Finra Unit 2

Option Contract

Considered to be a derivative security because the
value of the contract is derived from the value of the underlying security’s value moving upward or downward.

Equity Option

• The buyer of a call option — the right to buy the stock at a specified price (strike)
• The seller of a call option — the obligation to sell the stock at a specified price (strike)
• The buyer of the put option — the right to sell the stock at a specified price (strike)
• The seller/writer of the put option — the obligation to buy the stock at a specified price (strike)

Buyers three choices

• Exercise the option (exercise their right to buy or sell)
• Let the option expire unexercised
• Sell the option, called “Closing The Option”

Sellers three choices

• Close the option by repurchasing it
• Hope that it expires unexercised

Strike Price Scenarios

• The buyer of a call option — Buys at the Strike (if exercised)
• The seller of a call option — Sells at the Strike (if exercised)
• The buyer of the put option — Sells at the Strike (if exercised)
• The seller/writer of the put option — Buys at the Strike (if exercised)

Bull Positions

• Long calls or Short puts

Bear positions

• Short calls or Long puts

Premium Price

• Individual pays a sum of money to the writer of the
  contract. It is the total investment in the option.

• If investors guess wrong about the price movement of the stock, their only loss is the price (premium) of the option

• Based on the price of the underlying stock and its volatility, the time to expiration, and the current intrinsic value

• If the market price of the underlying stock moves in the direction the investors want by an amount that exceeds the price paid for the contract (called the Breakeven Point), they can profit either by exercising their right at the exercise price or by selling the option contract to someone else.

How do buyers lose their premium

• Buyers want the market price of the underlying stock to move in the direction of their option investment. If this does not occur before the Expiration Date or Expiry Date, the option expires, and the buyer
  loses the premium paid.
  • The buyer’s loss is limited to the amount of the premium paid.
  • The buyer’s possible gain can be unlimited, although it is based on the amount of movement in the stock or underlying security and the time left to expiration.

Stock, Index, and Interest Rate Options

Expire on the third Friday of the month of expiration at 10:59 p.m. Central Time (11:59 p.m. Eastern Time)

Foreign Currency Options

Expire at 10:59 p.m. Central Time (11:59 Eastern Time)
on the Saturday before the third Wednesday of the month of expiration

Last time notice of exercise

Notice of exercise must be given to the
broker/dealer no later than 4:30 p.m. Central Time (5:30 p.m. Eastern Time) on the third Friday of the expiration month.

Time that options expire

Options expire at 10:59 p.m. Central Time (11:59
p.m. Eastern Time) on the third Friday of the expiration month

Intrinsic Value

Market value of a stock or the underlying security determines if the option is In The Money or Out of The Money

Call option is in the money if

The market price is above the strike price.

A put option is In the money

If the market price is below the strike price

An option has no intrinsic value if it is out of the money

But it might have time value

Closing Options

• The investor would do the exact opposite transaction,
  essentially cancelling out the original position

• An investor will profit or lose money, depending
  on the premiums paid and received.

How do investors incorporate hedging to enhance stock position

• Buying options to protect their stock
• Writing options for income

When investors buy options to protect positions

They are hedging their position

Long a stock + long a put option

Buying an insurance on your stock to protect against the decline in price

Short a stock + long a call option

Buying an insurance on your short selling position to protect against price increase of the stock

Investors have a covered call if:

• They own the underlying stock, a convertible preferred stock, or a convertible bond.
• They have a bank escrow agreement (a guarantee from a recognized bank) stating that the bank will deliver the shares of stock to the broker/dealer upon demand.
• They own a call with the same or lower strike price.
• They have cash in their cash account to cover the full purchase of the stock.
• They have sufficient cash in their margin account to cover the Reg T requirement to purchase the stock in their margin account

Covered Put Writing

Obligation to purchase from the OCC the
amount of shares mandated by assignment of the notice of exercise.

