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CBOESeries56Review
Welcome:
Thisreviewismeanttocomplementthebookandthepracticequestionsthatyouhavereceivedaspartofyourpackage.Westresstheimportanceofreadingthroughthebookandofbecomingfamiliarwiththerulesintheirentirety.ThisreviewisNOTmeanttoserveasasubstituteforthebook,butratherasacomplement,aspreviouslystated.
Manyoftherulesarelengthyandareattimesdifficulttodecipher.Thisreviewtakesalargesampleoftheserulesandhighlightsimportantdetailstohelpyoutacklemanyofthequestionsontheexam.
Regardingexpectations,whilenooneexpectsyoutomemorizeeverywordinthebigbook,itwouldbeinyourbestinteresttothoroughlylearnEVERYiteminthisreview.Youshouldplaceallemphasisonknowingthismaterialasifyouwereguaranteedtohaveatleastonequestiononeachtopicdiscussed.
AFewAdditionalNotesofCaution:
Thereareseveralquestionsthatdiscussrisk,reward,andpossiblybreakevenlevelsofstrategieslikeverticalspreads(callspreadsandputspreads).Wedonotdiscusstheminanydetailinthisreview,butyoushouldhaveathoroughunderstandingofhowtoderivesuchanswers.
TheFINRAoutlinestatesthatyoushouldbecomfortablewithbasicputcallparity.Thisisnotdiscussedinthisreview,butshouldbeknownasitisconsideredbasicknowledgeforprofessionaloptionstraders.
Wewishyouwellontheexam.Ifyouhaveanyquestionsorconcernsbeforeoraftertheexam,pleasefeelfreetoreachouttous.
Thankyouagain,
TheStaffattheCBOEsOptionsInstitute
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ExamOverview:
105MultipleChoiceQuestions,butonly100count
100RealQuestions,5ExperimentalQuestions
2HourTimedExam
70outof100CorrecttoPass
QuestionsSegmentedinto5Sections
ScratchPaperandBasicCalculatorProvided
YouareNOTallowedtotakeanythingintothetestcenter!
NOExchangeSpecificRules
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Chapter1Review:Approximately9Questionswillstemfromthischapter.
WhoNeedsToTakethisTest?
Ifyouareamemberofanexchange,yousupervisetraders,youareatrader,oryouareaMarketMaker,youneedtotakethistest.
Furthermore,ifyouaresomeonewhosupervises,monitors,ortrainsanyoftheabove,youalsoneedtoberegistered.
Youmustberegisteredifyouaregivingadviceonspecificstocks.YoudoNOThavetoberegisteredtogivegeneraleconomicinformationorgeneraleconomicoverviews.
IfyourenotactivelyengagedintheSecuritiesbusinessatyourfirm,youdonothavetoberegistered.Registrationisdifferentfrombeingapprovedforemployment.
DonotregistermejustsoIcansitfortheSeries56Examifyoudonotintendonemployingmeasatrader.
WhodoesNOTneedtotakethisTest?
Ifyouareclericaloradministrative,ifyouarenotengagedinthesecuritiesbusiness,orifyoutradeFuturesorCommodities,youdoNOTneedtoberegistered.
YoumayNOTregisterpeopleoncetheyarenolongerfunctioninginaregisteredcapacity,iftheyarenolongerinvolvedinthefirmssecuritiesbusiness,orifyouaretryingtoregisterthemsolelytoavoidexaminationrequirements.
RegistrationForms:TheU4andtheU5
U4Thisistheformthatisfilledoutwhenyouarehiredasaregisteredperson.Forthepurposesofdeterminingyourcontinuingeducationrequirements,yourhiredateisthedatethatyouwereissuedaU4.TherearemanythingsthatneedtobereportedonyourU4.However,itisimportanttorememberthatachangeinmaritalstatusdoesNOThavetobereportedonyourU4.
U5Thisistheformthatisfilledoutuponyourdeparturefromafirm.Theformisissuedregardlessofwhetheryouareterminatedorwhetheryouresign.Itisfiledelectronicallyandshouldbefiledwithin30daysoftermination.
IfthereareanydiscoveriesmadethatrequireamendingyourU5,thereportingfirmhas30DAYSfromthedateofdiscoverytoupdateyourU5.
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ExchangeRegulationsandRulesofConduct
Whenyouapplytobeamemberofanexchange,therulesarefairlyuniform.Youmaybedeniedmembershipdueto:financialthresholds,yourinabilitytoadheretorulesandregulations,ifyouFAILanexam,orIFyourassociationwouldbringtheexchangeintodisrepute.FingerprintingisrequiredundertheSecuritiesActof1934.
Ifyouareapproachedonthetradingfloorregardingaviolation,youmaywaituntilaftertheclosetoaddresstheallegedviolation.
StatutoryDisqualification
ThisoccurswhenyouarebannedfromanSROorwhenyouarechargedbyanSRO.Thinkoftheprocessasonewhereyouareguiltyuntilproveninnocent.Hence,ifyouarecharged,youmustimmediatelyappealthosecharges.Furthertothatpoint,ifyouarechargedonmultiplecounts,youmustappealALLcounts.FailingtoappealjustoneofmanycountsmakestheStatutoryDisqualificationfinal.
IfyouarethesubjectofaStatutoryDisqualification,youmaycontinuetoworkwithyourcurrentSROduringtheappealsprocess,butyoumaynotgoandworkwithanyotherSRO.ReasonsanExchangemayissueaStatutoryDisqualificationare:
ANYfelonyinthelast10years CertainMisdemeanorsThistypicallyreferstofinanciallyrelatedones. RefusaltohonoranArbitrationresultoraward FailuretoPayDuesorFees DestructionofExchangeProperty
TheonlywayyoucanundoaStatutoryDisqualificationisiftheSECsaysit'sok.
Thatsaid,anSROmayfine,suspend,orotherwisedisciplineaMemberorMemberfirm.However,anSROmayNOTimprisonanindividual.Ithasnojurisdictiontodoso.
BusinessConductreferstoanythingthathastodowithtrading.ItisgovernedbytheSecuritiesActof1934.
ForanyviolationreportedonanExchange,ifitisalegitimatecomplaint,youdoNOThavetohaveawrittencomplaintinorderforthingstobeinvestigatedbytheExchange.Thecomplaintmusthavereasonabledetailsregardingaviolation.
Onceaviolationisreported,theExchangeMUSTinvestigatethematter!Asafirmorasanindividual,youaresupposedtoSELFreportanyactionsagainstyouoragainstafirmPROMPTLY!
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Foranyruleviolations,bothMembersandMemberFirmsmaybeheldliable.Ifyouhaveaclerkthatismisbehavingandhe'snotregistered,it'syourfault.
AsMarketMakersorBrokers,youshouldbeawareofwhatconstitutesjustandequitableprinciplesoftrade.
Youshouldnotrefusetotradewithsomeone,threaten,harass,intimidate,orexhibitretaliatorybehavior.
Everythingisopentoarbitrationexceptthingslikeclassactionsuits,sexualharassment.
ContinuingEducation
Therearetwotypesofcontinuingeducationelements:ARegulatoryElementandaFirmElement
TheRegulatoryElementisadministeredbyFINRAandmustbecompleted2yearsafterinitialemploymentandevery3yearsafterthat.Itmustbecompletedwithin120daysofanniversarydates.TheanniversarydateisdefinedasthedateyoureceiveyourU4.Ifthecontinuingeducationisnotcompletedontime(ifthe120dayshavepassed),thenyourlicenselapsesandyouarenotallowedtoactinaregisteredcapacityuntilyourectifythesituation.Onceyoucompletethecontinuingeducation,youareactivatedagain.
Ifyouaresubjecttoastatutorydisqualification,anSROortheSECmaymakeyoutakethecontinuingeducationearlier.
Reasonsthatyoumaybeaskedtodotheregulatoryelementearlierthan2years...
StatutoryDisqualificationbySRO,orderedtobySROorSEC,orifyougetfinedover$5K.
TheFirmElementEverymemberfirmshouldhaveaFirmElementanditshouldbeDOCUMENTED.TheFirmElementshouldcoverapplicableregulatoryrequirements,salespracticeconsiderations,etc.Forexample,optiontradingfirmsshouldhavesomethingwhereyouspendanhouronceayeargoingoversomethinglikeoptionsbasics.Registeredpersonsmustsignadocumentstatingthattheyhavecompletedthetraining.IfFINRAortheSECasks,thisfirmelementmustbedocumentedanddocumentationmustbeproducedondemand.
GiftstoExchangeandFirmEmployees
Youmaygiftupto$50toanExchangeemployeewithoutfirstobtainingpermissionfromtheExchange.
Youmaygiftupto$100toanemployeeofaMemberFirmwithoutfirstobtainingpermissionfromtheMemberFirm.
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TreatmentofClientsandCustomers
Youcannotguaranteeclientsthattheywillnotlosemoney.
