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CBOESeries56Review

Welcome:

Thisreviewismeanttocomplementthebookandthepracticequestionsthatyouhavereceivedaspartofyourpackage.Westresstheimportanceofreadingthroughthebookandofbecomingfamiliarwiththerulesintheirentirety.ThisreviewisNOTmeanttoserveasasubstituteforthebook,butratherasacomplement,aspreviouslystated.

Manyoftherulesarelengthyandareattimesdifficulttodecipher.Thisreviewtakesalargesampleoftheserulesandhighlightsimportantdetailstohelpyoutacklemanyofthequestionsontheexam.

Regardingexpectations,whilenooneexpectsyoutomemorizeeverywordinthebigbook,itwouldbeinyourbestinteresttothoroughlylearnEVERYiteminthisreview.Youshouldplaceallemphasisonknowingthismaterialasifyouwereguaranteedtohaveatleastonequestiononeachtopicdiscussed.

AFewAdditionalNotesofCaution:

Thereareseveralquestionsthatdiscussrisk,reward,andpossiblybreakevenlevelsofstrategieslikeverticalspreads(callspreadsandputspreads).Wedonotdiscusstheminanydetailinthisreview,butyoushouldhaveathoroughunderstandingofhowtoderivesuchanswers.

TheFINRAoutlinestatesthatyoushouldbecomfortablewithbasicputcallparity.Thisisnotdiscussedinthisreview,butshouldbeknownasitisconsideredbasicknowledgeforprofessionaloptionstraders.

Wewishyouwellontheexam.Ifyouhaveanyquestionsorconcernsbeforeoraftertheexam,pleasefeelfreetoreachouttous.

Thankyouagain,

TheStaffattheCBOEsOptionsInstitute

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ExamOverview:

105MultipleChoiceQuestions,butonly100count

100RealQuestions,5ExperimentalQuestions

2HourTimedExam

70outof100CorrecttoPass

QuestionsSegmentedinto5Sections

ScratchPaperandBasicCalculatorProvided

YouareNOTallowedtotakeanythingintothetestcenter!

NOExchangeSpecificRules

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Chapter1Review:Approximately9Questionswillstemfromthischapter.

WhoNeedsToTakethisTest?

Ifyouareamemberofanexchange,yousupervisetraders,youareatrader,oryouareaMarketMaker,youneedtotakethistest.

Furthermore,ifyouaresomeonewhosupervises,monitors,ortrainsanyoftheabove,youalsoneedtoberegistered.

Youmustberegisteredifyouaregivingadviceonspecificstocks.YoudoNOThavetoberegisteredtogivegeneraleconomicinformationorgeneraleconomicoverviews.

IfyourenotactivelyengagedintheSecuritiesbusinessatyourfirm,youdonothavetoberegistered.Registrationisdifferentfrombeingapprovedforemployment.

DonotregistermejustsoIcansitfortheSeries56Examifyoudonotintendonemployingmeasatrader.

WhodoesNOTneedtotakethisTest?

Ifyouareclericaloradministrative,ifyouarenotengagedinthesecuritiesbusiness,orifyoutradeFuturesorCommodities,youdoNOTneedtoberegistered.

YoumayNOTregisterpeopleoncetheyarenolongerfunctioninginaregisteredcapacity,iftheyarenolongerinvolvedinthefirmssecuritiesbusiness,orifyouaretryingtoregisterthemsolelytoavoidexaminationrequirements.

RegistrationForms:TheU4andtheU5

U4Thisistheformthatisfilledoutwhenyouarehiredasaregisteredperson.Forthepurposesofdeterminingyourcontinuingeducationrequirements,yourhiredateisthedatethatyouwereissuedaU4.TherearemanythingsthatneedtobereportedonyourU4.However,itisimportanttorememberthatachangeinmaritalstatusdoesNOThavetobereportedonyourU4.

U5Thisistheformthatisfilledoutuponyourdeparturefromafirm.Theformisissuedregardlessofwhetheryouareterminatedorwhetheryouresign.Itisfiledelectronicallyandshouldbefiledwithin30daysoftermination.

IfthereareanydiscoveriesmadethatrequireamendingyourU5,thereportingfirmhas30DAYSfromthedateofdiscoverytoupdateyourU5.

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ExchangeRegulationsandRulesofConduct

Whenyouapplytobeamemberofanexchange,therulesarefairlyuniform.Youmaybedeniedmembershipdueto:financialthresholds,yourinabilitytoadheretorulesandregulations,ifyouFAILanexam,orIFyourassociationwouldbringtheexchangeintodisrepute.FingerprintingisrequiredundertheSecuritiesActof1934.

Ifyouareapproachedonthetradingfloorregardingaviolation,youmaywaituntilaftertheclosetoaddresstheallegedviolation.

StatutoryDisqualification

ThisoccurswhenyouarebannedfromanSROorwhenyouarechargedbyanSRO.Thinkoftheprocessasonewhereyouareguiltyuntilproveninnocent.Hence,ifyouarecharged,youmustimmediatelyappealthosecharges.Furthertothatpoint,ifyouarechargedonmultiplecounts,youmustappealALLcounts.FailingtoappealjustoneofmanycountsmakestheStatutoryDisqualificationfinal.

