The ABC of Options and Arbitrage

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THE ABC OF OPTIONS AND ARBITRAGEBY S. A. NELSON


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S. A. NELSONNEW YORK

1904.


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THE ; ,A B C OF OPTIONS ANDARBITRAGE

BY S/A. NELSON

NEW YORKS. A. NELSON

1904


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COPYEIGHT, 1904,by

S. A. NELSON.


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PREFACE.IN the preparation of this little primer difficulty has

been experienced in reducing the technical and compli-cated terms and methods employed in the money marketto simple statements of fact that may be readily under-stood by the outsider or those unfamiliar with the sub-jects.WE desire to express our thanks for -substantial aidobtained from Mr. H. W. Rosenbaum, the late Mr. Dow,Mr. Charles Castelli, Mr. Leonard Higgms and the WallStreet Journal.

S. A. N.


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VOLUME VI.THE WALL STREET LIBRARY.


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CONTENTS.

CHAPTEK I.Definition of Stock Options 11

CHAPTER II.tlie Practice of Option Trading 14CHAPTER III.

American Contract Forms 18CHAPTER IV.

American Options or Privileges 22CHAPTER V.

Value of Options 30CHAPTER VI.

Castelli and Higgins on Options 44CHAPTER VII.

Arbitrage 51CHAPTER VIII.

Arbitraging in Rights 60


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CHAPTER IX.Usages of the London Stock Exchange 64

CHAPTER X.Method of Shipping Stocks Between London and NewYork 67

CHAPTER XLTrading in London Options from New York 73

CHAPTER XII.An Option Price List 77

CHAPTER XIII.The Conversion of London into New York Prices. ... 78

CHAPTER XIV.Stock Conversion Tables.. 80


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CHAPTER I.DEFINITION OF STOCK OPTIONS.

TRADING in options in the New York and London stockmarkets is governed by important differences of method.Abroad, the Committee of the London Stock Exchange,recognizes the legality of option dealing in stocks con-ducted under certain rules, but in New York the StockExchange does not recognize option trading. Outside ofthe New York Stock Exchange itself, however, Stock Ex-change members and firms deal in options under rulesregulated by custom and on contracts recognized andenforced by the civil law. The Wall Street option markethas very narrow limitations, but some time in the futureit is probable that it will play a much more interestingpart in the day's work of the money market than it doesto-day.

Mr. Charles Castelli in *The Theory of Options in Stocksand Shares thus defines stock options: By the paymentof an agreed premium, an operator in stocks and sharesacquires the faculty of becoming either a buyer or a sellerof stock at a fixed price and for a determined period. The

* London, 1877. 11


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12 THE A B C OF OPTIONS AND ARBITRAGE.loss is simply limited to his disbursement for such period,whereas the profit is indefinite, depending solely upon thefavorable movements of the stock operated in, during thetime he can exercise this right.

Mr. Leonard R. Higgins, in *The Put-and-Call says:The word Option in connection with transactions instocks and shares, means a right to buy or sell a certainquantity of stock on a given day, at a price agreed upon atthe time the bargain is struck, for which right the 'giver*of option money pays a consideration to the 'taker'; thesaid option money being payable at the end of the stipu-lated option period.The payment of option money may purchase the right :

First, to buy stock at a given price, at a specified futuredate, this option being known as the 'Call.' At the endfof the option period, the 'giver' declares whether he willexercise his option and Call the stock or not.

Secondly, to sell stock at a given price at a specifiedfuture date ; the option is then called a 'Put'. When the

* London, 1902.t In Wall Street the option is so written that it' owner canexercise the rights therein contained on one day's notice

except the last day, when notice is not required. This dis-tinguishes the New York option from that of London, wherethe rights can only be exercised on a specified future date.


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THE A B C OF OPTIONS AND ARBITRAGE. 13option expires, the 'giver* tells the 'taker' whether hewishes to put the stock on him at the agreed price or not.*

Thirdly, to either buy or sell (whichever may suit the'giver') stock at a prescribed price at a specified futuredate; the name of the double option is the Tut-and-Call.' f

* In New York this declaration is only necessary when therights in the option are exercised. Also in London, in actualpractice, the formal declaration of an option only takes place,when the market price at option time is so close to the agreedprice of the option that the bargain does not speak for itself.When the market price of the stock is distinctly above orbelow, it is understood by the taker that the stock is boughtor sold, as the case may be.

f Called a straddle in Wall Street


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CHAPTER II.THE PRACTICE OF OPTION TRADING.

THE practice of option trading in stocks is an old one.In Wall Street there is always more or less trading in op-tions but the trade is not conducted on scientific lines.Here the option is bought with the idea and advantage ofexercising its privileges before the option matures orexpires. In London, where the business is more of ascience, the privilege of the option must be exercised on astipulated day. There exists in this requirement an ad-vantage for the seller of the option.The London buyer of options is accustomed to trade

against his options to a much greater extent than theNew Yorker, and trading of this character calls for quitecomplicated calculations that would puzzle and confusethe average American stock speculator who wants a sim-ple, rather than a complicated proposition, and who prefer-ably always demands a quick, rather than a slow decision.The English stock speculator apparently is slower, morepatient and willing to work harder to secure a profit thanhis American contemporary, who despises small profits,

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THE A B C OF OPTIONS AND ARBITRAGE. 15and has a world-wide reputation among financiers for hisfailure to give proper regard to his interest account. Per-haps, for the same reasons, English, German and Frenchfinanciers are more skilled in the science of the foreignexchanges where the problems are complicated, and theprofits sometimes very small, but in the aggregate makea very important part of the banking business.

It is unquestionably a fact that the option businessoccupies a much higher status among financiers in Lon-don than it does among those of New York. The basisof the London option dealers' quotation seems vague,says a Wall Street student of finance, and on superficialview his offer to take 5% per cent, for the Tut-and-Call'(or Straddle) of Louisville & Nashville over a period oftwo months looks like a mere bet, but it is nothing of thekind. He works by rule of thumb, but he has an exacttheory behind it. He knows that the average quotationsof Louisville & Nashville will not fluctuate so much aathat over a great number of two monthly periods, and heworks exactly upon the lines of any other dealers in insur-ance. Just as the seller of life insurance knows thataccident or unsuspected disease may call upon him in oneparticular case to disburse a very heavy premium for arisk only recently taken, yet at the same time his actuariestables tell him that if he can only get enough business of


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16 THE ABC OF OPTIONS AND ARBITRAGE.the kind, the law of averages will bring him out with ex-penses and a legitimate profit. The option seller uses ex-actly the same principle that the bookmaker does when he'lays' every horse in a race. He knows that if he can 'layhis book round' he stands to make a profit whatever horsewins, provided of course he makes no bad bets. That isthe position of the London option dealer. In his mind hemakes a sum about as follows:

Per cent.The average two months' fluctuation, say 4^Working cost, interest on capital, and other contin-

gencies, say , %Margin of profit %

Total 53/8Of course the option dealer is also an active trader in

the market, and he can protect himself from the loss in-volved in some extraordinary fluctuation by buying orselling stock. Experience, however, has taught him thatthe less he does of this the better, and it will be found thata very small part of the option dealer's business consistsin direct transactions in the Stock Exchange. If the stockis put to him on an option, of course he sells it, and if itis bought from him, he buys it again to the greatest advan-tage in order to deliver.But his system is sound, and he knows that if he works


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THE ABC OF OPTIONS AND ARBITRAGE. 17it properly, the law of averages will bring him home. Hesays himself that a hundred tips are given for one thatcomes off, and possibly his mental attitude favors a posi-tion where he backs inertia against activity. Neverthe-less the options he sells are of definite and ascertainablevalue or there would not be a market for them.


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CHAPTER III.AMERICAN CONTRACT FORMS.

A CALL gives the owner and holder the right to callupon and buy from the writer of the privilege a certainamount of stock at a specified price, usually above themarket, within a limited time. A Wall Street privilegecarries with it the right to exercise delivery of the stockwithin a limited time. The London privilege specifies acertain date. At any time within the life of the WallStreet privilege you can exercise its rights. In Londonthe privilege is confined to a certain day, and before itsmaturity if it shows you a profit, you are obliged to tradein the open market and then balance the operation on set-tlement day.A Call reads as follows :

New York 19FOR VALUE RECEIVED, the bearer may CALL ON ME onone day's notice except last day when notice is not required

of the Stock of theCompany, at

per cent, any time in days from date.18


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THE A B C OF OPTIONS AND ARBITRAGE, 19All dividends for which Transfer Books close during

said time, go with the Stock.Expires 19MAssume that Union Pacific was selling at 100 and you

bought a Call to run one week at 101 for $100. If yourtransaction is confined simply to the Call the stock mustsell above 102% within the week before you derive anyprofit. If it sells at 102 and you Call from the writerof the privilege 100 shares at 101 you receive and payfor it at that price. You then sell the stock in the openmarket at 102. Your commission is %. You paid $100for your Call and you recover your option money. Any-thing above 102% would be net profit. If the stock wentdown your loss would be confined to the $100 you paidfor the privilege.