YouCANshareinaclient'sprofit.Ifyouopenanaccountforoneofyourfriends,thewaytoshareinprofitsistogetwrittenpermissionfromyouremployerandtohaveanagreementstatingthatprofitpercentagesarebasedonyourrespectivecapitalcontributions.
HedgeFundsarenotbrokers.TheyoperateasLLCs.
You'renotsupposedtotakelossesjustbecauseaclientmadeabadmove.Youmayneedtotakelossesincaseofatradingerror.YoumayalsobeallowedtotakecustomerlosseswithapprovaloftheExchange.
RecordKeepingofCustomerAccounts
Youshouldkeepbid,offer,orderandexecutioninformationandticketinfoforupto3years.ThiscomesfromSecuritiesActof1934.
Whenyouopenanaccountforanoptioncustomer,youshouldfileextrapaperworkforthatcustomerandkeeponfilefor3yearsonsiteatthebranchofficeandatasupervisoryofficeandthethirdyearmaybeinaremotelocation.
ENDOFCHAPTER1REVIEW
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Chapter2Review:Approximately8Questionswillstemfromthischapter.
KnowthedifferencebetweenaBrokerandaDealer!
ABrokertradesforothers.
ADealertradesforhimself.
DEFINITIONOFASECURITYThekeythingtoknowwhenthinkingabouttheoptionworldisthatoptionsandotherinstrumentswithLESSthan9monthstoexpirationarenotconsideredsecurities.Therefore,LEAPSaresecurities.9monthsisKEY.
QualifiedBlockYoucanprovideliquidityatadiscountbid.Youshouldexpeditiously(actualwordingmaybeinanexpeditiousmanner)getoutofthattrade,butthereisnotsomesettimebywhichyouhavetogetout.Thatway,youdonotupsetthebalanceofthemarket.
TheNASDAQMarketCenterisaplatformthatallowsfirmstotradeallNASDAQ,NYSE,andAMEXlistedsecuritiesonasingleplatform.
AnAlternativeDisplayFacility(ADF)isadisplayonlyfacilityoperatedbyFINRA.TheADFprovidesmemberwithafacilityforthedisplayofquotes,reportingoftrades,andthecomparisonoftrades.AsanSROdisplayonlyfacility,ADFdoesNOTprovideautomatedorderrouting,executionfacilities,orlinkagesbetweenADFtradingcenters.ADFtradingcentersarerequiredbyNASDruletoprovidedirectelectronicaccesstoallotherADFtradingcentersandprovidesuchaccesstoallFINRAmembersthatrequestit.
AnOverTheCounter(OTC)Securityisastockthattradesinsomemannerotherthanonaprimaryexchange(NYSE,AMEX,NASDAQ).Thistermisoftenusedtodefineastockthatistradedthroughsomesortofdealernetwork.UnlikeExchangebasedtransactions,OTCtransactionsaresubjecttocounterpartyrisk.InstrumentssuchasbondsandPennyStockstypicallytradeOTC.Thatsaid,beawarethatexchangelistedinstrumentsMAYALSOtradeOTC!
TheThreeActs
SecuritiesActof1933PrimarilydealswithIPOs.ThiswastheearliestAct,anddealswithpubliclyheldcompaniesattheirearliestmoments.
SecuritiesActof1934PrimarilydealswithSecondaryMarketRegulation.ThiswasthesecondAct,anddealswiththesecondstageofacompanyslife.ThisistheActtowhichmostofthereferencesinthetestpertain.TheSecuritiesActof1934establishedtheSECandturnedRegulatoryAuthorityovertotheExchangesandtotheNASD.ThisactgovernsSECONDARYTRADING.
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InvestmentCompanyActof1940Primarilydealswithhedgefunds,mutualfunds,andotherthirdmarketoperations.ThisisthelastoftheActs,andhencetheonethatdealswithcompaniesinmorematurestagesoftheirlife(suchaswhentheyareestablishedenoughtobeconsideredforamanagedfund).
SROsarethenationalexchangesandFINRA.
Thereare3typesofInvestmentCompanies:
FaceAmountPayableattheEndofthelifeofacontract ClosedEndFundThisisbasicallyanETF.ItisbackedbythesharesthattheETF
represents.Valueisbasedonmarketvalue. OpenEndFundValueisbasedonNetAssetValue(NAV),notonthevalueofshares
thattradeonanexchange.Thatsaid,NAVandtradingvaluemaydiffer.Thesefundsissuesharesandthenbuysharesbackfromyou.ThinkofanIndexFundlikeVanguard.
Youshouldknowthebasicsregardinghowtovalueopenendvs.closedendfunds.
MarketPriceforClosedEndFunds NetAssetValue(NAV)forOpenEndFunds
WhatdoesFINRAdo?
YougetU4'dandhence,registeredthroughFINRA. FINRAhandlestheeducationofindustryparticipants. FINRAexaminesinvestmentfirmsandcreatesindustryrules. FINRAisfundedbyasmalltransactionfeefromtradingactivities.TheSECdoesNOT
fundFINRA.
WhatdoestheOCCdo?
AlloptiontradesareclearedthroughtheOCC. TheCFTChasjurisdictionovertheOCCbecausetheOCCclearsFuturescontracts!There
isjointjurisdictionwiththeSEC. TheOCCisnotinvolvedinbreakingtrades.
DepositoryTrustandClearingCorporation(DTC)isliketheOCCexceptforStocks.TheexammayalsorefertotheNSCC,whichisasimilarbody.
OntheTopicofMarketMakers
Youshouldknowthedifferencebetweenafloorbrokerandamarketmaker.
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Differentexchangeshavedifferenttypesofmarketmakers.Somemarketmakersgetcompensatedbyexchangesjustforshowingup
Under1934Act,theyrefertomarketmakersasSpecialists.FloorBasedMarketMakerscanparticipateinbothopenoutcrytradingandinelectronictrades.
FloorBrokerDisclosuresRegardingMarketMakerOrdersIfyouareafloorbrokerandanothermemberasksyouwhetherthisorderisforanotherMarketMaker,youmustdiscloseyourclientifyourclientisindeedamarketmakerandifsocalledupontodoso.YoudothisONLYIFASKEDandonlyifthatmarketmakerisamemberofthatExchange.
Note:IfyouareabrokerholdingaMarketMakerorderandyouarenotaskediftheorderisforaMarketMaker,thenyoumusttreattheorderasaregularcustomerorder.
Ifyouarefacilitatingcustomerorders,youshouldnotbeusingyourmarketmakerdesignationtocircumventshortsellingrules.
Ifyouregisterasaproptrader,you'renotsupposedtohaveanycustomers.
ENDOFCHAPTER2REVIEW
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Chapter3Review:Approximately20Questionswillstemfromthischapter.
Youshouldknowhowtocalculaterisk,reward,andbreakevenlevelsforverticalspreads.
StockownershipYouhavealimitedliability,sothemostyoucanbeoutiswhatyoupaidfortheshares.
StockholderRights
Youhavetherighttotransfershares. Youhavetherighttodeclareddividends.Therearedifferentrightsforcommonand
preferredshares. Youhaveaccesstocorporateinfo. Theexdateisthedatethatthestockpriceshouldadjustforthedividend.Inorderto
getadividend,youmustbeashareholderofrecordONtherecorddate.
Stock,Options,andFuturesSettlementGuidelines
1) StocksnormallysettleT+3.Thisisalsoknownasregularwaysettlement2) FuturessettleT+13) CashsettlementforstocksisT+1.
a. Thisimpliesthatatradercouldbuystockthedayaftertheexdividenddate,designateitcashsettled,andcollectthedividendbecausehewouldbeastockholderofrecordontherecorddate.
4) OptionssettleT+1.However,ifyouexerciseacalloption,theSTOCKthensettlesT+3.5) Youmaybeaskedsomethingalongthelinesof,SupposethatonMonday,youbuy
stockanddesignateittobecashsettledandyoualsobuyacalloption.Onwhatdaydothoseproductssettlerespectively?TheanswerisTuesdayTuesday.ThisisbecausecashsettledstocksettlesT+1andoptionssettleT+1.
6) ThereissomethingcalledDelayedDeliverywhichreferstodeliveringasecuritybeyondstandarddates.Ifthereisaquestionregardingacustomerwhowantstoissueasecuritybutdoesnotwanttodeliveritfor30days,thiswouldbeanexampleofdelayeddelivery.
a. Anexampleofthiswouldbeamunicipalitythatissuesbonds.However,theydelaydeliveryfor30daysinordertoprintoutcertificates,shipthecertificates,andtoallowadequatetimeforanythingtheymayneed.
7) Ifacustomerbuysstock,hehasuntilT+3totakedeliveryoftheshares.Ifthesellerhappenstodeliverthesharesearly,thebuyermayrefusethatearlydelivery.Thismaybebecausethebuyersimplydoesnothavethemoneyanyearlierthanatthescheduledtime.