IfyouarethesubjectofaStatutoryDisqualification,youmaycontinuetoworkwithyourcurrentSROduringtheappealsprocess,butyoumaynotgoandworkwithanyotherSRO.ReasonsanExchangemayissueaStatutoryDisqualificationare:

ANYfelonyinthelast10years CertainMisdemeanorsThistypicallyreferstofinanciallyrelatedones. RefusaltohonoranArbitrationresultoraward FailuretoPayDuesorFees DestructionofExchangeProperty

TheonlywayyoucanundoaStatutoryDisqualificationisiftheSECsaysit'sok.

Thatsaid,anSROmayfine,suspend,orotherwisedisciplineaMemberorMemberfirm.However,anSROmayNOTimprisonanindividual.Ithasnojurisdictiontodoso.

BusinessConductreferstoanythingthathastodowithtrading.ItisgovernedbytheSecuritiesActof1934.

ForanyviolationreportedonanExchange,ifitisalegitimatecomplaint,youdoNOThavetohaveawrittencomplaintinorderforthingstobeinvestigatedbytheExchange.Thecomplaintmusthavereasonabledetailsregardingaviolation.

Onceaviolationisreported,theExchangeMUSTinvestigatethematter!Asafirmorasanindividual,youaresupposedtoSELFreportanyactionsagainstyouoragainstafirmPROMPTLY!

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Foranyruleviolations,bothMembersandMemberFirmsmaybeheldliable.Ifyouhaveaclerkthatismisbehavingandhe'snotregistered,it'syourfault.

AsMarketMakersorBrokers,youshouldbeawareofwhatconstitutesjustandequitableprinciplesoftrade.

Youshouldnotrefusetotradewithsomeone,threaten,harass,intimidate,orexhibitretaliatorybehavior.

Everythingisopentoarbitrationexceptthingslikeclassactionsuits,sexualharassment.

ContinuingEducation

Therearetwotypesofcontinuingeducationelements:ARegulatoryElementandaFirmElement

TheRegulatoryElementisadministeredbyFINRAandmustbecompleted2yearsafterinitialemploymentandevery3yearsafterthat.Itmustbecompletedwithin120daysofanniversarydates.TheanniversarydateisdefinedasthedateyoureceiveyourU4.Ifthecontinuingeducationisnotcompletedontime(ifthe120dayshavepassed),thenyourlicenselapsesandyouarenotallowedtoactinaregisteredcapacityuntilyourectifythesituation.Onceyoucompletethecontinuingeducation,youareactivatedagain.

Ifyouaresubjecttoastatutorydisqualification,anSROortheSECmaymakeyoutakethecontinuingeducationearlier.

Reasonsthatyoumaybeaskedtodotheregulatoryelementearlierthan2years...

StatutoryDisqualificationbySRO,orderedtobySROorSEC,orifyougetfinedover$5K.

TheFirmElementEverymemberfirmshouldhaveaFirmElementanditshouldbeDOCUMENTED.TheFirmElementshouldcoverapplicableregulatoryrequirements,salespracticeconsiderations,etc.Forexample,optiontradingfirmsshouldhavesomethingwhereyouspendanhouronceayeargoingoversomethinglikeoptionsbasics.Registeredpersonsmustsignadocumentstatingthattheyhavecompletedthetraining.IfFINRAortheSECasks,thisfirmelementmustbedocumentedanddocumentationmustbeproducedondemand.

GiftstoExchangeandFirmEmployees

Youmaygiftupto$50toanExchangeemployeewithoutfirstobtainingpermissionfromtheExchange.

Youmaygiftupto$100toanemployeeofaMemberFirmwithoutfirstobtainingpermissionfromtheMemberFirm.

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TreatmentofClientsandCustomers

Youcannotguaranteeclientsthattheywillnotlosemoney.

YouCANshareinaclient'sprofit.Ifyouopenanaccountforoneofyourfriends,thewaytoshareinprofitsistogetwrittenpermissionfromyouremployerandtohaveanagreementstatingthatprofitpercentagesarebasedonyourrespectivecapitalcontributions.

HedgeFundsarenotbrokers.TheyoperateasLLCs.

You'renotsupposedtotakelossesjustbecauseaclientmadeabadmove.Youmayneedtotakelossesincaseofatradingerror.YoumayalsobeallowedtotakecustomerlosseswithapprovaloftheExchange.

RecordKeepingofCustomerAccounts

Youshouldkeepbid,offer,orderandexecutioninformationandticketinfoforupto3years.ThiscomesfromSecuritiesActof1934.

Whenyouopenanaccountforanoptioncustomer,youshouldfileextrapaperworkforthatcustomerandkeeponfilefor3yearsonsiteatthebranchofficeandatasupervisoryofficeandthethirdyearmaybeinaremotelocation.

ENDOFCHAPTER1REVIEW

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KnowthedifferencebetweenaBrokerandaDealer!

ABrokertradesforothers.

ADealertradesforhimself.