But, assume that you were a bear and were short100 shares of Union Pacific at 100. If the market ad-vanced you could Call the stock and deliver it on yourbear commitment and thus limit your loss to approxi-mately $100. You would have been insured against fur-ther loss through the rights sold with the privilege.A Put reads as follows: New York 19POR VALUE RECEIVED, the bearer may DELIVER ME, on


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20 THE A B C OF OPTIONS AND ARBITRAGE.one day's notice except last day when notice is not required

Shares of the Stock of theCompany, at

per cent, any time in days from date.All dividends for which Transfer Books close during

said time, go with the StockExpires 19

MA Put is the opposite of a Call.Assume, for example, that Union Pacific is selling at

100. You believe that it will decline. You buy a Putat 99, good for one week for $100. If it declines below99 you buy 100 shares of stock in the open market anddeliver it to the writer of the privilege, deriving thedifference between the option price and the mar-ket price. Your risk would be limited to theamount of the option money. If you were a speculatorand the owner of 100 shares of Union Pacific and wishedto insure it against loss for a specified time, a Put wouldact as an insurance policy against loss. The cost of theoption would be the amount of your insurance premium.

Traders at times exercise privileges in another way.Assume that you are a trader and own a Put on 100Union Pacific at 99. The market declined to 98, andagainst the Put you bought 50 shares at 98, and again 53


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THE A B C OF OPTIONS AND ARBITRAGE. 21shares at 97. In the event of a rally you could sell outyour long

stock. If there is another decline you couldrebuy and resell, on a second rally, protected by the Put.Experienced traders, however, find that the latter oper-

ation works out better in theory than in practice.A Spread reads as follows:FOR VALUE EECEIVED, the bearer may DELIVER TO ME,

Shares of at orCall upon me for Shares of at

at any time within days from date.Expires 19M

If Union Pacific is quoted at 100 the Call price wouldprobably be 101 and the Put price 99.

Protected by such a privilege a trader can make ven-tures in the open market on either side.Yet another privilege is called the Straddle. This car-

ries the right to Put or Call a number of shares of aspecified stock at the same price. A Straddle on UnionPacific at 100 would give you the right to receive it ordeliver it at 100 up to and at the -maturity of the option.


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CHAPTER IV.AMERICAN OPTIONS OK PRIVILEGES.

AMERICAN options are usually employed in one of threeways:

(1) They are purchased in the hope and expectationthat as the price at which the option privilege may beexecuted approaches, the value of the option itself willincrease, so that the buyer can sell out his option at aprofit. Buyers of this type are dealers or brokers in op-tions.

(2) They are purchased by speculators who believe thatthe market, or a particular stock, is about to have a con-siderable advance or decline and that money can be madeby exercising the right incorporated in the option. Intransactions of this character the effort is made to buythe option at or near the beginning of a substantial mar-ket swing. There is, usually, active trading in optionswhen the market approaches the culmination of a pro-longed advance or decline, and the chance of reaction(within the time limit of the option) is strong.

(3) It is contended that the most important use of op-22


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THE ABC OF OPTIONS AND ARBITRAGE. 23tions by buyers is made when they are bought for theprotection of operators trading in the stock market. Ina case of this kind the holder of the option would regardhis option as a policy of insurance, the cost of the insur-ance being the price of his option.

Options are usually sold by (1) option dealers orbrokers; (2) by operators in stocks desiring to assist theirmanipulative deals, and (3) by operators in stocks wish-ing to partially protect profits or with some special objectin view:

(1) Option dealers or brokers may write and sell theirown options or simply deal in the options of others. Theirnumber is limited. Dealing in options on the floor ofthe Stock Exchange is not recognized by that institution.Stock Exchange members, however, frequently buy andsell options. Twenty years ago trading in options in WallStreet was much more common than it is to-day. Inrecent years trading in privileges in Wall Street has beengreatly restricted. Reasons for this are that representa-tive firms have been unwilling to undertake to sell optionson the insurance plan as in London; few men have beendisposed to sell them in small lots, and, during the periodwhen the Spanish War tax prevailed, the tax cut into theprofits of those dealing in options. In consequence ofthose conditions the option business for a time was to an


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24 THE A B C OF OPTIONS AND ARBITRAGE.extent degraded by its associations. Very largely the bus-iness has been diverted to the London market, where deal-ing in options is an important part of the securities' tradeand is so recognized. There has never been a time in thehistory of Wall Street when its market in options has ap-proached in importance that of the London market. It ispossible, and even probable, however, that the day is notfar removed, when Wall Street will recognize the possibil-ities of the insurance feature of the option market andprofitably cultivate it. As explained elsewhere, privilegesin London are sold for succeeding accounts ; that is to sayan option sold in January might run to the last accountin February or the last in March or even to the last inApril, the price depending upon and rising with the timewhich the option has to run. The tendency in the WallStreet market has been to make the Put or Call price fora period of about thirty days, 4 to 5 points from the mar-ket price. On the other hand the tendency in the Londonmarket has been to sell a closer option for the same per-iod; say 3 points from the market for thirty days.

Another distinction between the London and New Yorkoption is that the London option carries interest. SeveralNew York Stock Exchange houses have cable and financialconnections through which they acquire London options,permitting trading on such options, with settlement ofthe account in New York.


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THE ABC OF OPTIONS AND ARBITRAGE. 25Still another difference between the two markets is that

in New York options are generally sold with a specialobject in view, while in London the price of the option,the law of averages and the volumes of business are thoprimary factors entering into the financial calculation.

Undoubtedly this trade as conducted in London is morecomplicated than trading in stocks, as conducted in NewYork, and calls for more financiering skill. In theirstock transactions Americans apparently prefer the utmostsimplicity, and in this respect it is to be remembered thatmany traders in stocks are absolutely unable to arrive atan intelligent understanding of the bear operation instocks.

(2) Used in the manipulation of stocks by large opera-tors, the option does not enjoy the same favor in WallStreet that it did twenty or thirty years ago. The opera-tion is comparatively simple. A private banking house oflarge resources may desire to market, say, 100,000 sharesof stock. The house in question will offer a large operatora Call on this stock at a certain price, with the stipulationthat the operator shall make all the money he can by creat-ing a market for this stock. The operator's profits willconsist of the difference between the Call price of thestock, and the average gross selling price above the optionprice, less his expenses. An operator of this class under


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26 THE A B C OF OPTIONS AND ARBITRAGE.such conditions will sometimes make up a pool among hisassociate operators and traders, the pool taking all or apart of the stock, and adding its endeavors to work themarket up above the Call price. It will be readily under-stood that the object of all concerned in this transactionis to unload the stock upon the general public, at as highprices as can possibly be obtained.

It also happens at times that operators of this classreceive Puts on a large block of stock that they are ex-pected to market. The Puts are given to protect the oper-ator against an unexpected decline and as a guarantee ofgood faith. The operator expects to sell profitably, but ifhe has to buy more than he can sell, the principals, gener-ally bankers, agree to take this stock off his hands at aprice which will show him no loss.

(3) Large operators also occasionally resort to the useof options to assist their operations in other ways. Suchan operator may ostentatiously offer to buy Puts on thestock in which he is interested for the moment at a verycheap price. This is done to inspire confidence in theprospective buyer, but the guide is not a reliable one. Theoperator may be honest in his belief that the stock inquestion is about to advance, and in that way wish toincrease his following; but owing to the limited marketfor options of this kind in Wall Street, it is obvious that


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THE ABC OF OPTIONS AND ARBITRAGE. 27Puts of this character might at small expense be utilizedto assist in unloading stock at the prevailing market price.If the operator in such a case had definite knowledge thatthe stock in question was about to decline, rather thanadvance, he could protect himself against the Put by sell-ing a corresponding block of stock, short, and then onreceiving the stock, represented by the Put, deliver it tothe buyer at the higher price, and thus lose nothing.Where speculation for the decline is to be encouraged thisoperation can be reversed by offering to dispose of Calls.The willingness or unwillingness of large operators to

sell options is at times utilized as a suggestion of theirprobable market position. An operator may be bullishon a certain stock but his statements are doubted. Anagent is sent to him and he is asked if he will sell optionson the stock in question and on his reply a deduction maybe made on the probability of an advance or decline. This,however, is not a reliable guide, as the operator may refuseto dispose of options on various grounds not identifiedwith his market operations.