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Statutoryvs.CumulativeVotingRights
Shareholdershavevotingrights.Sometypesofvotingrightsmayprovidecertainbenefitsforcertainshareholders.YoushouldknowthedifferencebetweenStatutoryandCumulativeVotingRightsandwhattheyrepresentforshareholderswiththoserights.
StatutoryVotingRightsYoumayonlyvoteuptoyournumberofsharesforeachdirector.Thismeansthatifyouown100sharesandthereare5peoplevyingforadirectorspost,youmayvotewithupto100sharesforeachofthe5people.
CumulativeVotingRightsYoumayvoteyourtotalnumberofshares(thenumberyouowntimesthenumberofdirectorsupforelection)inanywayyoudesire.Thatis,ifyouown100sharesandthereare5peoplevyingforadirectorspost,youmayvotewithupto500sharesforasingleperson.Forthisreason,cumulativevotingrightsareconsideredabenefittolargeshareholderswhoaretryingtogetsomeoneelectedonacompanysboard.
Note:ThereisathirdtypeofvotingrightreferredtoasaContingentVotingRight,whichpertainstoPreferredShareholders.Typically,preferredshareholdersdonothavevotingrights.However,inthecasewherethecompanyfailstopayadividendtothepreferredshareholders,theycanthenissueavoteoncorporatematters,namelythosepertainingtounpaiddividends.
Proxy:Yougiveupyourvotingrightssoyoudonthavetogotoashareholdersmeeting.
VotingTrustIfacompanyisgoingbankrupt,aboardoftrusteeswillbeempoweredwithyourvotingrightsinordertoexpediteprocessesthatareexpectedtotakealongperiodoftime.
OptionContractAdjustments
WhentheOCCadjustsoptioncontractstheytrytobeextremelyconsistentonhowtheyapproachthingsbasedonthefollowing5parameters.
Fairnesstopositionholders Maintenanceofanorderlymarket ConsistentInterpretationandPractice EfficiencyintheExerciseProcess CoordinationwithOtherClearingAgencies
SpecialDividendIfthereisa5%specialdividenddeclaredonastock,therewillbeanOptionContractAdjustment.Ifitisa5%stockdividend,thedeliverableisadjustedfrom100sharespercontractto105sharespercontract.
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StockSplits:
Atraderowns1AugXYZ60CallandXYZSplits2for1.Thepostsplitpositionis2XYZ30Calls.
Atraderowns1XYZ60CallandXYZSplits4for1.Thepostsplitpositionwouldbe4XYZ15Calls.
o Inbothoftheseexamplesthedeliverableisstillthestandardforequityoptioncontractsof100shares.
Atraderowns1XYZ60CallandXYZSplits3for2.Thepostsplitpositionwouldbe1XYZ40Call,butthedeliverablewouldchangefrom100sharesto150shares.
Note:Exercisingyourtotaloptionpositioninanyofthe3examplesstillresultsinatotalstockpositionvaluedat$6,000.
Extraordinarydividends:Thereisathresholdwhereextraordinarydividendswouldcauseanautomaticadjustmenttotheoptioncontract5%dividendormore
Spinoffsituationsmayleadtosharesthatrepresentownershipinmultiplestocks.
StockDefinitions:
AuthorizedStockSharesthatmaybeissuedtothepublic.
CompaniesAUTHORIZEstock.
IssuedStockSharesthathavebeenissuedtothepublic.
OutstandingSharesSharesthathavebeenissuedtothepublicandtoinsiders.
Sharesthatareownedbyemployeesarestillconsideredoutstandingshares.
TREASURYSTOCKWhenacompanyrepurchasesshares,thosesharesbecomeTREASURYSTOCK.Thecompanyisnolongerpayingdividendsonthoseshares.
ParValueItdoesNOThaveANYrelationshiptocurrentvalue.Itisaminimumvalueatwhichacompanywouldsellmoreshares.
ParValueofPreferredStocksAcompanycouldissuepreferredshareswithparvaluedefinedas$10.Then,iftheystatethattheyaregoingtopay10%ofParasanannualdividend,thatwouldmean$1,REGARDLESSofmarketvalueofthestock.
StatedValueForaccountingpurposes,again,norelationshiptomarketvalueofshares
TransferAgentHandlesrecordkeepingforacompany,namelywhogetsthedividend.
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Preferredvs.CommonStock
Preferredstockusuallyhasnovotingrights Preferreddividendsareusuallypaidbeforecommondividends Inthecaseofliquidation,preferredshareholdersarepaidbeforecommonshareholders Bondholdersarestillhigheronthecreditorpeckingorderthanpreferredshareholders
TypesofPreferredStockholders
CumulativePreferredIftheyskipadividend,theyhavetopayitbacktoyoubeforethecommonshareholdersgetpaid.
NonCumulativePreferredTheycanskipadividendonyou
Optionsvs.Warrants
Warrants:
TheycanbearoundforalongtimeevenlongerthanLEAPS. Therearesomewarrantsthatareexchangetraded. Ifyouexerciseawarrant,sharescomefromthecompany,NOTfromthesecondary
market. Warrantscanbeperpetual!
Options:
Tradesonanationaloptionsexchange Fixedstrikesandexpirations ClearsthroughtheOCC Whenyouexerciseacalloption,theassignedpartymustdeliversharestoyoufromthe
secondarymarket. OptionsclearOCC,butwarrants,evenexchangetradedonesdoNOTclearOCC!
DividendsandExDividendDates:
Inordertoreceiveadividend,youmustbeastockholderofrecordontheRecordDate.Notethatforpurposesoftheexam,itmaynotmatterwhatelsetranspiresbeforeoraftertherecorddate.BeingastockholderofrecordONtherecorddateiswhatsimportant.
Forexample,simplypurchasingthestockbeforetheexdividenddateisNOTnecessarilyenoughtobeconsideredeligibleforthedividend.Thereasonisthatifyouweretopurchasestockthedaybeforetheexdividenddateandthenyouweretosellthestockoutlaterthatsameday,youwouldtechnicallyhaveboughtthestockbeforetheexdividenddatebutnotbe
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ashareholderofrecordontherecorddate.Thenyouwouldnotbeeligibletoreceivethedividend.Beawareofthiscaveat.
Exercisingacallthedaybeforetheexdividenddate(extendingthistoyoubeingashareholderofrecordontherecorddate)entitlesyoutoadividendevenifthecounterpartydoesnotfindouttheywereassigneduntilthenextday.
Asanadditionalnote,theexdividenddateistwodayspriortotherecorddate.Forthisreason,ismakessensethatregardingregularwaysettlement,youmustexercisecalloptionsthedaybeforetheexdividenddate,therebygivingyouthenecessaryT+3foryourstocktosettlebytherecorddate.
OntheTopicofIPOs
RegulationM:
ThisistheRegulationthatcoverstherestrictedperiodfollowinganIPO.ItprohibitsbiddingforsecurityduringrestrictedperiodbybankersordistributingbrokersinanIPO.Saidanotherway,ItrestrictsbankersandunderwritersfrombiddingonIPOsharesorfromtradingduringanapplicablerestrictedperiod.ThereisatimeperiodinwhichtheyarenotallowedtobuysharesintheIPO.
Thatsaid,investorsthatreceivesharesontheIPOareNOTrestrictedduringtherestrictedperiod.
IssuersarenotallowedtoparticipateintheIPO.OneoftheissuingbanksDOESparticipatebywayofaSTABILIZINGBID.OnlyOnefirmcanprovidethestabilizingbidonthefirstdayacompanygoespublic.ThisisabidBELOWtheIPOprice.
IfyougiveanindicationofinterestinanIPO,thisisaNONBINDINGinterest.
PennyStocks
Thesearestockstradingbelow$5pershare. Theyareconsideredextremelyrisky,andbecauseoftheirhigherlevelofrisk,youare
NOTallowedtotradethemonmargin. Furthermore,theSECrequiresspecialapprovalforcustomerstotradepennystocks.
However,youcanbuyorsellstocksunder$5toclosewithoutpermission.Therefore,youneedtofilloutadditionalpaperworkwhentradingPennyStocksunlessas
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previouslystated,youopenedapositionwhenthestockwasnotyetaPennyStockandyounowwantedtoclosethatposition.
StocksTradingUnder$1.00maybedisseminatedinincrementslessthanonecent.
CurrencyOptions:Youshouldknowthecontractspecifications.Namely,youshouldknowthattheJapaneseYenistypicallythecurrencythatdiffersfromallothers.Thisisforvariousreasons.
1) TheJapaneseYenistheonlymajorcurrencypairthatisquotedinYenratherthanUSdollars.
2) BecausetheYenisnotquotedinUSdollars,itthereforemakesitacurrencythatdoesnottradeinpennies!