DEFINITIONOFASECURITYThekeythingtoknowwhenthinkingabouttheoptionworldisthatoptionsandotherinstrumentswithLESSthan9monthstoexpirationarenotconsideredsecurities.Therefore,LEAPSaresecurities.9monthsisKEY.

QualifiedBlockYoucanprovideliquidityatadiscountbid.Youshouldexpeditiously(actualwordingmaybeinanexpeditiousmanner)getoutofthattrade,butthereisnotsomesettimebywhichyouhavetogetout.Thatway,youdonotupsetthebalanceofthemarket.

TheNASDAQMarketCenterisaplatformthatallowsfirmstotradeallNASDAQ,NYSE,andAMEXlistedsecuritiesonasingleplatform.

AnAlternativeDisplayFacility(ADF)isadisplayonlyfacilityoperatedbyFINRA.TheADFprovidesmemberwithafacilityforthedisplayofquotes,reportingoftrades,andthecomparisonoftrades.AsanSROdisplayonlyfacility,ADFdoesNOTprovideautomatedorderrouting,executionfacilities,orlinkagesbetweenADFtradingcenters.ADFtradingcentersarerequiredbyNASDruletoprovidedirectelectronicaccesstoallotherADFtradingcentersandprovidesuchaccesstoallFINRAmembersthatrequestit.

AnOverTheCounter(OTC)Securityisastockthattradesinsomemannerotherthanonaprimaryexchange(NYSE,AMEX,NASDAQ).Thistermisoftenusedtodefineastockthatistradedthroughsomesortofdealernetwork.UnlikeExchangebasedtransactions,OTCtransactionsaresubjecttocounterpartyrisk.InstrumentssuchasbondsandPennyStockstypicallytradeOTC.Thatsaid,beawarethatexchangelistedinstrumentsMAYALSOtradeOTC!

TheThreeActs

SecuritiesActof1933PrimarilydealswithIPOs.ThiswastheearliestAct,anddealswithpubliclyheldcompaniesattheirearliestmoments.

SecuritiesActof1934PrimarilydealswithSecondaryMarketRegulation.ThiswasthesecondAct,anddealswiththesecondstageofacompanyslife.ThisistheActtowhichmostofthereferencesinthetestpertain.TheSecuritiesActof1934establishedtheSECandturnedRegulatoryAuthorityovertotheExchangesandtotheNASD.ThisactgovernsSECONDARYTRADING.

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InvestmentCompanyActof1940Primarilydealswithhedgefunds,mutualfunds,andotherthirdmarketoperations.ThisisthelastoftheActs,andhencetheonethatdealswithcompaniesinmorematurestagesoftheirlife(suchaswhentheyareestablishedenoughtobeconsideredforamanagedfund).

SROsarethenationalexchangesandFINRA.

Thereare3typesofInvestmentCompanies:

FaceAmountPayableattheEndofthelifeofacontract ClosedEndFundThisisbasicallyanETF.ItisbackedbythesharesthattheETF

represents.Valueisbasedonmarketvalue. OpenEndFundValueisbasedonNetAssetValue(NAV),notonthevalueofshares

thattradeonanexchange.Thatsaid,NAVandtradingvaluemaydiffer.Thesefundsissuesharesandthenbuysharesbackfromyou.ThinkofanIndexFundlikeVanguard.

Youshouldknowthebasicsregardinghowtovalueopenendvs.closedendfunds.

MarketPriceforClosedEndFunds NetAssetValue(NAV)forOpenEndFunds

WhatdoesFINRAdo?

YougetU4'dandhence,registeredthroughFINRA. FINRAhandlestheeducationofindustryparticipants. FINRAexaminesinvestmentfirmsandcreatesindustryrules. FINRAisfundedbyasmalltransactionfeefromtradingactivities.TheSECdoesNOT

fundFINRA.

WhatdoestheOCCdo?

AlloptiontradesareclearedthroughtheOCC. TheCFTChasjurisdictionovertheOCCbecausetheOCCclearsFuturescontracts!There

isjointjurisdictionwiththeSEC. TheOCCisnotinvolvedinbreakingtrades.

DepositoryTrustandClearingCorporation(DTC)isliketheOCCexceptforStocks.TheexammayalsorefertotheNSCC,whichisasimilarbody.

OntheTopicofMarketMakers

Youshouldknowthedifferencebetweenafloorbrokerandamarketmaker.

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Differentexchangeshavedifferenttypesofmarketmakers.Somemarketmakersgetcompensatedbyexchangesjustforshowingup

Under1934Act,theyrefertomarketmakersasSpecialists.FloorBasedMarketMakerscanparticipateinbothopenoutcrytradingandinelectronictrades.

FloorBrokerDisclosuresRegardingMarketMakerOrdersIfyouareafloorbrokerandanothermemberasksyouwhetherthisorderisforanotherMarketMaker,youmustdiscloseyourclientifyourclientisindeedamarketmakerandifsocalledupontodoso.YoudothisONLYIFASKEDandonlyifthatmarketmakerisamemberofthatExchange.