Investors have a covered put if

• Have money equal to the exercise price on deposit with the broker/dealer
• Have a short position on the stock
• Have a bank escrow agreement for the cash from a recognized bank
• Own a put with the same or higher strike price

Uncovered Writing (Naked Option Writing)

• Write a call (or a put) without owning another position, either in stock or in purchased options.
• Unlimited risk exposure because the price of the
stock has an unlimited ceiling.
• A put writer has a limited risk exposure because the price of the stock can only go to zero. In either case, the potential loss can far exceed the writer's potential gain.

What determines the options compliance rules

Option Clearing Corporation

Options Disclosure Statement

Explains in layman’s terms the risks of the different types of transactions as well as what underlies the different options

Customer must sign options agreement within

15 days of the account opening

Requirements for opening an option account

• Obtain information and determine the suitability of the customer
• Present the options disclosure document to the customer
• Obtain account approval from the branch office manager or the registered options principal (ROP) – The customer can start trading at this point.
• Send immediately separate verification of information and the options agreement to the customer
• Make sure that the customer has signed the options account agreement within 15 days of opening the account.

When options contract are first written

All premiums are cleared through the OCC

When should options trade settle

The next business day

Options confirmation must contain the following

• The client’s name and account number
• The type of order, e.g., market, buy limit, sell stop
• The number of contracts
• The name of the underlying stock or security
• The exercise price and the expiration date of the option
• The type (or class) of the option, i.e., put or call
• The premium of the option
• The commission for the trade

For listed option contracts

The OCC guarantees that a corresponding
written option position can be exercised against the holder of the purchased option

When buying or selling (trading) options

The contracts settle on the next business days, known as T+1

Exercising of an option contract is treated in one of two ways

• Exercised equity options settle “regular way” in two business days (T+2).
• Exercised index and interest-rate options settle in one business day (T+1).

For all exercised options

The cash or underlying stock must be in the customer’s account by the settlement date

Exercising before the ex-dividend date entitles the buyer of the call

And the seller of a put, to the dividend.

American Style Foreign Currency

Can be exercised anytime

European Style Foreign Currency

Can only be exercised on the expiration date

Index Options

Options based on one of the many Indexes that
represent the movement of the stock market or a portion of the stock market.

Indices that index options are based on

• WILSHIRE 5000 — options based on the stocks in the Wilshire 5000
Total Market Index- These stocks are found on the New York Stock Exchange (NYSE), the American Stock Exchange, and the Nasdaq.
• OEX — options based on Standard & Poor’s 100 Index.
• SPX — options based on Standard & Poor’s 500 Index.

This is also the basis for the VIX options, the options based on the volatility of the stocks in this index

Minimum duration

3 months

In trading Index Options

The BUYER of the options always pays the seller, or writer, the premium.

In EXERCISING index options

The WRITER of the options always pays the buyer of the options the intrinsic value

Investment Act of 1940

• The Act defines three categories of investment companies, and requires them to register with the Securities and Exchange Commission (SEC).
• The Act also regulates the business practices of investment companies so that they operate in the best interest of their investors.

Three categories of investment companies

• Non-managed investment companies
• Face-amount certificates,
• Unit investment trusts (UITs)

Management Companies

Open end and Close end, actively managed portfolios, Involves daily securities research and trading

Face Amount Certificates

• Are one of the three categories of investment companies
• Purchased at a discount and mature at face amount.
• There is no secondary market trading; they must be redeemed from the issuer at maturity.

Unit Investment Trusts

• Issues redeemable trust certificates that represent an undivided interest in a portfolio of securities.

• Has a fixed, or static, portfolio that is established and monitored by the trustee.

• No investment advisor

• No board of directors

• Specific termination date specified in prospectus

Management Investment Companies

• Maintains a securities portfolio and hires an
  investment advisory firm to manage this portfolio

• Investment adviser manages the portfolio per guidelines established in an investment objective

• Investors purchase management company shares that represent an undivided interest in the management company’s portfolio

Advantages of Management Companies

• Professional management
• Diversification
• Liquidity

Two types of management companies

• Open-end management companies, more commonly called Mutual Funds
• Closed-end management companies, also known as closed-end funds or Publicly Traded Funds

Mutual Funds

Issue one class of stock called common stock

• When an investor submits a purchase order through a broker/dealer, it creates new shares and issues them to that investor. That investor’s funds are received by the mutual fund and placed in its investment portfolio.
  • When an investor wishes to sell his mutual fund shares, he submits a liquidation or redemption request to the fund through his broker/dealer. The mutual fund then takes cash from its investment portfolio, pays the customer for his shares, and destroys those redeemed shares.