3) Nevertheless,ALLcurrencyoptionsarecashsettledinUSdollars!
Furthermore,thestandardcontractvalueforallcurrenciesexceptfortheYenis$10,000.
Reserve(iceberg)OrdersTheseareordersinwhichacustomershowsasizethatismuchsmallerthanthetotalorder.Thisisoftendoneasatechniquetominimizetheorderseffectonthemarket.Oncethesmallshownsizeisfilled,theorderproceedstoshowsmallsizeagainuntiltheentirebalanceoftheorderisexhausted.However,muchlikeAllOrNone(AON)orders,becauseoftheirembeddedcontingency,ReserveOrdersdoNOTreceivecustomerpriorityonthehiddenpartoftheirorder.Theydo,however,receivecustomerpriorityonthedisplayedpartoftheorder.
Bullish,Bearish,andNeutralStrategies:
Forthispartofthestudyguide,ithelpstolearnthingsastheyaretaughtintheguideasopposedtowhatyoumayuseinrealtradingscenarios.Donotoverthinkthequestions.
TypicalEquity(Stock)Strategies:
Long(owningsharesbecauseyouthinkthestockwillgoupinthefuture) Short(sellingsharesbecauseyouthinkthestockwillgodowninthefuture) Dividend(owningsharesfordividendincome).
Reasonstobuyacall:
Tolockinapurchaseprice Asanalternativetobuyingstock Tohedgeashortstocksale
Motivationsforacoveredcall:
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Toincreaseportfolioincome Tohedgeaposition
MotivationstoSellaPut
Toincreaseportfolioincome Toacquirestockbelowcurrentprices
NakedcallYouhavenooffsettinglongstockorlongcallposition
NeutralStrategies
ATMCoveredcallwritingisconsideredneutral. Straddlewritingandcombinationwritingarealsoconsideredneutral.
BullishStrategies
OTMCoveredCallwritingisconsideredbullish BullSpreads(LongCallSpreadsandShortPutSpreads)
BearishStrategies
NakedCallSelling BearSpreads(LongPutSpreadsandShortCallSpreads)
Youshouldalsobefamiliarwithbasicputcallparity,usingonlycalls,puts,andstock(nointerestordividendconsiderations.
BesuretoKnow
IntheMoney(ITM) AttheMoney(ATM) OutoftheMoney(OTM) Thefivebasicoptiongreeks(delta,gamma,vega,theta,rho) ThedifferencebetweenBroadBasedvs.NarrowBasedindexes
ExerciseCutOffTimesforAmericanStyleIndexOptions(OEX)3:20p.m.CentralTime.
AMCashSettledOptions(SPX)Thesettlementvalueisbasedontheopeningprintofeachstockcomprisingtheindex.ItisNOTbasedonanaveragepriceofeachstock.Becarefulnottogettrickedupbythis.Optionsceasetradingthedaybeforethesettlementvalueisobtained.
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O.C.C.ClearingProceduresOCCwillRANDOMLYassignexercisedoptionstoClearingMembersthatholdshortoptionsinthosecontracts.ThoseClearingMembersmaythendistributethoseassignmentsinanonrandom,butstillfairprotocol.
Priortoexpiration,MarketMakersturninexerciserequeststotheirMemberClearingFirm.NOTtotheExchangeandNOTdirectlytotheOCC.OncetheirrequestsarereceivedbytheirMemberFirms,thosefirmsinturnsubmittherequeststotheOCC.
ETFsExchangeTradedFunds
Itisanequitylikesecuritythattracksanindexorbenchmark,buttradeslikeastockonanExchange.ETFsmaybeboughtorsoldthroughoutthetradingday.
AnauthorizedparticipantborrowssharesandplacestheminatrusttobacktheissuedsharesoftheETF.ThisisreferredtoasaCreationUnit.Atypicalcreationunitis50,000shares,butthesizemayvary.
TheholderofanETFmayexithispositioninoneoftwoways:
First,hemaysellhisETFsharesintheopenmarket.
Second,hemayredeemhisshares.
However,inordertoredeemhisshares,aholderneedstoownatleastasmanysharesasthoseinastandardcreationunit.Whilethisnumberistypically50,000shares,dependingontheETF,thatnumbercanrangewellintothehundredsofthousandsofshares.Forthisreason,thissecondmethodofredemptionisonlyavailabletoinstitutionaltraders.
BecauseETFstradeonExchanges,theyarenotsubjecttocounterpartyrisk.
ETNsExchangeTradedNotes
ThesearedebtinstrumentsandunlikeETFs,ETNsDOhavecreditrisk.
ADRs,ADSs,andGDRs
ADRs(AmericanDepositoryReceipts)areinstrumentsissuedbyaUSinstitution.Thentheybuyforeignsharestobackthoseinstruments.
GDRs:(GlobalDepositoryReceipts)LikeADRs,buttradeinmorethanonecountryandinmultiplecurrencies.ThesearelikeADRsbutinmultiplecurrencies.IssuingorDepositorybanksaresupposedtokeepupwithwhotheownersareanddistributedividends.
ENDOFCHAPTER3REVIEW
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Chapter4Review:Approximately50Questionswillstemfromthischapter.
Thischapteristhemeatoftheexam.
OntheTopicofOptionPrincipalsandonSupervisionofAccounts.
Eachfirmshouldhaveatleastoneoptionsprincipaliftheyaretransactingoptionsbusiness.TheyshouldbeapprovedbytheSRO.Toopenanoptioncustomeraccount,youcannotacceptanoptiontradeuntiltheaccounthasbeenapproved.Itshouldbeapprovedinwritingbytheoptionprincipal.
Branchofficesshouldhaveanoptionprincipal(usuallythebranchmanager)unlesstheyhave3orfewerprincipals(registeredindividuals)atthebranch.Anoffsitepersonmayapproveaccountsinthiscase.
Branchofficesshouldhaveanoptionprincipal(usuallythebranchmanager)workingatthefirmunlesstherearethreeorfewerregisteredpeopleatthebranch.Therewillbeanoptionsprincipalwhosupervisestheseofficesfromoffsite.
Verylargeoptionsfirmsmaydelegatesupervisoryauthoritytoqualifiedemployees.Theseprocedures/rulesmustbeinwriting.
AllOrNoneOrdersBecauseoftheirembeddedcontingency(allornone),theseordersarenoteligibleforcustomerpriority.Furthermore,theyarenoteligibletobedisplayedaspartofNBBOandtheymaybetradedthrough.
TheManningRule:
TheManningRuleprohibitsanNASDmemberfirmfromplacingthefirmsinterestbeforethefinancialinterestsiftheclients.Thiswouldinclude:
1) Notroutingorderstothebestmarketplaceinordertotakeadvantageofpaymentfororderflow(alongtheselines,paymentfororderflowinandofitselfisPERFECTLYLEGALprovidedthattheclientstillobtainsthebestexecution).
2) Ifafirmhasacustomerlimitorderandafirmlimitorder,thefirmshouldNOTexecutethefirmsorderaheadoftheclientsorder.
PublicCustomerOrdersmustbeindividualorders.AsaBD,youcannotgroupyourorderwithacustomerordertogetthesamepriority.
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TreasuryStock
StockthathasbeenrepurchasedbyacompanyisknownasTreasuryStock.Becausethestockisbackinthecompanyscoffers,TreasuryStockshareshavenovotingrights.
StepOutvs.GiveUpTrades
AStepOutfunctionsmorelikeaclientpositiontransferratherthanasatrade.Thereisnoexchangeofsharesorfunds,andthereisnochangeinbeneficialownership.Basically,BrokerAexecutesatradeonbehalfofitsclient,collectshiscommissionforexecutingthetrade,butlateron,thetradeisallocatedtotheclientsaccountwithBrokerB.
AGiveUpiswhentheexecutingbrokerplacesatradeonbehalfofanotherbrokerasifthatotherbrokerwasreallytheonethatexecutedthetrade.Thisistypicallyseenincaseswhereabrokeristoobusytoexecuteatradeforaclient,soheasksanotherbrokertoplacethetradeforhim.Inthiscase,ifBrokerAexecutesatrade,heisdoingsoonbehalfofBrokerBsclient.BrokerAdoesNOTcollectacommission(BrokerBdoes).TheclientstradeisreportedinBrokerBsbooks,indicatingthatthisisstrictlyBrokerBsclient.Onasidenote,aGiveUpmayalsorefertothedisclosureofyourClearingFirmnumberaspartofatransaction.
OrderTicketsThingsthatarerequiredonanorderticket:
1) ClearingHouseNumber(orAlphaSymbol)2) ClearingHouseNumber(orAlphaSymbol)ofcounterparty3) SecurityandOptionsymbolinformation4) TransactionDate5) NumberofContracts,Buy/Sell/SellShort,Opening/Closing6) TransactionPrice7) AccountNumber8) MarketCenterwheretransactionwasexecuted
YoumayseeaquestionaskingwhichisNOTrequiredonanorderticket,somakesureyouknowthe8pointsabove.