Note:IfyouareabrokerholdingaMarketMakerorderandyouarenotaskediftheorderisforaMarketMaker,thenyoumusttreattheorderasaregularcustomerorder.

Ifyouarefacilitatingcustomerorders,youshouldnotbeusingyourmarketmakerdesignationtocircumventshortsellingrules.

Ifyouregisterasaproptrader,you'renotsupposedtohaveanycustomers.

ENDOFCHAPTER2REVIEW

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Youshouldknowhowtocalculaterisk,reward,andbreakevenlevelsforverticalspreads.

StockownershipYouhavealimitedliability,sothemostyoucanbeoutiswhatyoupaidfortheshares.

StockholderRights

Youhavetherighttotransfershares. Youhavetherighttodeclareddividends.Therearedifferentrightsforcommonand

preferredshares. Youhaveaccesstocorporateinfo. Theexdateisthedatethatthestockpriceshouldadjustforthedividend.Inorderto

getadividend,youmustbeashareholderofrecordONtherecorddate.

Stock,Options,andFuturesSettlementGuidelines

1) StocksnormallysettleT+3.Thisisalsoknownasregularwaysettlement2) FuturessettleT+13) CashsettlementforstocksisT+1.

a. Thisimpliesthatatradercouldbuystockthedayaftertheexdividenddate,designateitcashsettled,andcollectthedividendbecausehewouldbeastockholderofrecordontherecorddate.

4) OptionssettleT+1.However,ifyouexerciseacalloption,theSTOCKthensettlesT+3.5) Youmaybeaskedsomethingalongthelinesof,SupposethatonMonday,youbuy

stockanddesignateittobecashsettledandyoualsobuyacalloption.Onwhatdaydothoseproductssettlerespectively?TheanswerisTuesdayTuesday.ThisisbecausecashsettledstocksettlesT+1andoptionssettleT+1.

6) ThereissomethingcalledDelayedDeliverywhichreferstodeliveringasecuritybeyondstandarddates.Ifthereisaquestionregardingacustomerwhowantstoissueasecuritybutdoesnotwanttodeliveritfor30days,thiswouldbeanexampleofdelayeddelivery.

a. Anexampleofthiswouldbeamunicipalitythatissuesbonds.However,theydelaydeliveryfor30daysinordertoprintoutcertificates,shipthecertificates,andtoallowadequatetimeforanythingtheymayneed.

7) Ifacustomerbuysstock,hehasuntilT+3totakedeliveryoftheshares.Ifthesellerhappenstodeliverthesharesearly,thebuyermayrefusethatearlydelivery.Thismaybebecausethebuyersimplydoesnothavethemoneyanyearlierthanatthescheduledtime.

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Statutoryvs.CumulativeVotingRights

Shareholdershavevotingrights.Sometypesofvotingrightsmayprovidecertainbenefitsforcertainshareholders.YoushouldknowthedifferencebetweenStatutoryandCumulativeVotingRightsandwhattheyrepresentforshareholderswiththoserights.

StatutoryVotingRightsYoumayonlyvoteuptoyournumberofsharesforeachdirector.Thismeansthatifyouown100sharesandthereare5peoplevyingforadirectorspost,youmayvotewithupto100sharesforeachofthe5people.

CumulativeVotingRightsYoumayvoteyourtotalnumberofshares(thenumberyouowntimesthenumberofdirectorsupforelection)inanywayyoudesire.Thatis,ifyouown100sharesandthereare5peoplevyingforadirectorspost,youmayvotewithupto500sharesforasingleperson.Forthisreason,cumulativevotingrightsareconsideredabenefittolargeshareholderswhoaretryingtogetsomeoneelectedonacompanysboard.

Note:ThereisathirdtypeofvotingrightreferredtoasaContingentVotingRight,whichpertainstoPreferredShareholders.Typically,preferredshareholdersdonothavevotingrights.However,inthecasewherethecompanyfailstopayadividendtothepreferredshareholders,theycanthenissueavoteoncorporatematters,namelythosepertainingtounpaiddividends.

Proxy:Yougiveupyourvotingrightssoyoudonthavetogotoashareholdersmeeting.

VotingTrustIfacompanyisgoingbankrupt,aboardoftrusteeswillbeempoweredwithyourvotingrightsinordertoexpediteprocessesthatareexpectedtotakealongperiodoftime.

OptionContractAdjustments

WhentheOCCadjustsoptioncontractstheytrytobeextremelyconsistentonhowtheyapproachthingsbasedonthefollowing5parameters.

Fairnesstopositionholders Maintenanceofanorderlymarket ConsistentInterpretationandPractice EfficiencyintheExerciseProcess CoordinationwithOtherClearingAgencies

SpecialDividendIfthereisa5%specialdividenddeclaredonastock,therewillbeanOptionContractAdjustment.Ifitisa5%stockdividend,thedeliverableisadjustedfrom100sharespercontractto105sharespercontract.

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StockSplits:

Atraderowns1AugXYZ60CallandXYZSplits2for1.Thepostsplitpositionis2XYZ30Calls.

Atraderowns1XYZ60CallandXYZSplits4for1.Thepostsplitpositionwouldbe4XYZ15Calls.

o Inbothoftheseexamplesthedeliverableisstillthestandardforequityoptioncontractsof100shares.

