central Options By Marty Kearney It is never too soon to think about year-end tax issues. Imagine that you

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1 YOUR RESOURCE FOR OPTIONS EDUCATION SM Options central IN THIS F A L L ISSUE: F E A T U R E : STRATEGY LEAPS END-OF-YEAR TAX O I C S E M I N A R O F F E R I N G S C O M M O N O P T I O N S T E R M S U P C O M I N G S E M I N A R S C H E D U L E Y O U R O P T I O N S Q U E S T I O N S A N S W E R E D : B I D A N D A S K I N V E S T O R C O N F E R E N C E S LEAPS End-of-Year Tax Strategy: The Thanksgiving - Christmas - Superbowl Strategy By Marty Kearney It is never too soon to think about year-end tax issues. Imagine that you have the opportunity to take a loss on a stock you own, but, since you like the prospects of that stock over the long term, you could still control an interest in the stock. Have you ever bought a stock and it went down in value? While this is not an investment objective one would strive for, we have all been there at one time or another. With a stock that has gone down in price, you have several options: 1. Sell the stock, take a loss, and move on with the rest of your life. Your market outlook is no longer bullish, you are uncomfortable with the position, and the prospect of owning this dog of a stock is not too appealing O P T I O N S continued inside

2 PAGE 2 MARTY KEARNEY is senior staff instructor of The Options Institute at the Chicago Board Options Exchange. He began his association with CBOE as an independent market maker in 1981, leaving the trading floor in 1992 to become a founding partner and registered options principal of PTI Securities L.P. Kearney has been a regular contributor to Reuters, WMAQ Radio, The CBS Radio Network, Derivatives Week, BARRON'S and others. He was previously a marketing director for NCR Corporation. To simplify the computations, the examples in this article do not include commissions or transaction costs. Commission and transaction costs will affect the outcome of all stock and options transactions and must be considered prior to entering into any transaction. Investors considering options should consult their tax advisors as to how taxes may affect the outcome of contemplated options transactions. continued from front 2. Buy more stock. You'll never learn. Double up to catch up. Your recalculated break-even point has been lowered, but the amount at risk has been increased dramatically. You may get more than one opportunity to try this with the same stock, increasing your risk every time. 3. Do nothing, hope the stock rallies, say a prayer, light a candle, make a wish, etc. Doing nothing is actually doing something. It is saying you think a rally in the stock is certainly a possibility. You don't like it enough to buy more and increase the risk substantially, but you are confident in your outlook. How can one take a tax loss on the higher cost shares of XYZ stock and still control the stock? There are very specific tax rules concerning what you can and cannot do before a tax loss can be established. (The accounting firm of Ernst & Young LLP has written a pamphlet entitled "Taxes and Investing: A Guide for the Individual Investor". An online version of this publication is available at and on the Web sites of the various options exchanges. Its treatment of the tax implications of various options strategies is much more complete than that given here). You should also consult a tax professional to discuss your specific situation. If we were to try to summarize the current rule, the key phrase would be "30 days." If you decide to sell a stock and establish a tax loss, you may not buy that stock or the equivalent position within 30 days of selling the stock. Those 30 days are both 30 days before and 30 days after the stock is sold. Let's examine three scenarios: 1. Sell 100 shares of XYZ at $50 on Dec. 29. Wait until the 31st day, and on Jan. 29 buy 100 shares of XYZ. Where's the problem? You have no position in XYZ for 30 days. Good earnings, the "January Effect, a major product announcement, it doesn't matter. If you buy the stock back within 30 days of the date of the sale you may not take the original sale, as a tax loss. 2. Buy 100 shares of XYZ on Nov. 28, wait until the 31st day, and on Dec. 29 sell 100 shares of XYZ. The problem? You already own 100 shares that you purchased earlier at a higher price. It didn't work. The stock has dropped to $50 per share as of Nov. 28. You are buying 100 more shares and risking an additional $5,000 for the next 30 days. Even if you buy the second 100 shares on margin, you still have $5,000 at risk. 3. A favorite! On Nov. 28 (Thanksgiving), buy one of the XYZ 13½ month LEAPS 40 strike price call at 15 points, or $1,500. On Dec. 29 (Christmas), sell your 100 shares of XYZ and take the tax loss. On Jan. 29 (Superbowl), with 11½ months remaining until the LEAPS call expires, revisit the original idea. If stock ownership is the desired position, buy 100 shares and sell the long LEAPS call. If owning the LEAPS call option is thought to be better, do nothing. The advantage of buying a LEAPS call 30 days before the date of the stock sale is: a. You are in the market. You are not selling to establish the loss and then waiting 30 days to reinstate the long position. b. You control an additional 100 shares, but your additional risk is limited to the cost of the LEAPS call: $1,500 in our example, versus the cost of an additional 100 shares, or $5,000. c. The LEAPS call with 13½ months of life will not experience a great deal of time decay in the next 60 days (getting you 30 days past