Exchangesdeterminewhatgoesonanorderticket.
Reg.SHOThisistheRegulationthatpertainstoanyshortsellingofstocks.
Therearedifferentwaysforasellordertobemarked.
Sell(long),SellShort,SellShortExempt
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AggregationABDmayaggregateallfirmwidelongandshortpositionsinordertodetermineanetfirmpositionforpurposesofsellingshort,providedhemeetsthefollowingrequirements:
1) Alltradersintheaggregationunitpursueonlythetradingobjectivesorstrategiesofthataggregationunit.Thisismeanttopreventpeoplefromclaimingthattheyareapartofanaggregationunitwhentheyneedtosellshort,butactingalonewhentheydontneedtosellshort.
2) Theaggregationunithasaspecificallydefinedplanoforganizationandtradingobjective.
3) Individualtradersareassignedtoonlyoneaggregationunitatatime.
LocateRequirementsAshortseller(orthebrokerrepresentinghim)shouldhavereasonablegroundstobelievethatasecuritythatistobesoldshortmaybeborrowedanddeliveredbythedeliverydatepriortohavingashortsaleexecuted.
HavingaLocatemeansthatyouhavesharesthatyouhavedesignatedtoborrowanddeliverthemtothebuyerthatyouhavesoldshortto.
AviolationofRegulationSHOisnotbeingcertainthatyouwillbeabletodeliveronyourrequirement.Asabroker,yourenotsupposedtoacceptasellshortorderinwhichyouhavereasonablegroundstobelievethattheclienthasnotfoundalocate.
ThresholdSecuritiesThereisalistpublishedbytheExchangesthatrepresentsthepublicaccountingofcurrentfailstodeliver.
AsecuritywillmaketheThresholdListifitmeetsANYofthefollowingcriteriaoverfiveconsecutivesettlementdays.
1) Thetotalnumberofsharesthatfailedtodeliverexceeds10,000shares.2) Thetotalnumberofsharesthatfailedtodeliverexceeds0.5%oftheoutstanding
shares.3) ThesecurityislistedonanotherExchangesthresholdlist
InorderforasecuritytoberemovedfromtheThresholdList,itmustfallbeneaththebenchmarkstandardsforfiveconsecutivetradingdays.
ApubliccustomershouldLOCATEsharestoborrowfordeliverybeforeexecutingashortsale.Thatsaid,alocatedoesNOThavetobeassuredmultipletimesinaday.Thismeansthatitisnotnecessarytofindalocateaftereachandeveryexecution,providedaninitiallocatewasfound.
ThreeviolationsofReg.SHOare:
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1) Sellingstockshortwithouthavinglocatedstockfordeliveryatsettlement2) Sellingstockshortandfailingtodeliversharesatthetimeofsettlement3) Sellingstockshortandfailingtodeliversharesatthetimeofsettlementwiththe
purposeofdrivingdownthesecuritysprice.
StockFuturesdoNOTneedtobeborrowedorlocatedbeforesellingshort.
Mustknowthedifferencebetweensellinglongandsellingshort.
IfastockisNOTownedbyaseller,itshouldbemarkedasashortsale. IfastockISownedbyaseller,itshouldbemarkedasalongsale. IfIbuysharesinXYZandsellthemlong15minuteslater,thatsnotaviolationeven
thoughstockhasntsettled.
Marketmakersareexemptfromhavingtofindalocateprovidedthattheyareinvolvedinbonafidemarketmakingactivity.
MarketMakersMUSTmarkshortsalesshortexempt.ThisallowsthemtotakeadvantageoftheT+6provisionexplainedbelow.Thatsaid,
Youcannotemployamarketmakerforthepurposeofshortingstock. Ifyouareamarketmakerdisplayingaonesidedmarketandendupshort1Mshares,
thatsanexampleofnotbeingabonafidemarketmaker. YoucannotusesomeoneelsesMMstatustosellstockshort
Inordertoavoidafailtodeliver,
1) CustomersshoulddelivershortstockbyT+32) MarketMakershaveuntilT+6untiltheyfail
a. Formarketmakersonly,inordertocloseoutafailtodeliveronT+4orT+5,theymaybuythesharesortheymayfindalocate.However,onT+6,findingalocateisnolongeraviablealternative.Thesharesmustbeboughtin.
b. IfamarketmakerfailstodeliverbeyondT+6,thenthepenaltyincurredisthatthemarketmakerwillnolongerbeallowedtosellsharesshortuntilhebuysthosesharesbackANDthosesharessettle.
c. SupposeamarketmakerhasshortstockpositionsatT+4,T+5,andT+6.Supposethatthenextday,themarketmakerfailstodeliversharesonwhatisnowT+7.Then,themarketmakermustfaceapenaltyonthesharesthatfailedtodeliver,butnotonthebalanceoftheshares(thosestillatT+5andT+6).
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InsiderTradingandInsideInformation
Knowwhatmaterialnonpublicinformationis.Ifyouhavematerialnonpublicinformation,then,
Donttradethestock Donttradethederivatives. Dontdiscloseinformationthatsomeoneelsemaytradeon.Youdbeintroubleforthat,
evenifyouyourselfdidnotactontheinformation!Afirmshouldannuallyletyouknowwhatinsideinformationisandyouaresupposedtosignsomethingannuallytoshowthatyouareawarethatinsidertradingisillegal.Onsite,yourfirmshouldhaveyourlasttwoyearsattestations.Thirdyearmaybeataremotelocation.
Yourfirmshouldalsogetallofyourbrokerageaccountstatements.Again,threeyearstotal,andtwoyearsonsite.
PeoplewithnonpublicinfoFirmswithaccesstomaterialnonpublicinformationshouldbedocumentingwhoisworkingonsuchdealstohavedocumentationinplacetofigureoutwhomaybeaculpritincasethereisabreachofinsideinformation.
ChineseWallViolations
TherearetwotypesofChinesewallviolations.Thefirstisabreachofbarrier.Thisoccurswhensomeoneinthefirmwithsensitivematerialinformationsharesinformationwithanothermemberofthefirm.Thesecondisalackofbarrier,whichiswhenthemembersofafirmthathavesensitivematerialinformationarenotseparatedfromeveryoneelse.Assuch,informationisallowedtobeaccessedbyanyone,evenwithoutdirectintent.
AfirmisresponsibleforsettinguppropersafeguardssuchthatChineseWallsarerespected.AChineseWallviolationMUSToccurbetweentwopeoplethatworkforthesamefirm.
NOThavingaDoNotTradeListisaviolationofChineseWallprotocols.
Thatsaid,ifyouaccidentallytradesomethingonaDoNotTradelist,youshouldcontactyourcomplianceofficerimmediately.DONOTTRADEOUTOFIT!Tradingoutofsomethingyouwerentsupposedtotradeinthefirstplaceonlydoublestheliability.
FrontRunningvs.TradingAhead
FrontRunningreferstothepracticeofhavinginformationaboutalargetradethatisabouttotakeplaceandusingyourpositionasaBROKERtomaketradespriortothelargetradebeingexecutedandimpactingthemarket.
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TradingAheadisthesamethingasabove,exceptthatitisdonebyANYONE.
RegulationFD(FairDisclosure)Thisregulationwasestablishedtoprohibitselectivesharingofmaterialinformation.
RegulationFD(FairDisclosure)ComesunderissuersIfIamanissuerofstockandIreleasenewstoasmallgroupthatissensitivetomycompany,IneedtoissueapressreleaseASAP.Youcannotselectivelygiveoutmaterialinformation.
AbrokeragefirmthatismakingachangeinrecommendationofastockandstartstoinformclientsdoesnotrepresentaviolationofRegulationFD(FairDisclosure)becausethebrokeragefirmisnotanissuer.
Sixspecificprohibitedtradingactivities:
NochangeinbeneficialownerTradingwithyourself MisleadingappearanceofactivetradingTradingbackandforthtocreatefalse
volume InducingPurchaseorSalebyOthersTradingtomovepricestogetotherstoact.It
mustinvolveatransactionorsetoftransactions! Sendinginformation(trueORfalse)withintenttomoveastockSpreadingaRumor
(doesnotrequiretransactions). DisseminationofInformationforConsiderationSameasabove,butformoney. Pegging,Fixing,orStabilizingGroupofTraderstrytogetanunderlyinginstrumentto
closeatastrikeYoushouldreallyKNOWtheabovedefinitionsandyoushouldhaveanexampleinyourheadregardingeachofthedefinitions
Ifthereisatenderoffer,forexample,ifalargeholderwantstobuyacompany,theyrenotsupposedtoputanyunduepressureorsolicitpeopletotendertheirshares.
KnowthattheRegulationisdesignedtopreventselectivedisclosurebytheissuer.