Large operators also use options, especially Calls, in theemployment of financial writers to encourage buying ofstocks undergoing manipulation. An operator may wishto advance a stock and unload upon the public. He willbribe those financial writers who will accept bribes, by of-


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28 THE A B C OP OPTIONS AND ARBITRAGE.the Calls at the market, or on a scale upward, in

return for their assistance in booming the stock orstocks in question in the financial columns of the publica-tions they control. Here, the Calls are not actually sold,but are exchanged for what is considered to be an equiva-lent in the form of illegitimate advertising.

Perhaps the largest dealer in privileges in the WallStreet market has been Mr. Kussell Sage. The price ofoptions and the time covered vary greatly. In those re-spects the New York and London option markets varygreatly. Sellers of options in London as a result of longexperience, if they sell a Call, straightway buy half thestock against which the Call is sold; or if a Put is sold,they sell half the stock immediately, finding that in thelong run this method usually works out a profit. Mr.Sage's custom, during his extraordinarily active career, hasbeen to sell Puts or Calls, running from 30 to 60 daysfor about $100 per 100 shares. It is also worth bearingin mind that Mr. Sage, like most other American optiondealers, has preferred to sell options on stocks in whichhe was interested as an insider and presumably knewrather more than the option buyer of the probable imme-diate course of market prices. Suppose, for example, thatMr. Sage owned a block of Missouri Pacific and that thestock had been advanced to 127. At that price there was


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THE A B C OF OPTIONS AND ARBITRAGE. 29a demand for Calls to run thirty days at 1 per cent, fromthe market. Believing that a reaction is probable, Mr.Sage disposes of Calls on 1,000 shares, and then MissouriPacific must advance to 128 before the stock is called,when the owner is willing to deliver the stock at whathe may consider to be a very fair or handsome price, asthe case may be, replacing his investment stock when adecline in the market permits him to profitably do so. Itwill be noted that a financier of large wealth, holdingblocks of speculative and investment stocks, could utilizethe option market in this and various ways, having specialobjects to be gained. The field, if a -broad one, would beextremely profitable to such an operator, but the fact is,that its limitations are very narrow and sharply defined.Mr. Sage, as the leading American option seller, hasnever sold options with the object of insuring the buyeragainst loss. He has backed his own market judgmentas against that of the buyer, or has sold when he was pro-tected by his holdings of stocks, or was willing to increasehis holdings at prices that appealed to him as an investorof large resources.


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CHAPTER V.VALUE OF OPTIONS.

THE New York dealer in options when asked how hearrived at the value of the Put-and-Call or Straddle re-plies that it is a matter of judgment, shrewd-guessingor that the value can only be determined when the optionhas been exercised or expired. Value, then not being as-certainable at the time of sale, would not govern the price^which is a gamble if having no object other than theexpectation that the buyer will lose.

It may be worth while, says Mr. Higgins in The Put-arid-Call, to discuss the conditions regulating the pricesof options, and to see if we can determine some method ofascertaining at any rate the probable minimum value ofa Put-and-Call for a certain given period.

In order to do this, let us first see what the giver forthe Call of a certain stock (in the London market) reallydoes. He thinks, for example, that Brighton 'A' stock isgoing to rise, but having, on previous occasions, found thatthe movement of this stock for some inscrutable reason hadbeen diametrically opposed to the favorable opinion he

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THE A B C OF OPTIONS AND ARBITRAGE. 31had preconceived for it, he seeks to insure himself againstunlimited risk,' and is willing to pay an insurance pre-mium for the convenience. Accordingly he goes to anoption dealer, who is willing to grant insurance againstrises and falls, and says : 'I wish to speculate in Brighton''A for two months; if I buy 5,000 stock, at what ratewill you insure me against loss?' The option dealer re-plies: 'I will take the risk of the rise or fall for 2^j percent., or the risk of both for 4 /2 per cent. Now what isit that suggests the figure of 4^2 per cent, to the optiondealer as a reasonable cover for the risk he is taking over ?He must say to himself: 'I do not think, judging frommy experience, that the fluctuation of Brighton Aduring the next two months will be more than 4% percent. It has been much more at times but the market isdull now, 4y2 per cent, is a good deal of money in hand,and I think the business is worth doing.' He forms inhis own mind an estimate of the probable movement of thestock during the next two months, and the result of hismental calculation is that he runs the risk of the rise andfall from the present market price of Brighton CA' for apremium of 4% per cent. Had the proposition been Con-sols he would probably have asked about % per cent.,Erie shares 2% per cent., St. Paul shares 5 per cent., allon the same rough-and-ready principle. Now, is it not


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32 THE A B C OF OPTIONS AND ARBITRAGE.possible to ascertain by statistics a figure which shouldrepresent more accurately the 'probable ri.-k' run than onewhich had been determined, in the first place, by guesswork, and in the second, by the speculative impulse of themoment?The writer is of the opinion that the risk can be ascer-

tjiinc-d with a considerable degree of accuracy; and in thisbelief he has selected some of the principal speculativestocks and traced their fluctuations from week to weekover a period of seven years from January, 1888, to De-cember, 1894. The price of each week has been compare^with those of the previous week, fortnight, month, twomonths, and three months (the fluctuations being carriedout in columns), and averages have been taken over thewhole period in question.The American stocks selected for the purpose are:

Erie, Norfolk & Western, Union Pacific, Chicago, Milwau-kee & St. Paul, and Louisville & Nashville.During the seven years under review these representa-

tive stocks have been subject to every kind of influence,financial and political; they have seen times of utter stag-nation, and times of the greatest activity; weak marketsand strong markets; alternate periods of excessive optim-ism and desperate depression. And during the whole termthey have moved up and down consistently with the spirit


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THE ABC OF OPTIONS AND ARBITRAGE. 33of the seasons through which they were passing, the fluc-tuations at one moment being rapid and violent, at anotheralmost imperceptible. If, therefore, an average be ascer-tained of the fluctuations for given periods in the marketprices of these representative stocks, would not that aver-age form a fair basis upon which to calculate the expectedperformance of these particular stocks in the immediatefuture? In fact, does it not come to a question of insur-ance pure and simple, a premium being asked to cover arisk ascertained by a kind of actuarial calculation? Verynearly, although there is a difference between this andother classes of insurance ; were it not so, one could reduceStock Exchange operations to a certainty, which is known,to borrow Euclid's expression, to be absurd. The differ-ence lies partly in the fact that the statistics governingthe premiums exacted for insurances upon life, fire, acci-dent, etc., are obtained with greater accuracy from resultsspread over a much longer period than it would be possi-ble, or even useful, to do in the case of stocks, and thatthe conditions from which these results follow are muchmore regular and reliable. Thus, a life insurance companyknows that out of one thousand ^healthy males' of thirtyyears of age, it can, with the greatest amount of certaintyexpect eight or nine to disappear from the scene of itsactuarial calculations before the age of thirty-one. In


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34 THE A B C OP OPTIONS AND ARBITRAGE.other words, the 'cost of carrying the life' for one yearof a man aged thirty, of robust health and good habits, isascertained to be under 9 per 1,000. Whatever thecompany can charge over and above this amount, plus theworking expense, must be its profit, always provided thatit can do sufficient business to establish an average. Andit is precisely these last words that express the great dif-ference existing between the insurance against fluctuationof stocks and most other classes of insurance. To calcu-late the value of a risk is one thing, but to make a profitby dealing on that basis is quite another. An individualmight insure the life of another to the extent of 1,000for 30 per annum (on the assumption that the actuarialrisk was 15, and consider that he was making 15 a yearby the transaction; but if the insured dies in the firstyear there is a loss of 970 in spite of all actuarial reck-oning. He must 'take the money' very many times tomake it pay.