3 PAGE 3 the stock sale on Dec. 29). The Options Investigator software* (used for educational purposes) shows that if XYZ is unchanged, the LEAPS call will have decayed about 60 cents in the 60 days you held the position. d. In-the-money call options have fairly large deltas, or rate of change in theoretical value for a one-unit change in the price of the underlying stock. The delta of the 40 call with XYZ at $50 is If XYZ goes to $60 on Jan. 29 (with 355 days left until expiration), there are a few interesting items to look at: The delta at $60 with 11½ months left is almost The option you bought at $15 should now theoretically be worth $ You got your tax write-off. You controlled XYZ for a fraction of its cost (roughly 30% of the stock cost). You participated in over 80% of the stock s rise to $60. If you stick with the long LEAPS call, the delta is over The tax laws, while complicated and getting even more complicated as they relate to securities, are very specific in regards to the "30 days before and after" rule. Although one could try something similar with shorterterm options or at-the-money calls, the problem could be fighting the effects of time decay. As you know, with a 13½ month LEAPS call, the time decay on a deep in-the-money call moves at a glacial pace. If the stock you own does not have LEAPS but you like this strategy, look at the longest-dated in-themoney call available (maybe a June or July). Use a software program like The Options Investigator* and testdrive the position, weighing the risks and potential rewards. The following are two examples of strategies that are not allowed: GRAPH: Profit and Loss Diagram (Prices represented as of expiration Friday. P & L of long stock reflected from this day forward, not original purchase price). 1. You sell 100 shares of XYZ at $50 on Dec. 29, establishing a tax loss. On the following Jan. 20, as XYZ announces good news, you buy (1) XYZ March 50 call option. The 100 shares of XYZ sold on Dec. 29 cannot be used as a tax loss. You established an equivalent position within 30 days. 2. You own 100 shares of XYZ that you own at higher prices. You buy another 100 shares of XYZ on Dec. 5. You then sell the original 100 shares on Dec. 29 to take the loss. Sorry, not allowed, you bought XYZ within 30 days of the date of the sale. Here are three important points about this strategy: 1. If you make money trading and/or investing with options, you will have to pay taxes. 2. Tax laws are specific in this area. You may not purchase the same or identical security 30 days before or 30 days after selling a security for a tax-loss. Buying a LEAPS call 31 days before selling your stock keeps you invested while risking only a portion of doubling up on stock In-the-money LEAPS calls have high deltas (high correlation to a move higher) with low theta (timedecay). After reviewing the position at the end of January (as the Superbowl approaches), you may decide that controlling a stock with a LEAPS call makes more sense than owning stock. -15 Portions of the previous article were drawn from "Understanding LEAPS, Using the Most Effective Option Strategies for Maximum Advantage" by Marc Allaire and Marty Kearney, McGraw Hill, *The Options Investigator can be ordered for free at

4 PAGE 4 UPCOMING OIC SEMINARS OCTOBER 1 Toronto, Basic 1 Washington, DC, Intermediate 2 Toronto, Intermediate Tuesday, October 14 6:30 p.m. - 9:30 p.m. Sheraton Chicago Hotel & Towers FREE admission If you understand the language of options, including basic long, short and simple spread trading strategies, this course covers the decision making variables that can affect your bottom line. We'll cover: Leveraging the Statistical Advantages in Options Trading Accurately Predicting Risk-to-Reward Ratios and Probabilities of Profit Understanding Option Modeling and the Projection of Future Theoretical Option Prices Using Volatility Movement to Your Advantage If you re attending the Traders Library Options Trading Forum, this SPECIAL EVENT immediately follows CBOE s Live Trading Event and Cocktail Party. Presented by: 7 Chicago, Directional Strategies 7 San Jose, Calif., Covered Calls 8 Chicago, Intermediate 8 San Jose, Calif., Intermediate 9 Hartford, Conn., Basic 14 Buffalo, N.Y., Basic 14 Chicago., Advanced, 6:30 p.m. - 9:30 p.m. 15 Parsippany, N.J., Basic 16 Parsippany, N.J., Intermediate 21 Sacramento, Calif., Basic To register or for more information, call OPTIONS or visit 22 San Francisco, Covered Calls 23 San Francisco, Intermediate 28 Detroit, Basic 28 New York Downtown, Covered Calls common options terms DELTA A measure of the rate of change in an option's theoretical value for a oneunit change in the price of the underlying stock. LEAPS Long-term Equity AnticiPation Securities, also known as long-dated options. Calls and puts with an expirations as long as thirty-nine months. Currently, equity LEAPS have two series at any time with a January expiration. IN-THE-MONEY An adjective used to describe an option with intrinsic value. A call option is in-the-money if the stock price is above the strike price. A put option is in-the-money if the stock price is below the strike price. TIME DECAY A term used to describe how the theoretical value of an option erodes or reduces with the passage of time. Time decay is specifically quantified by theta. VOLATILITY A measure of stock price fluctuation. Mathematically, volatility is the annualized standard deviation of a stock's daily price changes. 29 Detroit, Intermediate 29 Long Island, N.Y., Basic 30 Long Island, N.Y., Intermediate NOVEMBER 4 Miami, Basic 4 Fort Lee, N.J., Basic 5 Palm Beach, Fla., Basic 5 Philadelphia, Covered Calls 6 Boca Raton, Fla., Covered Calls Registration is required. All seminars are FREE and held from 6 p.m. - 9 p.m. (unless otherwise noted). To register for a seminar or order free educational materials, call OPTIONS or visit