Specifically,Reg.FDpertainstoISSUERSreleasinginformation.Thecompanyistheissuerofastock.Therefore,anysensitiveinformationreleasedbythecompanyisgovernedbyReg.FD.
Brokersarenotissuers.Therefore,anystatementstheymaketotheirpreferredclients(suchasissuingaresearchreportonastock,orupgrading/downgradingastock)arenotconsideredviolationsofReg.FD.Inaddition,TreasurySecuritiesarenotcoveredunderReg.FD.
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UnderReg.FD,ifacompanyofficialmistakenlysharesinformationwithalimitednumberofpeople,thatofficialshouldremedytheerrorbyquicklysharingthatinformationpublicly.Thiscouldmeanholdingapressconference,orissuingapublicstatementassoonaspossible.
Example:IfyouareatdinnerwiththeCEOofacompanyandheleakssensitivematerialinformationtoyou,youshouldDONOTHING!DoNOTtradethestock,donottradederivativesonthestock,anddonottellanyoneelsewhomaythentradeonthatinformationbecauseitcouldlandyouintrouble.
ENDOFREGULATIONFD.
DutchAuctionYoumustunderstandhowtheseauctionswork.Inatypicalauction,thereisareservepricefromwhichthingstypicallybegin.Thegoodsarethenbidupandtheyaresoldtothehighestbidder.InaDUTCHAUCTION,however,theprocessisdifferent.Theparticipantsentertheirbidsandquantitiespriortothestartoftheauction(e.g.,thisishowmuchImwillingtopayandthisishowmuchIwantatthisprice).
TheauctioneerthenhaseveryonespricesandeveryonessizeANDhehasareserveprice,thatis,apricebelowwhichhewillnotsellanymoreofhisasset.
Theauctioneerthenbeginstheauctionatthehighestprice.Ashelowerstheprice,thenumberofbidsnaturallyincreases.TheauctioneercontinuestolowerthepriceuntileitherhisentireorderisfilledORhisreservationpriceismet.
Iftheauctiongetstothepointwheretheentirebalanceoftheorderisfilled,atradewilltakeplaceandALLshareswilltradeatthelowestbidpricethatqualifiedfortheauction.
Ifthereservationpriceismetbeforeatotalfillisachieved,thenthequantityofsharesthatwerebidforatthereservationpriceorhigherwilltradeatthereservationprice.However,thisimpliesthatnotallauctionedshareswillbetraded.Therefore,whateverthetotalpercentageofsharesthattrades,thatisthepercentagethateachmarketparticipantwillreceiveatthereservationprice.
AntiMoneyLaundering
EveryMemberFirmshouldhaveanantimoneylaundering(AML)policyinplace.Whilethereisnosetcriteria,MemberFirmsshouldfollowtheguidelinesissuedviatheBankSecrecyAct.FirmsshouldofferAMLtrainingonanannualbasis.TheBankSecrecyActhastheguidelinesfortheserules.Youwanttomonitoryourfirmandindividuals.YoucomeupwithyourownAMLrulesatyourfirm,buttheyhavetofollowtherulesoftheBSA.TheyMUSTbeinwriting!
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Youhavetohavepoliciesinplacetocheckformoneylaundering.Youmayhaveoutsideinvestigatorscomeinandmakesurepeoplecantslipthingsbyyou.Thereshouldbeannual,writtentestingofemployees.Thereshouldbeonepersonatthefirminchargeofimplementingthisprogram.
AspartofAMLprotocol,MemberFirmsshouldroutinelychecktheOfficeofForeignAssetControls(OFAC)Listtocheckforfirms,countries,andindividualswithwhichwedoNOTconductbusiness.Newclientsshouldalwaysbecheckedagainstthatlist.Thelistmaychangefromtimetotime.Thislistshouldbecheckedperiodically,sinceonceacountry,firm,orindividualisonthatlist,theaccountmustbeclosedevenifthatentitywasnotonthelistwhentheaccountwasinitiallyopened.
TheantimoneylaunderingprotocolmayalsobereferredtoaspartofthePatriotAct.
WashSaleRuleThisisanIRSRulethatprohibitstaxpayersfromclaimingalossonastockthatissoldandsubsequentlyrepurchasedwithin30days.Itinvolvesatradertryingtotakeadvantageofalongertermlossinastock.Ifyousellastocktotakealongtermloss,youcannotbuythestockbackfor30days.Ifyoudo,itisnolongeralongtermloss.
PaintingtheTapeThisisdefinedastheconstantenteringofbuyandsellordersinanattempttocreatefalsevolumeinordertodrumupinterestinaparticularsecurity.
SpoofingThiscanhappenonthebidortheoffer,butforthesakeofsimplicity,letslookatwhathappensonthebid
Amarketparticipantentersanordertosellontheoffer.HethenentersaSizablebidbelowthecurrentbidwithoutintendingtohavethatbidexecuted.Theparticipantintendstocancelthebigbidifeitherthesellorderisfilledorifthebetterbidisremoved.ThisisSPOOFING.
SelfHelpIfanExchangedeclaresselfhelpagainstanotherExchange,itmeansthattheotherExchangesquotesmaybeunresponsive.Then,thefaultyExchangeisnotifiedbytheotherExchangethatitsquotesareunresponsive.Asaresult,theotherExchangeisallowedtotradethroughthemalignedExchangesquotes.
PositionLimitsForquestionsregardingpositionlimits,youdoNOThavetoknowspecificlimitsforspecificproducts.Youwilltypicallybegiventhepositionlimitsthataquestionwantsyoutouse.HOWEVER,thatamountmaybegiventoyouineitheroptioncontracts(e.g.25,000contracts)oritsshareequivalent(e.g.2.5MillionShares).
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Thetablebelowhas3examplesofpotentialpositionlimitviolations.Thesimplewaytoapproachthesequestionsistoturnthepositionlimitintoshares(e.g.25,000optioncontractsinto2.5Mshares)andseeifthereisanypotentialwayinwhichthesharenumbercanbeexceededatexpiration.ThatbeingthecaseExample1isa25,000contractcallspread.Thispositionfallswithintheguidelinesofthe25,000contractpositionlimit.ItisNOTaviolation.Example2has25,000longcallsand25,000longputs.ThatisALSOok,sincelongcallsandlongputsareonthesamesideofthemarketforpurposesofaggregatingsharepositions.Thereisnowayyoucouldendupwithmorethan2.5Msharesatexpiration.Example3DOESrepresentaviolationbecauseifthestocksettlesbetween$50and$55pershare,youcanseethatthereisawaythatthispositioncanexceedits2.5Msharelimit.NOTEthatpositionlimitsmaybeexceededwithproperdeltahedging.
Calls Strike Puts
+25,000 50 +0
25,000 55 0
Calls Strike Puts
+25,000 50 +25,000
0 55 0
Calls Strike Puts
+12,000 50 +15,000
13,000 55 10,000
BeawarethatPositionLimitsaresetbytheExchanges.Also,ifyouaredeltaneutral,youcanexceedpositionlimitsviasomethingcalledadeltahedgeexemption.
RecordKeeping
Mostrecordsmustbekeptforaperiodofthreeyears,ofwhichtwoyearsmustbeonsite,whilethethirdyearmaybeinaremotelocation.
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MarketMakerrecordsmustbekeptforSIXyears.
Interpositioning
Theinvolvementofathirdpartybetweenabrokerdealerandthebestavailablemarketpricethatresultsinthecustomerpayingabiggermarkupormarkdownthanwouldhavebeenthecaseifthethirdpartyhadnotbeenpresent.
RisklessPrincipalAtransactioninwhichaBD,afterhavingreceivedanordertobuyasecurity,purchasesthesecurityasprincipalatthesamepricetosatisfytheordertobuy,exclusiveofanyexplicitlydisclosedmarkupormarkdown,commissionequivalent,orotherfee,or,afterhavingreceivedanordertosell,sellsthesecurityasprincipalatthesamepricetosatisfytheordertosell,exclusiveofanyexplicitlydisclosedmarkupormarkdown,commissionequivalent,orotherfee.
Basically,itreferstothebrokerholdingtheresultingexecutedorder.Fromthebrokersstandpoint,thatorderisnotatrisk.Itisonlyatriskfromthecustomersperspective,sincetheorderwasexecutedonbehalfofthecustomer.
PrimeBrokerIfyourunahedgefund,youmayuseasmanyexecutingbrokersasyouwant,butyoumayhaveonebrokerthatholdsallyourpositions.ThatsthePrimeBroker.
Reg.NMS(NationalMarketSystem)Thisistheregulationthatcameintoexistencetohaveallthedifferentexchangesquotesunderoneumbrella.Allthenationalexchangesmustsharetheirquoteswitheachotherandmustsharetradereportswitheachother.
Theymustalsorouttoeachotherforpurposesofbestexecution.