Atraderowns1XYZ60CallandXYZSplits3for2.Thepostsplitpositionwouldbe1XYZ40Call,butthedeliverablewouldchangefrom100sharesto150shares.

Note:Exercisingyourtotaloptionpositioninanyofthe3examplesstillresultsinatotalstockpositionvaluedat$6,000.

Extraordinarydividends:Thereisathresholdwhereextraordinarydividendswouldcauseanautomaticadjustmenttotheoptioncontract5%dividendormore

Spinoffsituationsmayleadtosharesthatrepresentownershipinmultiplestocks.

StockDefinitions:

AuthorizedStockSharesthatmaybeissuedtothepublic.

CompaniesAUTHORIZEstock.

IssuedStockSharesthathavebeenissuedtothepublic.

OutstandingSharesSharesthathavebeenissuedtothepublicandtoinsiders.

Sharesthatareownedbyemployeesarestillconsideredoutstandingshares.

TREASURYSTOCKWhenacompanyrepurchasesshares,thosesharesbecomeTREASURYSTOCK.Thecompanyisnolongerpayingdividendsonthoseshares.

ParValueItdoesNOThaveANYrelationshiptocurrentvalue.Itisaminimumvalueatwhichacompanywouldsellmoreshares.

ParValueofPreferredStocksAcompanycouldissuepreferredshareswithparvaluedefinedas$10.Then,iftheystatethattheyaregoingtopay10%ofParasanannualdividend,thatwouldmean$1,REGARDLESSofmarketvalueofthestock.

StatedValueForaccountingpurposes,again,norelationshiptomarketvalueofshares

TransferAgentHandlesrecordkeepingforacompany,namelywhogetsthedividend.

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Preferredvs.CommonStock

Preferredstockusuallyhasnovotingrights Preferreddividendsareusuallypaidbeforecommondividends Inthecaseofliquidation,preferredshareholdersarepaidbeforecommonshareholders Bondholdersarestillhigheronthecreditorpeckingorderthanpreferredshareholders

TypesofPreferredStockholders

CumulativePreferredIftheyskipadividend,theyhavetopayitbacktoyoubeforethecommonshareholdersgetpaid.

NonCumulativePreferredTheycanskipadividendonyou

Optionsvs.Warrants

Warrants:

TheycanbearoundforalongtimeevenlongerthanLEAPS. Therearesomewarrantsthatareexchangetraded. Ifyouexerciseawarrant,sharescomefromthecompany,NOTfromthesecondary

market. Warrantscanbeperpetual!

Options:

Tradesonanationaloptionsexchange Fixedstrikesandexpirations ClearsthroughtheOCC Whenyouexerciseacalloption,theassignedpartymustdeliversharestoyoufromthe

secondarymarket. OptionsclearOCC,butwarrants,evenexchangetradedonesdoNOTclearOCC!

DividendsandExDividendDates:

Inordertoreceiveadividend,youmustbeastockholderofrecordontheRecordDate.Notethatforpurposesoftheexam,itmaynotmatterwhatelsetranspiresbeforeoraftertherecorddate.BeingastockholderofrecordONtherecorddateiswhatsimportant.

Forexample,simplypurchasingthestockbeforetheexdividenddateisNOTnecessarilyenoughtobeconsideredeligibleforthedividend.Thereasonisthatifyouweretopurchasestockthedaybeforetheexdividenddateandthenyouweretosellthestockoutlaterthatsameday,youwouldtechnicallyhaveboughtthestockbeforetheexdividenddatebutnotbe

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ashareholderofrecordontherecorddate.Thenyouwouldnotbeeligibletoreceivethedividend.Beawareofthiscaveat.

Exercisingacallthedaybeforetheexdividenddate(extendingthistoyoubeingashareholderofrecordontherecorddate)entitlesyoutoadividendevenifthecounterpartydoesnotfindouttheywereassigneduntilthenextday.

Asanadditionalnote,theexdividenddateistwodayspriortotherecorddate.Forthisreason,ismakessensethatregardingregularwaysettlement,youmustexercisecalloptionsthedaybeforetheexdividenddate,therebygivingyouthenecessaryT+3foryourstocktosettlebytherecorddate.

OntheTopicofIPOs

RegulationM:

ThisistheRegulationthatcoverstherestrictedperiodfollowinganIPO.ItprohibitsbiddingforsecurityduringrestrictedperiodbybankersordistributingbrokersinanIPO.Saidanotherway,ItrestrictsbankersandunderwritersfrombiddingonIPOsharesorfromtradingduringanapplicablerestrictedperiod.ThereisatimeperiodinwhichtheyarenotallowedtobuysharesintheIPO.

Thatsaid,investorsthatreceivesharesontheIPOareNOTrestrictedduringtherestrictedperiod.

IssuersarenotallowedtoparticipateintheIPO.OneoftheissuingbanksDOESparticipatebywayofaSTABILIZINGBID.OnlyOnefirmcanprovidethestabilizingbidonthefirstdayacompanygoespublic.ThisisabidBELOWtheIPOprice.