It is just so with the taker of option money. Not onlymust he ascertain the average past behavior of the stockhe is about to deal in, but he must be careful that he cansell this risk a sufficient number of times during the yearto establish the average upon which his premium is based.Now, most people who are conversant with the nature

of speculative transactions in stocks, and with options in


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THE ABC OF OPTIONS AND ARBITRAGE. 35particular, will know that owing to the fickle nature ofgivers of option money it is impossible to establish theaverage as suggested above. In actual practice, it is foundby option dealers that, unlike other classes of insurerswho are willing, e. g., to insure their lives although theyare in the best of health and spirits at the moment, ortheir houses in spite of their entertaining no immediatefear of being burned out, the giver of the option moneyonly seeks protection when he considers that the optionmoney paid does not anywhere nearly represent the riskof which he is relieving himself by passing it onto histaker. There is not that noble unselfishness about a buyerof a Put or a Call which is displayed by the man whoinsures his life only because 'All men are mortal' and pro-vision must be made for his family. Indeed, where wouldour great life insurance companies be if they only re-ceived proposals from people who came in because theywere not feeling well. It amounts to this, that the greatestdemand for options, springs up at a time when it is leastprofitable for the taker to operate, when dealing againstthe option in the firm stock is fraught with the most ser-ious danger and difficulty; and per contra, just when theoption taker has a chance of recouping his losses by 'run-ning the Put-and-Call' in a dull and inactive market, hefinds that there are 'no qivers' Then it may be asked


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36 THE A B C OF OPTIONS AND ARBITRAGE.how is it possible ever to find a taker of option money atanything like a reasonable rate? The answer is that theoption dealer does not work upon any regular system oractuarial basis, but is guided in his operations mainly bythe speculative impulse of the moment. This speculativeimpulse does not exist in any other description of insur-ance, and had it existed to any appreciable extent, the lifeof the great insurance corporations would be as extinct atthe present moment as is the business of the majority ofthe great option dealers who have found by experience thatit is the givers, and not the takers, of option money whohave gained the advantage in the long run. A comparisonof the table of the Average Fluctuations with lists of op-tion quotations ruling in the market during past yearswill suffice to illustrate the argument that takers of optionmoney have been carrying on an insurance business withno margin for profit and working expenses, even if theycould rely on being able to take the same amount of optionmoney on the same quantity of stock all the year roundand for many years in succession.To lay down a distinct rule for the amount which, in

order to provide a reasonable margin for profit and work-ing expenses it would be necessary to add in the shape of'loading,' to the option values, as set out at the end ofthis chapter, would be extremely difficult; for the condi-


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THE A B C OF OPTIONS AND ARBITRAGE. 37tions of the markets vary so much that what might appeara liberal allowance at one time would be inadequate atanother. It is safe to assert, however, that in order tocarry an option-taking business to a successful issue itwould be essential:

Firstly, to ascertain the past average fluctuation over aconsiderable period of time of the stock to be operated in.

Secondly, to consider whether there is any special in-fluence at work calculated to modify that average resultin the immediate future (such as a particular scarcity ofthe stock for delivery, financial strain, or probability ofpolitical complications).

Thirdly, to accept risks on approximately the sameamounts of stock at regular intervals of time.

Fourthly, to add to the 'average value' of the Put-and-Call an amount which will give a fair margin ofprofit and allowance for working expenses.

Fifthly, to make provision for possible default on thepart of the giver (since the option money only becomespayable at the end of the option period), and for specialcontingencies, such as large differences or bad debts onoption stock carried over through buying one-half of thestock to convert the Call into a Put-and-Call or lossthrough an unexpected rise in the money rate, none ofthese mischances being provided for in the 'average

value'


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38 THE A B C OF OPTIONS AND ARBITRAGE.tables, which have been calculated simply from the aver-age fluctuations.

Sixthly and lastly. To be careful that, having onceaccepted a risk, the option shall be allowed to run to theend of the option period without being tampered with byhedging operations in the firm stock or 'cutting the loss*before its time, and that at the expiration of the optionthe profit or loss shall be taken as final and the positionbe absolutely closed.

Neglect of any of these conditions would completelyspoil the average and convert a stocks insurance businessinto a mere gamble. Let us examine how far they havebeen observed in the quotations of options for two monthsand three months respectively in two of the leading spec-ulative shares of the American railroad market St. Paulshares and Louisville & Nashville.Taking the first-named stock we find that in 1888

fifty-two fluctuations of two months averaged 4.47 percent.; the same number of fluctuations in 1889 averaged3.02 per cent.; in 1890, 6.05 per cent.; in 1891, 4.63 percent.; in 1892, 2.88 per cent; in 1893, 6.48 per cent.;and in 1894, 4.29 per cent. showing a grand averageover the seven years of 4.54 per cent.The three months' fluctuations in the same stock came

out as follows: In 1888, 4.20 per cent.; in 1889, 3.16 per


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THE ABC OF OPTIONS AND ARBITRAGE. 39cent; in 1890, 8.lf per cent.; in 1891, 6.70 per cent; in1892, 2.


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40 THE A B C OP OPTIONS AND ARBITRAGE.and working expenses ; that no bad debts were incurred bygivers failing to pay up at the end of the time; that everyoperation was closed at the expiration of the option, andthat no unfortunate hedge against a dangerous-looking op-tion was ever done during its currency. The taker wouldhave had a running risk of 8,000 shares against him, oneoption maturing every week and another taking its place;he would have dealt fifty-two times in 1,000 shares in eachyear, and again fifty-two times in 1,000 shares in rebuyingor re-selling to close his position; that is, in 104,000 shares(of $100 each), or in a total of 728,003 shares in the s


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THE ABC OF OPTIONS AND ARBITRAGE. 4Jvember, 1890) say 26,000; he would then have to chargefor the option:

Per cent.(1) The average value, say 4%(2) Proportion of working cost 1,300 %(3) Proportion of 5 per cent, interest on a

capital of 26,000 %(4) Other contingencies %(5) Margin of profit %Total 53/8

Thus, by taking every week 5% Put-and-Call of 1,000Louisville shares for two months ahead, and closing theoperation in each case at option time, a taker would securea profit in the average of $.50 per share equal to 5,230 on52,003 shares. On the basis of 5% his profit would be2,600, and at 4y8 he would have paid his working ex-

penses and the interest on his capital but have no profit.Now, to turn one moment for fact, notice that :In the first week of January, 1895, the two months'

single options in Louisville and Nashville shares and St.Paul shares were quoted at $1.87%,, equal to $3.75 for thePut-and-Call

The three months' single options of these two stocks


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42 THE A B C OF OPTIONS AND ARBITRAGE.on the same date were quoted respectively, $2.25 and$2.371/2, equal to $4.50 Put-and-Call on Louisville and$4.75 on St. Paul. The 'average values' for three months-come out 5.34 per cent, on Louisville and 5.29 per cent, onSt. Paul, and, treating these figures in the same manner aswe have done in the case of the two months' options, wefind that, on the basis of $6.25 the option taker would haveaveraged a profit of $.50 per share during the seven years,1888-1894, and that at the premium of $5.75 he wouldhave just paid his expenses and interest on capital. Atany lower premium he would have worked at a loss.The appended table of average value is by no means

complete, although it has been prepared, as far as it goes,with a considerable amount of care, and the main objectof introducing it is to offer a practical reply to those whohave been heard to say: 'If the option dealer thinks itgood enough to take the money, it cannot be 'business' forme to give it.' ''


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THE ABC OF OPTIONS AND ARBITRAGE. 43TABLE OF AVERAGE VALUE.

The approximate value of the Put and Call of someleading stocks, as ascertained by the average fluctuationsfor the period in question, between Jan. 1, 1888, and Dec.31, 189.4.


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CHAPTER VI.CASTELLI AND HIGGINS ON OPTIONS.

THE difference between English and American tradingin options along complicated rules of procedure is so pro-nounced that a study of the subject from the English pointof view cannot be pursued with financial profit by Ameri-can stock traders. This statement, however, does not applyto the simpler methods of option trading. Mr. H. W. Ros-enbaum, who is perhaps Wall Street's oldest option trader,has conducted in the London market very profitable opera-tions for New Yorkers. Prior to the second election ofthe late William McKinley to the Presidency of the UnitecfStates, Mr. Rosenbaum for a New York client of responsi-bility, negotiated the purchase in the London market ofa large number of Calls on American stocks. On the sub-sequent rise, the stocks were sold and the rights incorpo-rated in the privileges exercised as they

matured. In oneinstance a profit in excess of $100,000 was returned to aNew Yorker who had not been required to deposit onepenny as margin, Mr. Rosenbaum giving him the necessarycredit. Of course had the options proved to be valuelesstheir cost would have been promptly defrayed. New York


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THE ABC OF OPTIONS AND ARBITRAGE. 45option operations in the London market, however, are ob-viously confined to the more simple forms.

In 1877, Mr. Charles Castelli, a stock broker publishedThe Theory of Options. His illustrations are for the mostpart based on transactions in foreign securities, and haveat this time no practical value to Americans as they arenot applicable to American markets. After an explanationof the more simple forms of trading in Puts and Calls heundertakes the task of unraveling the mysterious operationof Complicated Options. The essential qualities intrading in them, he says, are good judgment and a thor-ough memory of the working and skillful application ofoptions. To acquire these qualities, as might be expected,years of study are required. Several years ago a Londonbroker in options came to Wall Street and endeavored tointerest several firms in the advisability of engaging in thisbusiness. He was unsuccessful. Undoubtedly the chiefhandicap under which he labored was his inability to makehimself and his business understood.A later and more useful book than that of Mr. Castelli

is The Put-and-Call by Mr. Leonard E. Higgins, which isalso published in London. He refers significantly to thevalue of options to buyers, saying:

In all the examples of option dealing considered, theoperator has been made to deal against his options in firm


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46 THE A B C OF OPTIONS AND ARBITRAGE.slock for the option period. *ln actual j>ni


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THE ABC OF OPTIONS AND ARBITRAGE. 47A stock may be bought call o' more or bought put o'

more; in the former case the buyer is 'giving optionmoney/ and in the latter he is 'taking option money/ Inlike manner if A sells to B stock call 0* more, the option tocall rests with B, and A is 'taking option money.' If Asells stock to B put o' more, he is giving the option moneyand has the right to put on B.The price given for the firm stock may carry the right

to buy twice, three times, or any number of 'times, theamount of the firm stock dealt in; the options beingtermed 'call of twice more/ 'call of three times more/ etc.,or, in selling direction, 'put of twice more/ 'put of threetimes more/ etc. Such fancy options, however, are notvery frequently indulged in.Of the most popular method of operating, Mr. Higgins

says:It may be worthy of remark that 'calls' are more often

dealt in than 'puts/ the reason probably being that the ma-jority of 'punters' in stocks and shares are more inclinedto look at the bright side of things, and therefore moreoften 'see' a rise than a fall in prices.

