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Do you know the two kinds of rules?
I'm talking about the ones that trader use to assure good results, plus the industry rules which assure a fair "playing field" for everyone. This blog is about the second kind, which have been adopted by the options industry and are contained in the little book:
“Characteristics and Risks of Standardized Options”
Everyone who opens an options trading account gets a copy of this book, and any disputes with your brokerage company will refer to it. Here's a brief outline of the sections which are important for trading stock options:
Chapter 1
- What is an option?
- Physical Delivery
- Cash Delivery
- Exercise/Settlement Value
- Standardized Terms
- Series
- Trading Hours
Chapter 2
- Option Holder
- Option Writer
- Exercise Price
- Expiration Date
- Style
- Contract Size
- Exercise
- Assignment
- Cash Settlement
- Premium
- Opening Transaction
- Closing Transaction
- Long & Short
- Spreads
- Straddles
- Covered Call Writer
- ATM, ITM, OTM
- Intrinsic Value
- Time Value
Chapter 3
- Options on Equities
This chapter is very important for both holders and writers of options.
Chapter 8
- Exercise
- Assignment
- Settlement
Chapter 9
- Tax
- Commissions
- Margin
Chapter 10
- Risks of Options Holder
- Risks of Option Writers
- Other Risks
Regulation “T”
In a "margin" account, your brokerage company will allow you to borrow up to 50% of the purchase price of new securities . Let's you have $60,000 of stocks, then you can purchase another $30,000 worth on margin, and hold $90,000 worth in your account. So far, so good!
However, if you are fully extended in this manner, the market might trip up and the value of your new stocks may drop to $20,000. You get a "Regulation T" notice from your broker, and must immediately voluntarily reduce your margin holdings to $75,000, or face liquidation by your brokerage.
Never let your brokerage company force a sale of your stocks. First, this will red flag your account--which could bite you in the ass down the road. They may downgrade your options rating down to Level Two or worse. Second, you want to retain control of which stocks you sell. There are tax consequences, among other things, that could be affected. Instead, sell some of your profitable stocks and reduce your margin exposure.
Pattern Day Trader
What is a day trader? Someone who trades in and out (buy and sell, or sell and buy) on the same day, without leaving positions overnight. You need to keep a minimum of $25,000 in your account to day trade. But if you drop below this amount, and trade this way 4 times in 5 days, you will get a flag waved at you for "pattern day trading". Your account may be frozen until you get it back over $25,000 or until a fixed number of days has gone by. See your brokerage company for their specific rules about this.
See you in class! Graeme
Here's your homework... a series of quizzes to make sure you understand the Rules!
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