IfyougiveanindicationofinterestinanIPO,thisisaNONBINDINGinterest.

PennyStocks

Thesearestockstradingbelow$5pershare. Theyareconsideredextremelyrisky,andbecauseoftheirhigherlevelofrisk,youare

NOTallowedtotradethemonmargin. Furthermore,theSECrequiresspecialapprovalforcustomerstotradepennystocks.

However,youcanbuyorsellstocksunder$5toclosewithoutpermission.Therefore,youneedtofilloutadditionalpaperworkwhentradingPennyStocksunlessas

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previouslystated,youopenedapositionwhenthestockwasnotyetaPennyStockandyounowwantedtoclosethatposition.

StocksTradingUnder$1.00maybedisseminatedinincrementslessthanonecent.

CurrencyOptions:Youshouldknowthecontractspecifications.Namely,youshouldknowthattheJapaneseYenistypicallythecurrencythatdiffersfromallothers.Thisisforvariousreasons.

1) TheJapaneseYenistheonlymajorcurrencypairthatisquotedinYenratherthanUSdollars.

2) BecausetheYenisnotquotedinUSdollars,itthereforemakesitacurrencythatdoesnottradeinpennies!

3) Nevertheless,ALLcurrencyoptionsarecashsettledinUSdollars!

Furthermore,thestandardcontractvalueforallcurrenciesexceptfortheYenis$10,000.

Reserve(iceberg)OrdersTheseareordersinwhichacustomershowsasizethatismuchsmallerthanthetotalorder.Thisisoftendoneasatechniquetominimizetheorderseffectonthemarket.Oncethesmallshownsizeisfilled,theorderproceedstoshowsmallsizeagainuntiltheentirebalanceoftheorderisexhausted.However,muchlikeAllOrNone(AON)orders,becauseoftheirembeddedcontingency,ReserveOrdersdoNOTreceivecustomerpriorityonthehiddenpartoftheirorder.Theydo,however,receivecustomerpriorityonthedisplayedpartoftheorder.

Bullish,Bearish,andNeutralStrategies:

Forthispartofthestudyguide,ithelpstolearnthingsastheyaretaughtintheguideasopposedtowhatyoumayuseinrealtradingscenarios.Donotoverthinkthequestions.

TypicalEquity(Stock)Strategies:

Long(owningsharesbecauseyouthinkthestockwillgoupinthefuture) Short(sellingsharesbecauseyouthinkthestockwillgodowninthefuture) Dividend(owningsharesfordividendincome).

Reasonstobuyacall:

Tolockinapurchaseprice Asanalternativetobuyingstock Tohedgeashortstocksale

Motivationsforacoveredcall:

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Toincreaseportfolioincome Tohedgeaposition

MotivationstoSellaPut

Toincreaseportfolioincome Toacquirestockbelowcurrentprices

NakedcallYouhavenooffsettinglongstockorlongcallposition

NeutralStrategies

ATMCoveredcallwritingisconsideredneutral. Straddlewritingandcombinationwritingarealsoconsideredneutral.

BullishStrategies

OTMCoveredCallwritingisconsideredbullish BullSpreads(LongCallSpreadsandShortPutSpreads)

BearishStrategies

NakedCallSelling BearSpreads(LongPutSpreadsandShortCallSpreads)

Youshouldalsobefamiliarwithbasicputcallparity,usingonlycalls,puts,andstock(nointerestordividendconsiderations.

BesuretoKnow

IntheMoney(ITM) AttheMoney(ATM) OutoftheMoney(OTM) Thefivebasicoptiongreeks(delta,gamma,vega,theta,rho) ThedifferencebetweenBroadBasedvs.NarrowBasedindexes

ExerciseCutOffTimesforAmericanStyleIndexOptions(OEX)3:20p.m.CentralTime.

AMCashSettledOptions(SPX)Thesettlementvalueisbasedontheopeningprintofeachstockcomprisingtheindex.ItisNOTbasedonanaveragepriceofeachstock.Becarefulnottogettrickedupbythis.Optionsceasetradingthedaybeforethesettlementvalueisobtained.

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O.C.C.ClearingProceduresOCCwillRANDOMLYassignexercisedoptionstoClearingMembersthatholdshortoptionsinthosecontracts.ThoseClearingMembersmaythendistributethoseassignmentsinanonrandom,butstillfairprotocol.

Priortoexpiration,MarketMakersturninexerciserequeststotheirMemberClearingFirm.NOTtotheExchangeandNOTdirectlytotheOCC.OncetheirrequestsarereceivedbytheirMemberFirms,thosefirmsinturnsubmittherequeststotheOCC.

ETFsExchangeTradedFunds

Itisanequitylikesecuritythattracksanindexorbenchmark,buttradeslikeastockonanExchange.ETFsmaybeboughtorsoldthroughoutthetradingday.

AnauthorizedparticipantborrowssharesandplacestheminatrusttobacktheissuedsharesoftheETF.ThisisreferredtoasaCreationUnit.Atypicalcreationunitis50,000shares,butthesizemayvary.