This special inclination to buy 'calls' and to leave 'puts'severely alone does not, however, tend to make 'calls' dearand 'puts' cheap, for it can be shown that the adroit dealerin options can convert a 'put' into a 'call/ a 'call' into a


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48 THE A B C OF OPTIONS AND ARBITRAGE.'put/ a 'call o' more' into a 'put-and-call/ in fact anyoption into another, by dealing against it in the stock. Wemay therefore assume, with tolerable accuracy, that the'calP of a stock at any moment costs the same as the 'put*of that stock, and half as much as the Put-and-Call.

After giving eight examples of option trading in theLondon market Mr. Higgins, as a giver of option money,arrives at the following conclusions :

1. That a Call of a certain amount of stock can be con-verted into a Put-and-Call of half as much by setting one-half of the original amount.

2. That a Put of a certain amount of stock can beturned into a Put-and-Call of half as much by buyingone-half of the original amount.

3. That a Call can be turned into a Put by selling allthe stock.

4. That a Put can be turned into a Call by buying allthe stock.

5 and 6. That a Put-and-Call of a certain amount ofstock can be turned into either a Put of twice as much byselling the whole amount, or into a Call of twice as muchby buying the whole amount.

Mr. Higgins relates this anecdote: An operator inorder to disguise his position and avoid suspicion, mayelect to give for the Put-and-Call of a stock instead of


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THE A B C OF OPTIONS AND ARBITRAGE. 49either the Call or the Put, and afterward turn his positioninto the single option by degrees. There is a story of aGerman banker, anxious to dispose of a large amount ofsome bank stock, approaching an option dealer who, aftersome conversation upon the merits of the stock in ques-tion, took money from him for the Put-and-Call of a con-siderable portion of the amount the banker really wishedto dispose of. Some little time after the option dealerfound that the stock was easier to buy than to sell, and notwishing to have this large block thrown on his hands hetook every opportunity of raising the price whenever itcould be done at the expense of buying a few thousandpounds more of the stock. A short time before the optionbecame due the selling seemed to have ceased, and, in fact,the price rose so rapidly that the option dealer began towonder where he would get the balance of stock from incase it was called of him. Indeed, so great was his uneasi-ness that by degrees he covered the whole of his position,the seller of the stock, unknown to him, being his optiongiver ; and on the day the option was due, the price was sofar above the option price that no doubt was left in hismind as to which way the banker would declare his option.At option time the banker approached the dealer, who said :*I congratulate you on the fine fit you have on your option ;you, of course, call the whole of your amount.' 'On the


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50 THE A B C OF OPTIONS AND ARBITRAGE.contrary/ replied the knowing banker, 'I do not call any Iput it; on you.' And the operation being well timed, anunfavorable announcement concerning the affairs of theinstitution was made that afternoon, and the option dealerfound himself the unwilling possessor of the whole amountof stock which had belonged to the banker, who through-out the operation had never once been obliged to show hishand.The above anecdote, which is probably fictitious, is

noc quoted so much with a view to dwell upon the ethicsof Stock Exchange transactions as to remind the readerthat the apparent market in 100 shares is one thing, andthe actual market in 10,000 something very different.The reader will understand that the operations as de-

scribed by Messrs. Castelli and Higgins are possible onlyin the London and Continental markets.


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CHAPTER VII.ARBITRAGE.

THE business of arbitraging between stock markets isone of the minor fields of industry pursued in the NewYork money market. An arbitrage business can be, andfrequently is, conducted between New York and London,New York and Boston, New York and Philadelphia, andthe New York Stock Exchange and the New York Con-solidated Exchanges.By long odds the most important arbitrage accounts are

conducted between New York and London. It is taken forgranted that the reader understands the business of thearbitrageur to be, buying in one market at a price andselling in another market at a better price, the object beingto net the difference that may exist between the buying andselling prices in the two markets. Or, the operation maybe reversed by selling first in one market and buying inanother.The net difference between the purchase and sale does

not represent profit, as out of the difference, the arbitra-geur must defray his expenses.

Frequenters of Wall Street brokerage houses are famil-61


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52 THE A B C OF OPTIONS AND ARBITRAGE.iar with the first question of every speculator on his arrivalat the office How is London? Usually the tone ofthe London, influences the tone of the New York market,but at times they are quite wide apart, and then the arbi-trageur becomes busy. The arbitrageur's transactions inthe two markets tends to bring the quotations close to-gether.With London time five hours ahead of New York time,9 A. M., in Wall Street is 2 P. M., in London. When Wall

Street starts business in the morning London is about clos-ing the day's business. At 9:15 A. M., or thereabouts, theWall Street news agencies have distributed the 2 P. M.,London prices over the ticker and on the news slips.Long before the New York Stock Exchange opening,

the arbitrage houses have been cabling to and receivingcables from their London correspondents. Their clerkshave tabulated prices and reduced the London quotationsto their New York equivalents. They also have to codetheir orders to be sent abroad and translate those received,and pay close attention to instructions. Mistakes are socostly that few are made. London prices are invariablyhigher than ours, the difference being represented by thecost of shipment and the prevailing rate of exchange. Onanother page the reader is informed how the New Yorkequivalent of the London price is obtained.


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THE ABC OP OPTIONS AND ARBITRAGE. 53There are less than a dozen firms engaged in the arbi-

trage trade. They are all wealthy firms, and have invari-ably been engaged in the stock brokerage and banking busi-ness for many years. It may also be remarked that theyare invariably foreign houses; that is to say, they areEnglish or German firms and here the Hebrew financieris in a business environment that appeals to him. Ofcourse arbitraging between New York and London makesnecessary a strong financial London connection. WhyAmerican houses are not represented in this trade to agreater extent is due as much to indifference as anythingelse, but at the same time, as has already been said^ it isprobable that the English and German financier has akeener appreciation of a volume of small profits, and willspend more money in the form of work to secure the smallprofit than his New York brother.

In arbitraging between the two markets, assume thatSt. Paul is quoted at 93% sellers (or offered at 93%)in London at 3 P. M., while the first Wall Street quotationis 911/4. All American stocks are quoted in London on anarbitrary basis of $5 to 1 (i. e., $1 equals 4 shillings),and so the London offered price of 93% is equal to a WallStreet quotation of 90.69 (with sterling exchange at 4.85)so that with the New York opening quotation of 9114bid, the arbitrage house buys St. Paul in London at 93%


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54 THK ABC OF OPTIONS AND ARBITRAGE.and sells St. Paul in New York at 911/4. On this trans-action there would be a certain profit of 50 cents per share,or $50 per hundred shares, or one-half of one point. As-suming that the transaction is carried out to the end, andthe stock bought in London is delivered in New York, theexpense of shipping the St. Paul from London to NewYork would have to be deducted from the gross profit andit would leave a net profit of about 371/2 cents per share.This expense would consist of the cost of transportation,the interest on the cost of the sfock (offset in part by theinterest on the stock borrowed for delivery in New York)and other incidentals described in detail in the chapterdescribing the method of shipping stocks between NewYork and London.But the arbitrageur does not carry out each transaction

to the end, as might be supposed. The next trade follow-ing the one described may be a purchase of St. Paul inNew York against a sale in London. Assuming that 100shares are dealt in, the arbitrageur finds that he has boughtand sold 100 shares in each market, the stock is then ex-changed, and, each account balances. The arbitrageur trysif possible to even up his accounts for each day ; but it willbe readily understood that as he can borrow and lend ineach market a series of unsettled or unbalanced trans-actions can be carried over an indefinite period at the