PlanProcessorThisispartofReg.NMS.andreferstoanySROorsecuritiesinformationprocessoractingasanexclusiveprocessorinconnectionwiththedevelopment,implementationand/oroperationofanyfacilitycontemplatedbyaneffectivenationalmarketsystemplan.
Rule610(AlsopartofReg.NMS):PricingofAccesstoquotesmustbenondiscriminatorytoProfessionals,especiallythosewhoarenotmembersofyourexchange.Exchangesshouldnothavediscriminatorytermsformarketparticipantswhenitcomestochargingforquotes.
AlsounderRegulationNMS:Thereisa30secondresponse.Ifyoureceivealimitordertosell200contractsandyouarebidfor100contractsatthesameprice,youmay
Buy100contractsandroutebalanceiftheycanbefilledaway
Buy200contracts
Youhave30secondstodecide.
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Aspecialistshoulddisplayacustomerlimitorderanditssizewhenthecustomerlimitorderisequaltothebestbidorbestoffer.
ExplanationofDeMinimischange
IfyouareaSpecialistandyouarebidfor,say,amillionshares,andacustomerordercomesinwitha300sharebidatthesameprice,youdoNOThavetoupdateyourbidtoreflectonemillionthreehundredshares.ThesmallchangeinbidsizerelativetotheexistingbidiswhatisreferredtoasaDeMinimischange.
Ontheotherhand,ifyouareaspecialistandyouarebidfor300sharesandsomeonejoinsyouatthesamebidpricefor200shares,youshouldreflectanewbidof500sharesbecausethechangeislargerelativetotheoriginalbidsize.
Ifyoureceiveanordertobuy100sharesandyouarebidfor100sharesandyoubuyforthecustomerinsteadofyourownaccount,youdonothavetodisplaythe100sharespriortotradingthem.
Oddlotordersdonothavetobedisplayed.
Anycontingentorderdoesnothavetobedisplayed(AON).
Rule605Allthedifferentexchangesmustbeabletoproducealistofordersthathavebeenroutedtothembydifferentbrokersonamonthlybasis.
Rule606Everyquarter,brokershavetogiveareportontheroutingoftheirordersinordertocomplywiththeManningRule.
CustomerrequestonorderroutingUponRequest,theymusttellyouwhereyourorderswent.
Ifyouareaclientofabrokeragefirm,youcansay,Iwanttoseewhereyouroutedordersforthelast6months.Annually,theyhavetotellyouthatyoucangetaccesstothatinformation.
Rule610:PricingofAccesstoquotesmustbenondiscriminatorytoProfessionals,especiallythosewhoarenotmembersofyourexchange.Exchangesshouldnothavediscriminatorytermsformarketparticipantswhenitcomestochargingforquotes.
Youshouldtrytoavoidhavinglockedquotes(wherethebidofonequoterequalstheofferofanotherquoter),oneitherthesameoronseparateexchanges.
Youaresupposedtotrytoprotectagainsttradethroughs.
ENDOFREGULATIONNMS
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OnthesubjectofBroadvs.NarrowBasedIndexes,knowyourstocksymbols.SPX,RUT,DJX,andNDXareBroadBasedIndexes.DOWisNOTthesymbolfortheDow(DJIAorINDU).Rather,itisthesymbolforastockcalledDowChemical.
MarkingtheCloseisillegalanddoesnotnecessarilyhavetoincludeatrade.Forexample,ifaMarketMakeruptickshisbidsontwoconsecutivedaysfiveminutesbeforetheclose,thatsanexampleofMarkingtheCloseevenifnotradestookplaceonthetightermarket.
Riskbasedhaircutappliestoprofessionals.Thereare15%movesinindex.Knowthedifferencebetweenriskbasedhaircutandcustomerportfoliomargining.
CustomerPortfolioMargining(CPM)Firmmustbeauthorizedforit.Knowwhatitis.
TransferPackagesareexchangespecific.
BothparticipantsinaJBO(JointBackOffice)mustberegisteredBD,musthaveaSeries27principalonstaff,andbothparticipantsmusthave$1M.
ENDOFCHAPTER4REVIEW
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Chapter5Review:
Approximately13Questionswillstemfromthischapter.
OrderPriority
Customers:PriceTime
Theyhavefirstoverallpriorityandmustbetradedwithinjustaboutallcaseswheretheyareonaparticularoptionmarket.
BDs:ProRataa.k.aPriceSizeTime
ThereisnopricetimepriorityregardlessofwhentheyenteredtheorderbookUNLESSmultipleBDsshowequalpriceandsizeandthereisanoddnumberofcontractsthatneedstobedistributed.
AdditionalNotes
Eachexchangeshouldmakeavailabletoallofitsmemberswhatallthecustomerpublicordersare,sothatthereisnomistakeregardingpossibletradethroughs.
AllorNone(AON)orminimumquantityorderslosetheirpricetimepriority. Reserve(Iceberg)orderslosetheirpricetimepriorityonthehiddenpartoftheorder.
LockedandCrossedMarkets ALockedMarketisoneinwhichthebestbidequalsthebestoffer. ACrossedMarketisoneinwhichthebestbidexceedsthebestoffer.
IntermarketSweepOrders(ISOs)andLinkage
Atsomepoint,theregulatorybodiesdemandednotonlymultiplelisting,buttheyalsorequiredamannerinwhichtomakesurethatNBBOwashonoredandthattradethroughswereeliminated.ThiswasthebeginningoftheLinkageProcess.ThroughLinkage,ordersaresenttoALLexchangeswithbetterquotes.Wherevertheorderisfilled,thatiswheretheorderisrecorded.Definition:ATradeThroughisatransactionthattakesplaceoutsideofNBBO.Example:Supposewehavethefollowingmarketsforaparticularoption:CBOE 2.202.40AMEX 2.102.30ISE 2.002.30,2.35(meaningthattheresa2.35offerbehindthe2.30offer)
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AnordercomestotheCBOEtobuy20contracts.Eventhoughotherexchangeshavebetteroffers,thesystemdeliversaFlashtoallCBOEmarketmakerstoseeifanyoneisinterestedinsellingtheoptionsat2.30.Ifso,thetradestaysatCBOE.Ifnot,anISO(IntermarketSweepOrder)isexecuted.TheISOProcessASweeporderisaLIMITorderthatwillsweepthetopofmarketofALLexchangeswithbetterpricesthanCBOE.Forthisexample,thismeansthatthe2.30offerontheAMEXaswellastheoneontheISEwillbehit.Notethatthe2.35offerontheISEwillNOTbehitbecausewhileitisabetterofferthanCBOEsoffer,itisNOTtopofmarket(rather,itisonelevelbehindthetopofmarket).Atthatpoint,theSweeporderreturnstoCBOEandtheprocessrepeatsitselfwitha150msFlashtoseeifanyonewantstoselltheoptionsat2.35.Ifso,theorderremainsatCBOE.Ifnot,asecondsweeporderissenttargetingthe2.35offeronISE,whichisnowtopofmarket.NoLinkageOrders:Forvariousreasons,afirmmaydecidetosendanordermarkedNoLinkage.Ifthatoccurs,marketmakersontheexchangeinwhichtheorderoriginatedwillreceiveaflashtoseeifanyonewantstotradeatNBBO.Ifso,thetradeisexecutedonthehomeexchange.Ifnot,theorderiscanceled.ReminderofAONOrders:Becauseoftheirnonstandardcondition,AONordersareNOTallowedaspartofNBBO.Therefore,therecannotbeatradethroughofanAONorder.
ElectronicCommunicationNetworks(ECNs)AlternativeTradingSystems(ATS)TheydoeverythinganationalsecuritiesexchangedoeswiththeexceptionofSROauthority.Theydonthavespecificrules.Theirwholeideaistofacilitatecrossesamonglargeinstitutions.Theycankickyouout,buttheycannotdisciplineyou.Exampleisdarkpools.
DarkPools,ECNs,a.k.a.AlternativeTradingSystems(ATS)ThereareguidelinesthatmustbefollowedbyDarkPoolparticipants.DarkPoolsandotherECNsrepresentameansforBDstooperateautomatedtradingplatformstocollectandexecuteordersinsecuritieselectronicallyandwithoutregisteringasanationalsecuritiesexchange.
AsanexchangeorECN,youshouldhavearoutingmechanismtosendorderstothebestmarkets.
Tradingcenters(exchanges)andECNsshouldtrytheirbestnottoallowtradethroughs.
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Insofarasregulationgoes,anATSmayNOTsetrulesgoverningtheconductofsubscribers.TheymayNOTdisciplinesubscribersotherthanthroughexclusionfromtrading.Tosetdisciplinaryrules,anECNmustregisterasanationalsecuritiesexchange.