Mutual funds engage in forward pricing

• As the fund receives purchase and redemption requests
during a given business day, the fund holds those requests until after the close of business.
• Fund calculates its new NAV, based on which the day’s redemption and purchase requests are executed.

Following factors have no effect of NAV

• Shareholder purchases and redemptions
• Portfolio purchases and liquidations
• Shareholder distribution reinvestment

Close end management company

It issues a fixed number of common stock shares through an IPO. Subsequently, those shares
trade in the secondary market. The shares may be listed on an exchange or may trade OTC. They also have constantly fluctuating intra day pricing, expressed as a bid and ask.

Open end management companies

Continuously issues new shares and redeems outstanding shares, its number of outstanding shares fluctuates daily.

Close-end management company

Issues a fixed number of shares through an IPO. Thereafter, those shares trade in the secondary market.

Mutual Funds share classes

• Class A shares — front-end load sales charge
• Class B shares — back-end sales charge
• Class C shares — % of assets under management

Mutual funds charge 12b-1 fees

• Investment Company Act of 1940 that allows investment companies to charge fees to help offset the fund’s marketing and distribution costs.
• The Investment Company Act of 1940 mandates that a mutual fund sales charge may not exceed 8.5%.

Break-point

Is a quantity discount granted by mutual funds for large purchases or account balances.

• Allow a customer to purchase a large dollar amount of a mutual fund at a reduced sales charge.
• Must be outlined in the prospectus. Individuals, corporations, and pension funds may all take advantage of quantity discounts on mutual fund share purchases.

Special exceptions to the quantity discounts available to customers:

• Quantity discounts are not given to investment clubs, partnerships, or others who are
banding together for the purpose of taking advantage of a sales breakpoint.
• Husbands, wives, and minor children investing together are allowed to take advantage
of sales breakpoints.

Sales break point

Term for the dollar amount at which a reduced sales charge is given to investors. Breakpoints usually start for investments as low as $10,000 to $25,000, and increase incrementally for larger investments

Brakepoint sale is a violation of FINRA

Takes place when a customer invests a large dollar amount
near a sales break point, but is not informed of the available discount.

Brakepont sale can be avoided by

Informing the customer of the breakpoint
and having either of the following signed
by the customer:
• A letter of intent (discussed in Section 5.6)
• A customer statement that the customer
was informed but declined to take advantage of the breakpoint discount

Rights of Accumulation

Cumulative quantity discounts that allow
investors to take advantage of reduced sales charges based on their accumulated ownership in a mutual fund

Letter of Intent

Form letter that is issued by a mutual fund and signed by an investor. States that the investor intends to take advantage of reduced sales charges by purchasing enough of the mutual fund over a 13-month period (10 month if backdated) to qualify for the discounted sales charge (3 months for it to be backed up)

Conversion Privelage

Allows an investor to redeem one fund and
purchase another within the family at NAV (no sales charge).

Redemption

When a mutual fund company receives a redemption request from an investor, it must send the redemption proceeds to the investor within seven calendar days

Redemption Fees

If there is a redemption fee, it can be up to 1% of
the NAV, and is deducted from the NAV at the time of redemption.

Local Govenment Investment Pools

The state treasurer or the authorized governing board of another governmental entity (such as a county) oversees a pooled investment fund that operates like a money market mutual fund for the exclusive benefit of governments
within the entity's jurisdiction

Municipal Fund Securities

Unlike local government investment pools, municipal fund securities are established for retail investors

Two taxed advantage savings account for college

• College savings plans
• Prepaid tuition plans

ABLE Accounts

•Congress created ABLE accounts in the Achieving a Better Life Experience Act of 2014. The ABLE Act amended Section 529.
• ABLE accounts enable parents of disabled children who won’t attend higher education to save for their children’s future needs, such as assisted living and physical therapy.