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THE A B C OF OPTIONS AND ARBITRAGE. 55arbitrageur's convenience. The fewer actual shipmentsmade, however, the greater his profits will be.In the London market the first New York .prices arrivea few minutes after 3 P. M. The London arbitrageursthen study the New York market in international stocksvery closely until their Stock Exchange closes, which timeis 4 P. M., except on account days, when it is 4 :30 P. M.When the London exchange closes, though, trading inAmericans does not cease in London where a curb marketexists. The market in Americans after the formal closingadjourns to Snorter's Court, and dealings are continuedthere, sometimes until 7 o'clock in the evening, Londontime. The arbitrageurs' clerks in London have desk ac-commodations at the London cable offices and they have aconstant stream of cable orders transmitted by messengerboy service to the market. In Wall Street the arbitrageurs*clerks are provided with temporary accommodations out-side the rail on the Stock Exchange floor. As regards theLondon market it may be added that abroad, prices arereduced to sixteenths. Here the minimum change is one-eighth.A good idea of the mechanism of the arbitrage trade be-tween London and New York may be had in considering thefollowing description, that of a Londoner : It is one ofthe most amazing of modern miracles that a man can more


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56 THE A B C OF OPTIONS AND ARBITRAGE.quickly purchase and sell stocks at a distance of 3,000 milesthan a man in Fleet Street can operate on the LondonStock Exchange, a quarter of an hour's walk away. It isthis, I had almost said, fatal facility that has enabled somany English speculators to take a hand in the Americanboom, when the loss of -a few minutes might mean the win-ning or losing of a small fortune.You would think that whehn stocks and shares are fluc-

tuating wildly many times within an hour, it would besheer madness for any one in another continent to haveanything to do with them, but with such marvellous rapid-ity are messages transmitted nowada}-s by cable that atransaction can be completed in Wall Street almost asquickly as in the London Stock Exchange by a broker onthe spot. This speed in the transmission of orders enablesthe arbitrageur to secure his profits.

Suppose I have an order to buy 10,000 worth of Illi-nois Central. The purchase is completed within a coupleof minutes of handing in the message in Snorters' Courtand I can receive a reply from New York within five min-utes, a marvellous feat when you consider that the doublemessage has travelled 6,000 miles.As you may imagine these messages are reduced to the

smallest possible dimensions. In fact, a cablegram, pur-chasing, say, 100,000 of stock, will probably consist of


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THE ABC OF OPTIONS AND ARBITRAGE. 57three or four words only, with the time of despatch and asingle letter to serve as name and address of the receiver.

These messages are despatched with what is literallylightning speed by a highly skilled band of cablists, thepicked men of the army of operators, who must not only beexceedingly expert cablists, but unfailingly accurate intransmission, for an error might mean loss of thousandsof pounds. It says much for their skill and care that mis-takes are very rare indeed.

There are three rival cable companies in London allalmost wholly expert and reliable one British, one French,and the third American. From 3 P. M., which means 10A. M. in New York, messages pour into these offices at therate of many hundreds an hour and are flashed with in-conceivable rapidity over the wires from London via Ire-land and Canada to New York, the actual transmissionover 3,000 miles of wire only taking a single minute. Andquickly as these messages flash and fly westward underthe Atlantic, other messages are flashing from Xew Yorkto London over the same wires without any possibility ofgetting in each other's way.As many as 500 messages are often despatched in an

hour and between 2,000 and 3,000 in a day ; and almost asmany are received in return, recording their contents onthe almost endless serpent of paper which streams fromthe receiving machine.


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58 THE A B C OF OPTIONS AND ARBITRAGE.Even at a shilling a word it is possible to spend im-

mense sums on cabling, a single firm often paying thtcable companies as much as 600 or 800 in a week, andperhaps it is no exaggeration to say that during the re-cent boom in American rails the receipts of the threecable companies were not less than 10,000 a week.The arbitrage business between New York, Boston,

Philadelphia and Chicago is not very large. A few firmsare engaged in it, and others have unsuccessfully attemptedto trade in an arbitrage way in those stocks which have aninter-city market. Considerable expenditures are neces-sary in conducting the business. First, a special wire isrequired, then telegraph operators and clerks, to say noth-ing of brokers and the multitude of minor expenses. Toarbitrage between the domestic markets the same rules areobserved as prevail between New York and London, butit is obviously easier to effect the evening-up operation.One has only to ship by express balances in stock fromChicago or any other city to New York and make deliveries.At times, however, stocks in out of town names are not atechnical good delivery, and a transfer of the stock certi-ficate may be required. In shipping stocks from NewYork to other cities the methods are substantially the sameand very simple.

While arbitraging between the Stock and Consolidated


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THE ABC OF OPTIONS AND ARBITRAGE. 59Exchanges is not a recognized industry, nevertheless sucha business is transacted. It is probable that more speedand alertness is displayed in this quarter than in any otherbranch of the arbitrage trade. In the more active stockson the Consolidated Exchange the arbitrageur stands in aparticular crowd and signals with the fingers of his handto his telephone or telegraph operator. In this way prices,including bids and offers and actual sales are signalled withmarvellous rapidity and accuracy. When well organized,there are excellent profits in this business, and betweenthe two exchanges a larger and more profitable business istransacted than is generally believed.Between the two Exchanges it is an easy matter to settle

balances. So many transactions are made in a day that inthe ordinary course of things, the trading in a particularstock will balance, thus enabling the arbitrageur to evenup his trades on each exchange. When this is not possible,balances are delivered in stock for which payment is madeby check.

Necessarily then it will be perceived that the businessof arbitraging in stocks has rather narrow limitations, con-fined as it is to a few international banking firms, to Am-erican concerns having private wires between New Yorkand the large interior cities, and to members of the Stockand Consolidated Exchanges.


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CHAPTER VIII.ARBITRAGING IN RIGHTS.

IN the five years prior to 1904 trading and arbitragingin stockholders' rights at times assumed quite large pro-portions in Wall Street. Generally this business was con-fined to rich banking firms, who were content with verysmall but very certain profits.

For example, a railroad having its stock listed on theStock Exchange, desired to raise new capital. Its stockwas quoted at say 110. The company offered to its stock-holders of record on a certain date the right to sub-scribe to 10 per cent, of their holdings at par, or say100.Assume then, that you had 100 shares. That would

give you the right to subscribe for 10 shares at par or$1,000. In the open market the rights dealt in beforethe actual issue of stock, would probably sell for 9%. Atthose figures your rights on 100 shares would have amarket value of $97.50.

If you did not care to sell your rights, but preferredto subscribe to the new stock as an investment, your sub-


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THE ABC OF OPTIONS AND ARBITRAGE. 61scription money would be forwarded to the company andon the date of issue the company would forward you anew certificate of stock for the 10 shares, costing you$1,000 and having a market value of, say, $1,100.

Or, you could accept the other alternative and betweenthe date of the company's offer and the closing of thebooks you could dispose of your, rights to the arbitrageur.The arbitrageur is willing to pay you slightly under the

market value of the stock for your rights. Thus, if 110is bid for the stock, he may offer you 9%, or $97.50, forthe rights on 100 shares. On buying the rights for100 shares of new stock at, say, 9%, he will sell 100 sharesof old stock at 110. In that way he will derive a grossprofit of $25 on the transaction.

Technically, however, the arbitrageur is long theright to subscribe to 100 shares of new stock at 100,and short 100 shares of old stock at 110. He pays forand owns the rights. Temporarily he borrows 100shares of old stock, on which he will probably receive in-terest of 2, 3 or 4 per cent., or slightly under the actualcall money rate, and delivers it to the buyer at 110.When he exercises his rights and receives from the

company a new certificate of 100 shares for which he pays$10,000, he notifies the firm from which the old stock wasborrowed that the loan will be returned. It is accordingly


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O^ THE ABC OF OPTIONS AND ARBITRAGE.returned and the arbitrageur is now even, In- havingbought 103 shares at 10934, and sold them at 110, nettingthe difference, plus the interest received on the borrowedstock.

His expenses have consisted of clerk hire, general officeexpenses, and at times it is necessary to employ a part ofhis capital. But, as a rule, this branch of the stock broker-age or banking business is incidental to larger and moreprofitable operations.

There are also other methods of arbitraging, which areeven more complicated. For example, when the UnitedStates Steel Corporation was formed, relatively little ac-tual capital was employed, the stocks of the minor corpora-tions being merged in the large corporation. Stockholderssimply exchanged their stocks in the minor companies forstock in the new corporation.The basis of value was made upon the most insignificant

company in the group, which in this instance was the Am-erican Steel Hoop Company. A holder of 100 commonand 100 preferred shares in the American Steel HoopCompany found that he would receive in exchange forhis shares so many common and preferred shares in theUnited States Steel Corporation. Before the issue of itsnew stock, the shares of the United States Steel Corpor-ation were dealt in on the curb when and as issued.


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THE ABC OF OPTIONS AND ARBITRAGE. 63Arbitrageurs found then that they could buy on the StockExchange at the market prices shares in the old companiesand sell at the same time against their purchases an equi-valent amount of new stock on the curb, and in that wayscalp a profit. Temporarily they were long of the oldstock and short of the new, having to carry the old andborrow the new, until they effected the exchange.The operation simply called for quick thinking and quickaction. As a result of the arbitrageur's operations the

stocks in the old and new corporations rapidly approachedeach other in equivalent market prices, and thereafteruntil the merger was effected profits were reduced toeighths and quarters.