InordertoacquireATSstatus:
1) AfirmmustfirstberegisteredasaBD2) ItmustfileaninitialoperationreportwithrespecttothetradingsystemonformATSat
least20Daysbeforecommencingoperation.NotefurtherthattheSECdoesnotactuallyapprovetheATSfiling.However,thefilingmustcomplywithallapplicablerequirementsunderReg.ATS
3) Theinitialoperationreportmustbeaccurateandmustbekeptcurrent
TheObviousErrorRule
Allexchangetradesarebindingcontracts.Promptlyuponfindingoutabout(an)unmatchedtrade(s),youshouldtrytoreconciletheunmatchedtrade(s).
Thatsaid,thereareproceduresavailabletoaddressObviousErrors.
OnceamarketparticipanthasfoundreasontocitetheObviousErrorRule,hemustfollowtheensuingtimeline:TimelineforReportingofObviousError
1) 15MinutestoReporttheObviousErrorREMEMBERTHISONE!!!2) 60MinutesfortheCommitteetoReviewtheCase3) 30MinutestoAppealtheDecision
TradeReportingandTRFTradeReportingFacilityThisiswherethingsgetreportedtothetape.ItisanautomatedtradereportingandreconciliationserviceoperatedontheACTtechnologyplatform.ItmaybeusedforNASDAQlistedsecuritiesaswellasforNYSEandotherregionalexchangelistedsecurities.
TheTRFhandlestransactionsthatarenegotiatedbrokertobroker.
Youhave30secondstoreportthesetrades.Duringnormaltradinghours,ifatradeisNOTreportedtothetapewithin30seconds,itshouldbereportedasquicklyaspossibleanddesignatedLATE.
OTCtransactionsthatinvolveatleastoneFINRAmembermustbereportedtothetapewithin30seconds.If2FINRAmembersareinvolved,thentheselleristypicallythereportingparty.
Youcandoequitytradesbetween12a.m.and8a.m.EST.Theygetreportedby8:15am.Ifthemarketisclosed,buttheFINRAreportingfacilityisopen,thetrademustbereportedwithin30
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secondsofexecution.Anythingthattradeslateatnight(after6:30p.m.EST)isreportedthenextdayby8:15
Onthesubjectoftrades,everytradeMUSThavewhatisreferredtoasaBeneficialChangeinOwnership.Thatis,youcannottradewithyourself.Thisincludestwopeopletradingwitheachotherwhentheyshareanaccount.
Furthertothatpoint,ifatradewasmadeinerroranditisallowedtobeundone,itmustbeBUSTEDorADJUSTED.Whateveryoudo,doNOTsimplymakeatradethatdoestheopposite!Thatsimplycreatesfalsevolumeandisillegal.
TheTradeBlotterArecordoftradesandthedetailsofthetradesmadeeachday.Thesedetailsincludethingssuchasprice,timesize,andbuy/sellinformation.TradeBlottersincludeexecutions,NOTunfilledorders.
Onaseparatenote,Firmsshouldrecordalltheirbidsandoffersinthesamewayexchangesrecordtheirs.ThisissoFINRAcancomeinandinvestigate.
AnOfficeSupervisormustreviewtheTradeBlotteronadailybasis.HeshouldalsoreviewInstantMessagesandPhoneCalls.HedoesNOThavetoreviewoutsideresearch.
FastMarkets
Itispossiblethatyoucouldgothroughopeningrotationmiddayincaseofafastmarket.Ifaftertheopeningrotation,youarestillinafastmarket,theoptionsmaybehalted.
Exchangescanhalttradingfor2days.Iftheexchangefeelsthatitcannotrestoreorderafter2days,itmaycontinuetokeepthestockhalted,buttheremustbeareviewafter2days.
Ifthestockishalted,theoptionsarehalted.
Indexoptionsmaybehaltedbasedoncircuitbreakersthatmaybeinplaceatcertainexchanges.CircuitBreakerscomeintoplayaftera10%moveinanindex.
InFastMarketconditions,bidsandoffersmaynotbecorrect.
Theendofafastmarketiswhenorderofficialshavedecidedthatwecanrestorefairandorderlymarkets.Wemaygothroughanopeningrotationandwemaysuspendfirmquoterequirements.
CircuitBreakersIfthereisa10%moveinanindividualstock,theremaybea5minutehalt.
TradingHaltsorCircuitBreakersmaybereferredtoasTradingPausesandtheycantakeplacefrom9:45amto3:35pmEST.
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Ifthereisa10%moveinanindividualstock,therewillbea5minutehaltinthatstock
Ifthereisa10%declineintheoverallmarket,thenthemarketishaltedfor:
ONEHOURprovidedthatthedeclineoccurredpriorto2pmCST 30MINUTESprovidedthatthedeclineoccurredbetween2:00and2:30pmCST NOHALTifthedeclineoccursinthelast30minutesofthetradingday
Inanycase,equipmentfailureonyourenddoesNOTconstituteareasonforafastmarket.
OPRATheOptionsPriceReportingAuthority.ItprovideslastsaleinformationandcurrentoptionsquotationsfromacommitteeofParticipantExchanges.
OPRAisnotinvolvedintheclearing,settlement,orassignmentprocessofoptiontrades.
OATSOrderAuditTrailSystemthatkeepsupwithEVERYNASDAQbidandoffer.NASDAQMarketMakersandFINRAmembersmusthaveaserveronsitetotrackallquotingdata.
COATSTheoptionsversionofthethingabove.TheCisforconsolidated.
ExerciseandAssignment:
Automaticexerciseoccurswhenanoptionisonecentinthemoney.IfyoudonotwantanoptiontobeexercisedwhenitisonecentinthemoneyORifyouwanttoexerciseanoptionthatisnotinthemoney,youneedtoissueaContraryExerciseAdviceform.
Ifastockishalted,youmayneedtotelltheExchangewhetheryouwanttosubmitacontraryexerciseadviceform.
AlloptionexchangetransactionsshouldgothroughtheOCC.Before9amCentral,theOCCtakesclearingmemberdatafromallexchangemembersanddeliversadailypositionreport.Yes,thisisafterthemarketopen.
IfIhaveexercisedanoptioncontractandtheassignedpartywantstodeliverthesharesearly,Icanrefusethat!ThisisbecauseyouhaveuntilT+3tocomeupwiththemoney.
ExerciseandAssignmentTimesthatNeedtoBeKnown
Exchangehoursare8:30amto3:15CENTRALTIME
Preopeningquotescannotbesubmitteduntilafter8:15a.m.
5:30pmESTIntheeventtheExchangeprovidesadvancenotice,onorbefore4:30p.m.onthebusinessdayimmediatelypriortothelastbusinessdaybeforetheexpirationdate,indicatingthatamodifiedtimeforcloseoftradinginnoncashsettledequityoptionsonthelastbusinessdaybeforeexpirationwilloccur,thedeadlinetomakeafinaldecisiontoexerciseor
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notexerciseanexpiringoptionshallbe1hour30minutesfollowingthetimeannouncedforthecloseoftradingonthatday.
7:30pmESTMembersandMemberFirmsmustdeliveraCEAorAdviceCanceltotheExchangewithin3hours30minutesfollowingthetimeannouncedforthecloseoftradinginnoncashsettledequityoptionsonthatsamedayifsuchTPHorganizationemploysanelectronicsubmissionprocedurewithtimestampforthesubmissionofexerciseinstructions.
5:30pmESTFornoncustomeraccounts,MembersandMemberFirmsthatdonotemployanelectronicprocedurewithtimestampforthesubmissionofexerciseinstructionsarerequiredtodeliveraCEAorAdviceCancelwithin1hourand30minutesfollowingthetimeannouncedforthecloseoftradingonthatday.
8:00pmESTThisisthetimeuptowhichOCCClearingMemberscansubmitexercisenotices
MarketMakerObligations
MarketMakersareexpectedtorefrainfromselling25centsoutsideofparity.
Forcalls,parityismeasuredoffthebidpriceoftheunderlying. Forputs,parityismeasuredofftheofferpriceoftheunderlying.
Thereare4thingsthataMarketMakershoulddo:
Priceyouroptioncontractsfairly Maintainyourmarketquotes Standuptoyourquotes Competewithothermarketmakers
OrderRouting
Youcanroutyourorderstospecificexchanges.
IfanorderisroutedtoaparticularExchangeandthatExchangeisnottheBestBidOffer(BBO),theordershouldbereroutedORexecutedatBBO.
PaymentforOrderflowisnotillegal.Itsimplyneedstobedisclosed.
Itshouldnotbetothedetrimentofaclient.YoucanrouttoyourfavoriteexchangealldayaslongastheyareNBBO.
Ifthelowestofferforanoptioncontractis5cents,andsomeoneentersasellmarketorder,itwillshowupasat5cents
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CabinetOrdersdonothavetobereportedonthetape.Theyareordersthattradeatonecent.
FacilitationOrdersShouldknowsizerules.Minimumincrementis500contractstofacilitateacross(IthinkthatsonlyforAON).
ENDOFCHAPTER5REVIEW