tobrokerage 'firms of instructions to exercise or not toexercise options, the manner or time in which writers ofoptiOns 'are notified by their brokerage firms that op-tfbnShave been assigned an exercise, the handling ofcust6mers' funds, securities and accounts, the safe-guarding of customers' positions in options, or other'matters relating to the handling of options transactionsbY.15rokeragefirms. Readers should consult with theiroWh'bro"kerage firms for information concerning suchrnatt~rs.

,.- -~ ,

, .7 . T,o.isbooklet does not attempt to describe the

rteks"torinvestors that may be associated with the waytrading 'is, eonQycted in any particular options market0lVifl-anv market rotan underlying or related interest.The reader should not assume that either the optionsmarkets or the markets for underlying or related inter-ests wiU:beeffiCient,liqutd, continuous and orderly in

all circumstances or thatthey will be or remain open atall times. Eveh on relatIVely normal days, there will bevariances inithe market.makingperformance of spe-

cialists and market makers in the various marketswhich derive prirnarUy'from differences in:~ndividualskills, capital, wiUingness to-acoeot risk/ability to

hedge risk, tradingstrategies;:al'ld market~ma1


95/129

interest, may fail or may not work effectively or effi,;ciently at times. During the past few years, for exal1Fpie, the operations of various U.S. markets have been

disrupted by earthquake, .flood, fire, electricity out-ages, and computer failure. Moreover, no system canbe expected to work perfectly at all times. The options

markets may rely on manual methods to record tradeinformation, and errors or omissions can occur in ttl~rreports of price, volume and other information; and

these can be expected to be exacerbated on days ofsignificant volume or volatility.

It is also beyond the scope of this booklet to discussthe risks that may result to investors from the use bymarket participants of options pricing theories. There

are a number of publications that are commerciallyavailable which discuss such theories.

8. This booklet does not attempt to describe risksthat may be inherent i n an investment in the underlyinginterest. It is obvious that the investment potential of

an option can be dependent on the performance oftheunderlying interest and that investors in options aretherefore subject to the risks that may affect the valueof that interest. For example, one of the risks under-taken by a purchaser of a call option (or a writer of aput option) on 'l:(Z stock is that 'l:(Z may decline in

price during the life of the option. The risk of thisdecline is dependent on the risks that may affect theeconomy or the stock market generally or 'l:(Z specifi-cally. Similarly, the holder of a dollar-denominatedoption on a foreign currency is subject to the risk fac-tors affecting the relative values of the U.S. dollar and

the foreign currency. A discussion of these types ofrisks is beyond the scope of this booklet.

9. This booklet does not attempt to describe sys-temic risks that could affect the options markets andthe investors in those markets. The options markets,

like all securities markets, are interrelated with, andfrequently interdependent upon, other aspects of na-tional and international financial and capital systemsand upon the national and world economy. Any distur-bance or crisis of one part of these interrelated sys-tems could severely disrupt or even threaten the

performance of the options markets or of ace. Bankfailures, payments breakdowns, large and sudden ec-onomic shocks, the failure of a large securities firm,market or clearing organization, or other such eventscould cause other failures on a widespread basis and

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could affect the liquidity and solvency of the partici-pants in the options markets. The specific causes ofsystemic failure or disruption are not easy to predict,

and a discussion of them is beyond the scope of thisbooklet.

10. All examples in this booklet are based on hypo-thetical values that are not necessarily indicative of theprices in an actual transaction. Readers should notassume that options will necessarily be priced in ac-

cordance with any example in this booklet or in accor-dance with any pricing formula or model. As noted inthe discussion of "Premium" in Chapter II, option pre-miums are not fixed by acc or any of the optionsmarkets.

11. The examples in this booklet do not include taxconsequences, commissions or other transactioncosts, nor do they include the impact of applicablemargin requirements. As discussed in Chapter IX,these items can be very significant and should betaken into account by all investors.

SUPPLEMENTS

appear on the following pages

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DECEIfBER 1997-SUPPLEIfENT

To accommodate the lntroduction of trading in

cash-settled optionson indexes of mutual funds, the

February 1994 edition of the booklet entitled Char-acteristics and Risks of Standardized Options is

amended by adding the following disclosure to

Chapter IV, Index Options, following the third full

paragraph on p. 26:Index options may be traded on underlying

indexes designed to reflect the net asset values of

selected mutual funds in specified categories. For

example, an underlying index may be designed to

reflect the net asset value of a selected group' of

growth funds, or a selected group of growth and

income funds. These indexes are calculated and

disseminated based on the reported net asset val-

ues of the mutual funds included in the index.

Mutual funds typically report their net asset values

only once per day following the close of trading inthe primary markets for the securities held in the

funds' investment portfolios. Mutual fund indexes

are based on these closing values and are not

updated during the trading day. Mutual fund

indexes as reported during the trading day will thus

be based on non-current information, not onlybecause the funds' portfolios may have changed

since the previous day's close, but also because the

values of the funds' portfolio securities during the

trading day may vary from their values at the previ-

ous day's close. Therefore, reported fund index val-

ues should not be relied upon as indicative of the

current values of the mutual funds included in the

indexes. In this respect, mutual fund indexes are

comparable to other indexes that are not updated

during the trading day, including certain foreign

stock indexes. These other indexes are not updatedbecause their component stocks may not be traded

in their primary home country markets during all or

part of the options trading day.

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MARCH2000

SUPPLEMENT

The February 1994 edition of the booklet enti-

tled CharacteristiCs and Risks of StandardizedOptions< (the "options booklet") is amended 'asfollows:

1. The second full paragraph after the exam-

ple on page 21 of the options booklet is amended

to read:

When an underlying security is converted into

a,right to receive a fixed amount of cash, options on

that security will generally be adjusted to require

the delivery upon exercise of a fixed amount of

cash, and trading in the options will ordinarily

cease when the conversion, becomes effective. Asa result, after such an adjustment is made all

options on that security that are not in the money

will become worthless and all that are in the money

will have no time value. If the option is European-

style (as may be the case for a flexibly structured

stock option designated as a European-style

option), the expiration date of the option will ordina-

rily be accelerated to fall on or shortly after the date

on which the conversion of the underlying security

to a right to receive cash occurs. Holders of an in

the money option whose expiration date is acceler-ated must be prepared to exercise that option prior

to the accelerated exercise cut off time in order to

prevent the option from expiring unexercised. Writ-

ers of European-style options whose expiration

date is subject to being accelerated bear the risk

that, in the event of such an acceleration, they maybe assigned an exercise notice and be required to

perform their obligations as writers prior to the orig-

inal expiration date. When the expiration date of a

European-style option is accelerated, no adjust-

ment will be made to reflect the accelerated expira-

tion date. There is no assurance that the exercise

settlement date for an accelerated option will coin-

cide with the date that the cash payment to the

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holders of the underlying security becomes avail-able from the issuer of the underlying security. Cov-ered writers of an accelerated option.may therefore

be required to pay the cash' amount in respect ofthe option before they receive theCas~ payment onthe underlying security.

2. The third and fourth sentences of the par-agraph under "Exerci

Characteristics and Risks of Standardized Options_OCR

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