Such an arbitrage transaction involves considerablelabor, nice bookkeeping and a slight element of risk. Gen-erally it is confined to banking houses, and to those iden-tified with underwriting the new stock or company, as thecase may be.


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CHAPTER IX.USAGES OF THE LONDON STOCK EXCHANGE.

STOCKS in London are bought and sold for the currentsettlement, which takes place twice a month, and is com-posed of three days, viz. :First. The so-called making up or contango day, onwhich day London brokers make their arrangements forcarrying over or borrowing stocks until the next settle-ment, or declare that they will take up or deliver the stocks.On this day also the settling price is fixed by the LondonStock Exchange, and all accounts are made up and basedon this price. Also the rate of interest (called contango)is fixed for carrying over or borrowing stocks, and all op-tions have to be declared at 12 o'clock.

Second. This is called the Ticket Day, on which allclearing tickets are passed.

Third. This is the Pay Day, on which stocks are de-livered and paid for, and on which day all differences arepayable.

Deliveries of stock have to be made in London in 10-share certificates, and every certificate of $1,000 par value

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THE ABC OF OPTIONS AND ARBITRAGE. 65has to have an English government stamp of 2s. affixed.Of course, this stamp only has to be put on once, and ifcertificates can be obtained which already bear the stampthey are a good delivery.Payment for American shares and bonds in London is

made in pounds sterling at the invariably fixed rate of $5to 1, thus 100 shares of stock at $75 equal $7,500, equalto 1,500, etc.The commission for buying and selling American stocks

is usually 6d. per share, equal to about $12.50 rjer 100shares. There is no commission for continuing transactionson settlement day over to the next settlement. The onlyremuneration which the broker in London obtains for thework entailed, consists of charging his clients usuallyone-half per cent, per annum more interest than that whichhe has to pay for having stocks carried over, or allowing toclients who are short of the market one-half per cent,per annum less than that which he receives on borrowedstock. It is only on exceedingly rare occasions that stocksin London are so scarce as to command a premium (calledbackwardation ), which premium, however, if it shouldoccur, would be credited to the client who is long, orcharged to the one who is short.On every bargain made in London an English govern-

ment stamp of Is. has to be affixed to the contract note.


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66 THE ABC OF OPTIONS AND ARBITRAGE.Dividends an- collected by the London .broker, from

which, however, the Knglish income tax, which is at pres-ent Is. per pound, or equal to 5 per cent, is deducted. Thusa dividend of $1,000 would net only $950. There are noother expenses connected with the business, except those forcabling, which are, however, very small.

Regarding the time limit of orders it maybe said thatorders sent from Wall Street to London during the after-noon or evening, unless otherwise agreed, are considered inLondon good until 2 P. M., in London, thus (allowing forfive hours difference in time) receiving an answer by about9:30 A. M., barring delays of the cable companies. Or-ders sent during the day are usually considered good forthe rest of the day, unless an arrangement is made thatthey should be good only for a certain length of time, sayfifteen to thirty minutes, or unless the cable states howlong the order should be in force, as for instance, imme-diately, five minutes/' one hour, etc., etc.


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CHAPTER X.METHOD OF SHIPPING STOCKS BETWEEN LONDON AND

NEW YORK.THE usual way of bringing stocks from London to New

York is to arrange with some New York banking house totake up the stock on Pay Day in London and ship it over,and to deliver it here on arrival against payment. Theprice of the cable transfer has to be arranged with thebanker, and there are no other charges except postage andinsurance, which latter is about 50 cents on each $1,000value. The banker also charges interest on his outlay ofmoney from the time of his payment in London until thedelivery of the stocks here.

Sometimes also stocks are brought over by instructingthe London broker to ship and draw on New York, but inmost cases the Exchange figures out a little higher in thisway.

Sometimes it is also practicable to exchange the sharesby delivering the stocks in London and receiving them sim-ultaneously here both against payment.The usual method of shipping stock from New York to

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68 THE A B C OF OPTIONS AND ARBITRAGE.London is to have the shares transferred into 10-share cer-tificates and sell a draft with the stock attached to someNew York banking house. The only charges are the insur-ance and the postage. Unless certificates can be obtainedwhich already have been in England and have the pre-viously mentioned government stamp of 2s. on each tenshares attached, the same will have to be affixed in Londonjwhich, of course, is charged to the client. There are noother expenses connected with forwarding stock from Lon-don to New York, or New York to London.

Should stocks arrive in London before Pay Day, thebroker of course charges interest for carrying them overuntil he can deliver them on the settlement.Many of the large arbitrage houses never insure shares,but ship the certificates, after having the numbers certifiedto by a notary public, and in case of loss of the certificates,new ones are issued by the corporation that issued the lostcertificates.The cost of insurance, however, is so small (50 cents to

60 cents on each $1,000 value) that it is regarded as thebetter plan to insure. Bonds, of course, are always insured.

Sometimes it is also possible to exchange shares with ar-bitrage houses, who are long in London and short inNew York.

For the purpose of illustrating the cost of shipping stock


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THE A B C OF OPTIONS AND ARBITRAGE. 69to and from New York, the following illustrations wereprepared by Mr. H. W. Kosenbaum :

Example No. .1.Pro forma statement of cost of 1,000 St. Paul bought

in London at 154 /2 and shipped to New York.Bought 1,000 St. Paul at 154i/2 30,900.006d. commission per share 25Contract stamp 1.Cables to and from London 10.

25.11

Total cost 30,925.11To bring the stock to New York we buy for the London

Settlement Day a cable transfer at, say, $4.87%, to be paidin New York upon delivery of the stock here, with interestfrom the time of payment in London until reimbursementhere, say about 10 days, subsequently:

30,925.11 at $4.873/4 $150,839.37Insurance at 50c. per $1,000, about. $75Postage 1.

Total cost in New York, about 150%On these transactions about ten days' interest will have

to be paid to the bankers for their outlay of the money


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70 THE A B C OF OPTIONS AND ARBITRAGE.while the stock is in transit, which, however, is compen-sated for by

nothaving to pay

for the stock here until ar-rival and delivery in New York.

Example No. 2.Pro forma statement of cost of 1,000 Ontario & Western

sold in London at 35, and shipped to London :Sale of 1,000 Ontario & Western at 35 7,000Less commission and stamp 25 1.Cable expenses 9.English gov't stamp of 2s. on each

10 shares 10.35.10

6,964.10We ship the stock to London with draft, andsell the draft to banker at, say, $4.87,amounts to $33,917.11

Less insurance and postage 17.48

Net proceeds $33,899.63or equal to 33 90-100 per share.

In the matter of evening-up positions, most of the NewYork firms doing business in London prefer not to bringany stocks over, or to ship them abroad, except in cases of


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THE A B C OF OPTIONS AND ARBITRAGE. 71absolute necessity, such as when a position should becomeunwieldly large, or when stocks or money should becomevery scarce. As a general rule, they prefer to leave stock?which they are long of in London and wait for a daywhen the London market is somewhat higher than theNew York market, and then turn their position by sellingout their long stock in London and buying it back inNew York, or in the reverse case to wait for a day whenLondon is lower than New York and buy in the shortstock in London and sell it out in New York, thus eveningup their position.The exchange of stock transaction cables between New

York and London, if the proper arrangements are made,is very rapid; and, in fact, much more so than betweenNew York and Boston or Philadelphia, and when the busi-ness is well organized answers are generally received in fif-teen or twenty minutes.

Writing of the probably closer relations that will existin the future between the New York and London stockmarkets. Mr. H. W. Rosenbaum says: It seems strangethat so few persons take advantage of the facilities thatare offered to occasionally transact business in Londonin preference to New York, and how few are familiarenough with the situation to take the pains to buy in thelowest and sell in the highest market.


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72 THE A B C OF OPTIONS AND ARBITRAGE.The customs of the London Exchange may be different

from ours in some minor details, but any one may easilybecome familiar with these differences, and thus be ableto determine quickly which of the two markets is the moreadvantageous.

I am not alluding to the arbitrage business, which is abranch of stock exchange business in itself, although theability to arbitrate may be easily and quickly acquired.

I refer particularly to the opportunities which are of-fered in London at certain times when the New York Ex-change is closed.Many houses having recently become cognizant of this

fact have, with the sanction of their clients, often executedlarge orders in London, which could not possibly have beenexecuted in New York, and especially large buying andselling orders were given over night, and were executed atprices that could not have been obtained in our marketeither at the close of business or at the opening the follow-ing morning.One of the principal advantages which the Londonmarket offers is that stocks bought or sold between settle-ments are free of interest. Thus, when money is very ac-tive in New York, it may often be preferable to buy in theLondon market, and vice versa, when stocks are scarce inNew York it may be preferable to sell in London.