Direct Participation Program

No-traded, pooled investments that allow passive investors to participate directly in the cash flows of a business venture, usually in real estate, oil and gas, or other energy-related ventures

Tax reform act of 1986

Classified income and deductions from DPPs as “passive” and imposed limitations on passive losses.

After 1986

• Passive income is taxable as ordinary income.
• Passive losses can only be deducted against passive income.
• Passive net losses cannot be deducted against ordinary income.
• Capital gains and losses can be realized upon the sale of partnership interest or termination of the partnership.

Tenants in common

Arrangement where two or more people share ownership rights in a property or parcel of land.

REITS

Invests in a portfolio of real estate with the intention of profiting from rents and the appreciation of the property.

REIT qualifications

• There must be at least 100 shareholders.

• No five shareholders can own
more than 50% of the shares.

• At least 75% of the assets must be held
in real estate, Treasuries, or cash.

• At least 75% of income must come
from real estate.

• At least 90% of net investment income must be paid
out to investors as dividends.

Equity Reits

These trusts provide a triple source of income by owning and/or renting properties — collecting rental income, paying dividends, and capital gains from property sales.

Mortgage Reits

A trust that lends out money for mortgages on real estate and receives interest in return. These trusts are more susceptible to interest-rate risk. REITs that specialize in providing financing during the construction of a project may be referred to as construction and development REITs. These REITs aim to profit on appreciation rather than traditional cash flows from rents

Hybrid Reits

These trusts are a combination of both equity REITs and mortgage REITs. They are typically sold as open or closed-end funds similar to mutual funds

Private Reits

Exempt from registration with the SEC and are generally sold only to institutional and accredited investors

Non traded REITS

Register with the SEC and are subject to registration and disclosure requirements, but are not listed on an exchange; they trade over-the-counter (OTC)

Listed Reits

Public (registered and regulated by the SEC) and listed on a major stock exchange. This makes it easier for investors
to research and trade these REITs.

Hedge Funds

Refers to an investment pool, most often
organized as a limited partnership, excluded from the definition of investment company and offered under a private placement registration exemption that:
• Is privately organized (private equity)
• May only allow institutional or accredited investors
• Is managed by professional investment managers

Index ETFS

Portfolios of securities that are set up to track, or parallel, an index, such as the Dow Jones Industrial Average or the S&P 500

Actively managed ETFs

Designed to meet a particular goal, such as investing
in certain sectors or regions of the world economy; the sponsor determines the objective and trades securities at its discretion

Exchange-Traded Notes

They enter the market as an alternative to the ETF to make it easier for retail investors to invest and maximize the returns in hard-to-access instruments, particularly in the
commodity and currency areas

Systematic Risk

Any risk that impacts the market, or entire sector of the market, as a whole. Because these risks affect markets so broadly, they are referred to as “undiversifiable risk” and cannot be eliminated by diversifying within an asset class. The only way to mitigate is by employing hedging strategies

Non systemic risk

Impact a particular company, and are therefore
sometimes referred to as “specific risk.” These risks can be mitigated through diversification.

Market Risk

Risk investors will experience due to market influences. Is an example of systematic risks

Interest Rate risk

Risk that a change in interest rates will have
an adverse effect on the prices of existing bonds.

Reinvestment risk

Risk that an investor will have to reinvest the
coupon payments or principal payment received from a bond at a lower rate than when the bond was issued or purchased.

Inflation Risk (Purchasing Power risk)

Risk that the rate of inflation will exceed the nominal rate of return of an investment, causing the investor to earn a negative real return, which results in a loss of purchasing power over time. Fixed income securities are particularly prone to inflation risk.

Currency Risk

Risk that fluctuating currency exchange rates will negatively affect the value of an investment

Political Risk

Risk that an investment’s return could be affected negatively by any political changes or by the instability of a particular country’s government.

Prepayment risk

Risk to a lender that the borrower may repay the loan sooner than anticipated.