TheholderofanETFmayexithispositioninoneoftwoways:

First,hemaysellhisETFsharesintheopenmarket.

Second,hemayredeemhisshares.

However,inordertoredeemhisshares,aholderneedstoownatleastasmanysharesasthoseinastandardcreationunit.Whilethisnumberistypically50,000shares,dependingontheETF,thatnumbercanrangewellintothehundredsofthousandsofshares.Forthisreason,thissecondmethodofredemptionisonlyavailabletoinstitutionaltraders.

BecauseETFstradeonExchanges,theyarenotsubjecttocounterpartyrisk.

ETNsExchangeTradedNotes

ThesearedebtinstrumentsandunlikeETFs,ETNsDOhavecreditrisk.

ADRs,ADSs,andGDRs

ADRs(AmericanDepositoryReceipts)areinstrumentsissuedbyaUSinstitution.Thentheybuyforeignsharestobackthoseinstruments.

GDRs:(GlobalDepositoryReceipts)LikeADRs,buttradeinmorethanonecountryandinmultiplecurrencies.ThesearelikeADRsbutinmultiplecurrencies.IssuingorDepositorybanksaresupposedtokeepupwithwhotheownersareanddistributedividends.

ENDOFCHAPTER3REVIEW

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Thischapteristhemeatoftheexam.

OntheTopicofOptionPrincipalsandonSupervisionofAccounts.

Eachfirmshouldhaveatleastoneoptionsprincipaliftheyaretransactingoptionsbusiness.TheyshouldbeapprovedbytheSRO.Toopenanoptioncustomeraccount,youcannotacceptanoptiontradeuntiltheaccounthasbeenapproved.Itshouldbeapprovedinwritingbytheoptionprincipal.

Branchofficesshouldhaveanoptionprincipal(usuallythebranchmanager)unlesstheyhave3orfewerprincipals(registeredindividuals)atthebranch.Anoffsitepersonmayapproveaccountsinthiscase.

Branchofficesshouldhaveanoptionprincipal(usuallythebranchmanager)workingatthefirmunlesstherearethreeorfewerregisteredpeopleatthebranch.Therewillbeanoptionsprincipalwhosupervisestheseofficesfromoffsite.

Verylargeoptionsfirmsmaydelegatesupervisoryauthoritytoqualifiedemployees.Theseprocedures/rulesmustbeinwriting.

AllOrNoneOrdersBecauseoftheirembeddedcontingency(allornone),theseordersarenoteligibleforcustomerpriority.Furthermore,theyarenoteligibletobedisplayedaspartofNBBOandtheymaybetradedthrough.

TheManningRule:

TheManningRuleprohibitsanNASDmemberfirmfromplacingthefirmsinterestbeforethefinancialinterestsiftheclients.Thiswouldinclude:

1) Notroutingorderstothebestmarketplaceinordertotakeadvantageofpaymentfororderflow(alongtheselines,paymentfororderflowinandofitselfisPERFECTLYLEGALprovidedthattheclientstillobtainsthebestexecution).

2) Ifafirmhasacustomerlimitorderandafirmlimitorder,thefirmshouldNOTexecutethefirmsorderaheadoftheclientsorder.

PublicCustomerOrdersmustbeindividualorders.AsaBD,youcannotgroupyourorderwithacustomerordertogetthesamepriority.

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TreasuryStock

StockthathasbeenrepurchasedbyacompanyisknownasTreasuryStock.Becausethestockisbackinthecompanyscoffers,TreasuryStockshareshavenovotingrights.

StepOutvs.GiveUpTrades

AStepOutfunctionsmorelikeaclientpositiontransferratherthanasatrade.Thereisnoexchangeofsharesorfunds,andthereisnochangeinbeneficialownership.Basically,BrokerAexecutesatradeonbehalfofitsclient,collectshiscommissionforexecutingthetrade,butlateron,thetradeisallocatedtotheclientsaccountwithBrokerB.

AGiveUpiswhentheexecutingbrokerplacesatradeonbehalfofanotherbrokerasifthatotherbrokerwasreallytheonethatexecutedthetrade.Thisistypicallyseenincaseswhereabrokeristoobusytoexecuteatradeforaclient,soheasksanotherbrokertoplacethetradeforhim.Inthiscase,ifBrokerAexecutesatrade,heisdoingsoonbehalfofBrokerBsclient.BrokerAdoesNOTcollectacommission(BrokerBdoes).TheclientstradeisreportedinBrokerBsbooks,indicatingthatthisisstrictlyBrokerBsclient.Onasidenote,aGiveUpmayalsorefertothedisclosureofyourClearingFirmnumberaspartofatransaction.

OrderTicketsThingsthatarerequiredonanorderticket:

1) ClearingHouseNumber(orAlphaSymbol)2) ClearingHouseNumber(orAlphaSymbol)ofcounterparty3) SecurityandOptionsymbolinformation4) TransactionDate5) NumberofContracts,Buy/Sell/SellShort,Opening/Closing6) TransactionPrice7) AccountNumber8) MarketCenterwheretransactionwasexecuted

YoumayseeaquestionaskingwhichisNOTrequiredonanorderticket,somakesureyouknowthe8pointsabove.