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CHAPTER XLTRADING IN LONDON OPTIONS FROM NEW YORK.THERE is an increasing disposition to trade in London

options from New York. Several excellent firms are en-gaged in this business. In the great rise that culminatedin 1903, immense profits were paid by London dealers totheir fortunate New York customers.The regular London option is always either a Put or a

Call, or both, at the market price of the stock at the timethe bargain is made, to which is immediately added thecost of carrying or borrowing the stock until the maturityof the option.

Options in London are always for a specific settlement,say, for instance, for the End April or May Settlement andcannot be exercised before. Of course dealing can alwaysbe made against options by selling against Calls, or buyingagainst Puts as the case may be. When making suchtransactions against options which have a long time to run,most operators make sales or purchases for the same set-tlement on which the option matures, thereby avoidingeither a Bear position or a Bull position in the stock


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74 THE ABC OP OPTIONS AND ARBITRAGE.market, with the attendant risks of the money market,or of a scarcity of stock, and the necessity of makingup the differences on borrowed or loaned stock duringthe intervening settlements. This is in most cases thesimplest and best way of dealing against a future option.

Options at a distance above or below the market price aredone occasionally, and are called fancy options. Thesehowever, are not regularly quoted and can only be done onspecial occasions, while the regular option as describedabove, can be bought at any time in practically unlimitedamounts.

All option contracts are subject to the rules of the Lon-don Stock Exchange, and must be declared on the firstday (Contango or making up day) of the Settlement forwhich the option was bought.

Dividends go with the stock, a Call being entitled to thedividend declared, and a Put having to make good the divi-dend.

AYhen the London option matures it is incumbent uponthe broker to declare for the account of his client the Callif the Call is above the Call price, or the Put if the stockis below the Put price. Therefore, clients who do not wishto carry stock over or remain short of stock after theoption has expired should instruct their brokers to sellout their stock at maturity if above the Call price, or buy


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THE ABC OF OPTIONS AND ARBITRAGE. 75in the stock if below the Put price, as otherwise the brokerwould declare the option and carry forward the positionfor account of his client.

Or, another explanation is: 1. In accordance withthe rules and regulations of the London Stock Exchange,options in London are only available at the specified period.The option has to be declared in London at 12 o'clock onthe first day of the respective settlement (called the Con-tango or Option Day) and the securities are delivered andpaid for on the third dady of the settlement (called PayDay) therefore, when an option is quoted for the end of acertain month, it must be understood to be for the settle-ment at the end of that month. The settling days are gen-erally announced by the London Stock Exchange Commit-tee about two months ahead, and are usually so arrangedthat the three days' follow each other without any inter-vening Saturday, Sunday or holiday.

2. The London Option price is always arranged whenthe order is executed. The price is the price at which thesecurity could be bought or sold, deliverable at the timewhen the option matures. Therefore interest at a fairrate (called Contango) is added immediately to the cashprice of the security when the order is executed, and theprice at which the option is then reported as bought in-


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76 THE A B C OF OPTIONS AND ARBITRAGE.eludes the interest, and is consequently the price flat (without any further interest) at which the securities will bereceived or delivered at maturity of the option. Divi-dends, however, go with the securities, the owner of theCall being entitled to the dividend, the owner of the Puthaving to allow the dividend if the option is exercised.


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CHAPTEK XII.AN OPTION PRICE LIST.

A specimen option price list quoted by a Wall Streetbroker is as follows : New York^ October ^ 1900

OPTIONS IN LONDON.QUOTATIONS.

The quotation is for the single option (either a Putor a Call. ) The double option (Straddle) is double thepremium. Mid. Nov. End Nov. End Dec.

Per cent. Per cent. Per cent.Louis. & Nash 2 2% 2%Atch. Pfd 2 2y 2%Un. Pac. Com 2% 2% 2?4St. Paul 2V8 23/8 2%Nor. Pac. Com 2 2%Nor. Pac. Pfd 1%N. Y. Central 2%So. Pacific iy2 1% . 2Anaconda % i/>pershPennsylvania 1% 2i/8

Orders for the purchase and sale of stocks against op-tions executed for % per cent, commission.

77


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CHAPTER XIII.THE CONVERSION OF LONDON INTO NEW YORK PRICES.THE conversion of London into New York prices with-

out a table is a rather clumsy arithmetical calculation.Taking the London price, you multiply it by the WallStreet price of demand sterling exchange, and then divideby five.

Mr. H. W. Rosenbaum has arranged the following veryexcellent tables, enabling anyone to quickly convert Lon-don prices into New York prices by deducting from theLondon prices the figures named.

For instance, with exchange at $4.87% :London price 75Deduct , 01.88

New York equivalent 73.12If the London price is 75%, you would adopt the same

process and add the fraction of 0.37 to the price, makingthe equivalent 73.50.

78


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THE ABC OF OPTIONS AND ARBITRAGE. 79When stocks are quoted over 100, you add the two to-

gether, as, for instance:

Exchange, $4.87y2 .London price . 156.50Deduct $2.50 for 100Deduct $1.40 for 56 3.90

152.60or, say, 152%.

If you want to convert New York prices into Londonprices you reverse the process by adding the difference tothe New York price and the result will be near enough forall practical purposes.


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CHAPTER XIV.STOCK CONVERSION TABLES.

EXCHANGE ATLONDON IPRICE. I 483 |483V2 | 484 |484V2 | 485 |485V2 | 486

11


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THE ABC OF OPTIONS AND ARBITRAGE. 81EXCHANGE AT

LONDONPRICE.


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82 THE A B C OF OPTIONS AND ARBITRAGE.EXCHANGE AT

LONDONPRICK. 483 1 483% | 484 [484^ 485 14867, 48669


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THE A B C OF OPTIONS AND ARBITRAGE. 83EXCHANGE AT

LONDONPRICE.


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84 THE A B C OF OPTIONS AND ARBITRAGEEXCHANGE AT

LONDON-PRICE.


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THE A B C OF OPTIONS AND ARBITRAGE. 85EXCHANGE AT

LONDONPRICE.


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THE A B C OF OPTIONS AND ARBITRAGE.EXCHANGE AT

LONDONPRICE.


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THE ABC OF OPTIONS AND ARBITRAGE. 87EXCHANGE AT

LONDONPRICE.


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Nelson'sWall Street

LibraryVol. I. The A B C of Wall StreetBy S. A. Nelson. 164 pages, illustrated. Com-

pletely and accurately descriptive of the money andspeculative markets, and also containing a dictionaryof Wall Street words, names and phrases.

Vol. II. The Anatomy of a RailroadReport and Ton Mile CostBy Thomas F. Woodlock. 116 pages. An analysis ofrailroad reports written by an authority on the sub-ject for investors, stockholders and students, togetherwith a study in railroad economics of value to anyoneinterested in American railroad finance and management.

Vol. III. The Theory of Stock ExchangeSpeculationBy Arthur Crump. 125 pages. A volume that shouldbe studied by every trader in stocks.Other volumes in preparation.

The series is bound in cloth and leather and can beordered through booksellers and newsdealers generally,or will be mailed postpaid for $1.00 each.

S. A. NELSON, PUBLISHER19 Park Place New York City


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Vol. IV.

The ABCof

Banks and BankingBY MR. GEO. M. COFFINEx- Deputy Comptroller of the Currency

THE object of this book is to give a simple and conciseexplanation of the principles and practice of bank-ing in the United States, and it is successfully accom-

plished. It is designed to appeal to the outsider as well asthe man in the bank. While by no means the last, or everyword about banking, it can be accepted as an authoritativeprimer, covering a field that has hitherto been somewhatneglected. In view of the growth of commercial andeconomic education, the author hopes that the book will beserviceable to teachers and students as well as businessmen. The chapter arrangement is : Banking in General,Various Kinds of Banking, Capital Stock, Shareholders'Rights and Liabilities, Undivided Profits, Dividends andSurplus, Deposits, Checks, Lawful Money Reserve, IssuingBank Notes, Borrowing Money, Loans and Discounts,Exchanges, Collections, Letters of Credit, Bonds, Mort-gages and Stocks, Bank Reports, Examinations, Directors,Executive Officers, Internal Administration and Bookkeep-ing, and other suggestions. The student and young busi-nessman cannot fail to find this little volume of decidedvalue, and every banker would do well to place it in thehands of his clerks and depositors. 137 pages, 16 mo., $1.25,

S. A. NELSON, PUBLISHER19 Park Place New York City


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Vol. V.The ABCofStock SpeculationBY S. A. NELSON

THIS book expounds Dow's Theoryof Speculation, the value of whichis recognized by traders of experi-ence,

Documents

The ABC of Options and Arbitrage