5 PAGE 5 bid and ask Q: I HEAR THAT INVESTORS LOOK FOR "UNDER-VALUED" OR "OVERPRICED" OPTIONS -- HOW DO THEY DETERMINE WHAT THAT IS? A: In a word, the answer is volatility. An option is fairly valued if its implied volatility is equal to the volatility of the underlying stock over the life of the option. For example, to calculate the fair value of the option that expires in December, we first would need to calculate the standard deviation of the stock's returns between now and the third Friday of December. But to calculate that standard deviation, we need the closing prices for the stock during the next six months, which poses a significant challenge. Typically, investors study the historic volatility of the underlying stock and then project that forward into the future. Very often the future will be like the past, but just as often, it isn't. So when all is said and done, we can only know if our option today was over- or under-valued when we look back into the past from some point in the future, and by then it's unfortunately too late. So, you can make assumptions based on past performance, but there is no guarantee that the assumed behavior will actually play out in the future. Q: WHAT IS "LEVEL 1 OPTION TRADING" AND "LEVEL 2 OPTION TRADING"? A: Most brokerage firms have different categories for the kind of option strategies they allow their clients to use, and that's probably what you're referring to. Typically, the lowest level permits covered calls only, the next level, the purchase of options. After that, they might allow certain spread strategies and the highest level permits writing naked calls. This is only a generalization, each firm will have its own specific guidelines. Discuss trading policies with your brokerage firm. Q: WHAT DOES THE TERM "QUADRUPLE WITCHING HOUR" MEAN? A: That is a newer term that refers to the third Friday of March, June, September and December, when options, index futures, single stock futures, and options on index futures expire concurrently. Massive trades in options and underlying stocks by hedge strategists and arbitrageurs can cause above average volume and added market volatility. Derivatives contracts based on stock indices do not generally involve the actual exchange of any underlying security, but rather are cash-settled based on some fair market value at a specified time. Many arbitrage strategies involve simultaneous, offsetting transactions in a basket of stocks representing an index and a derivatives contract on the index. When the derivatives contract reaches expiration, the usual practice is to buy or sell the basket of stocks at the exact price used for cash-settling the derivatives contract. In the early 1980's when organized futures and options exchanges began trading standardized contracts based on stock indices, the final value of those indices for cash-settlement purposes was usually the close of trading on the third Friday of the month. Every month there is an expiration on options and options on the futures. But expiration of the futures, where a large proportion of the arbitrage activity takes place, only occurs once a quarter. So on the third Friday of the last month of each quarter, stock exchanges would be deluged with orders to buy or sell huge quantities of stock at exactly the closing price used for cash-settling the derivatives contracts. This combined expiration of options, futures and options on futures came to be known as the Triple Witching Hour. Because these arbitrage strategies were market-neutral, simply taking advantage of price discrepancies between the index and derivatives on the index, they didn't represent any real opinion on the market's direction. But unwinding only one side of the strategy with a market order and letting the other side cash-settle sometimes caused huge gyrations in the markets during the final hour of trading on the third Friday of that month. Eventually, many of these expiring contracts switched from using Friday's closing price to using the opening price or trading range for each of the component stocks in determining their settlement values. This lessened the pressure for immediate execution at any price, and allowed the possibility of delayed openings for order imbalances at exchanges that have such procedures in place. So while the triple expiration of options, futures and options on futures can still have an impact on how the market opens on that day, the kinds of gyrations that routinely occurred in those early days is rarely observed today. You may see your options questions answered in Options Central. Send them to OIC at: options@theocc.com or One North Wacker Drive, Suite 500, Chicago, IL

6 investor conferences OIC is participating in the following upcoming events. To register, call the telephone number listed. Traders Library 3rd Annual Options Trading Forum Oct Sheraton Chicago Hotel & Towers Call for registration information San Francisco Money Show Oct San Francisco Marriott Call and mention OIC priority code # AAII Investor Conference Nov. 5-7 Riviera Hotel and Casino, Las Vegas Options for the Thinking Investor Nov Singapore Visit for registration information One North Wacker Drive, Suite 500 Chicago, Illinois OPTIONS The American Stock Exchange THE-AMEX Chicago Board Options Exchange THE-CBOE International Securities Exchange Pacific Exchange PCX-PCX1 Philadelphia Stock Exchange THE-PHLX The Options Clearing Corporation Options involve risk and are not suitable for everyone. Prior to buying or selling options, you must read the option disclosure document, Characteristics and Risks of Standardized Options, which can be obtained from your brokerage firm, from any Exchange on which options are traded, by calling OPTIONS, or by writing The Options Clearing Corporation, One North Wacker Drive, Suite 500, Chicago, Illinois Consult your tax advisor for tax considerations. For More Information Call OPTIONS or write The Options Industry Council. If you have additional questions about options, call your financial advisor or one of the Exchanges listed here.