Exchangesdeterminewhatgoesonanorderticket.

Reg.SHOThisistheRegulationthatpertainstoanyshortsellingofstocks.

Therearedifferentwaysforasellordertobemarked.

Sell(long),SellShort,SellShortExempt

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AggregationABDmayaggregateallfirmwidelongandshortpositionsinordertodetermineanetfirmpositionforpurposesofsellingshort,providedhemeetsthefollowingrequirements:

1) Alltradersintheaggregationunitpursueonlythetradingobjectivesorstrategiesofthataggregationunit.Thisismeanttopreventpeoplefromclaimingthattheyareapartofanaggregationunitwhentheyneedtosellshort,butactingalonewhentheydontneedtosellshort.

2) Theaggregationunithasaspecificallydefinedplanoforganizationandtradingobjective.

3) Individualtradersareassignedtoonlyoneaggregationunitatatime.

LocateRequirementsAshortseller(orthebrokerrepresentinghim)shouldhavereasonablegroundstobelievethatasecuritythatistobesoldshortmaybeborrowedanddeliveredbythedeliverydatepriortohavingashortsaleexecuted.

HavingaLocatemeansthatyouhavesharesthatyouhavedesignatedtoborrowanddeliverthemtothebuyerthatyouhavesoldshortto.

AviolationofRegulationSHOisnotbeingcertainthatyouwillbeabletodeliveronyourrequirement.Asabroker,yourenotsupposedtoacceptasellshortorderinwhichyouhavereasonablegroundstobelievethattheclienthasnotfoundalocate.

ThresholdSecuritiesThereisalistpublishedbytheExchangesthatrepresentsthepublicaccountingofcurrentfailstodeliver.

AsecuritywillmaketheThresholdListifitmeetsANYofthefollowingcriteriaoverfiveconsecutivesettlementdays.

1) Thetotalnumberofsharesthatfailedtodeliverexceeds10,000shares.2) Thetotalnumberofsharesthatfailedtodeliverexceeds0.5%oftheoutstanding

shares.3) ThesecurityislistedonanotherExchangesthresholdlist

InorderforasecuritytoberemovedfromtheThresholdList,itmustfallbeneaththebenchmarkstandardsforfiveconsecutivetradingdays.

ApubliccustomershouldLOCATEsharestoborrowfordeliverybeforeexecutingashortsale.Thatsaid,alocatedoesNOThavetobeassuredmultipletimesinaday.Thismeansthatitisnotnecessarytofindalocateaftereachandeveryexecution,providedaninitiallocatewasfound.

ThreeviolationsofReg.SHOare:

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1) Sellingstockshortwithouthavinglocatedstockfordeliveryatsettlement2) Sellingstockshortandfailingtodeliversharesatthetimeofsettlement3) Sellingstockshortandfailingtodeliversharesatthetimeofsettlementwiththe

purposeofdrivingdownthesecuritysprice.

StockFuturesdoNOTneedtobeborrowedorlocatedbeforesellingshort.

Mustknowthedifferencebetweensellinglongandsellingshort.

IfastockisNOTownedbyaseller,itshouldbemarkedasashortsale. IfastockISownedbyaseller,itshouldbemarkedasalongsale. IfIbuysharesinXYZandsellthemlong15minuteslater,thatsnotaviolationeven

thoughstockhasntsettled.

Marketmakersareexemptfromhavingtofindalocateprovidedthattheyareinvolvedinbonafidemarketmakingactivity.

MarketMakersMUSTmarkshortsalesshortexempt.ThisallowsthemtotakeadvantageoftheT+6provisionexplainedbelow.Thatsaid,

Youcannotemployamarketmakerforthepurposeofshortingstock. Ifyouareamarketmakerdisplayingaonesidedmarketandendupshort1Mshares,

thatsanexampleofnotbeingabonafidemarketmaker. YoucannotusesomeoneelsesMMstatustosellstockshort

Inordertoavoidafailtodeliver,

1) CustomersshoulddelivershortstockbyT+32) MarketMakershaveuntilT+6untiltheyfail

a. Formarketmakersonly,inordertocloseoutafailtodeliveronT+4orT+5,theymaybuythesharesortheymayfindalocate.However,onT+6,findingalocateisnolongeraviablealternative.Thesharesmustbeboughtin.

b. IfamarketmakerfailstodeliverbeyondT+6,thenthepenaltyincurredisthatthemarketmakerwillnolongerbeallowedtosellsharesshortuntilhebuysthosesharesbackANDthosesharessettle.

c. SupposeamarketmakerhasshortstockpositionsatT+4,T+5,andT+6.Supposethatthenextday,themarketmakerfailstodeliversharesonwhatisnowT+7.Then,themarketmakermustfaceapenaltyonthesharesthatfailedtodeliver,butnotonthebalanceoftheshares(thosestillatT+5andT+6).

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InsiderTradingandInsideInformation

Knowwhatmaterialnonpublicinformationis.Ifyouhavematerialnonpublicinformation,then,

Donttradethestock Donttradethederivatives. Dontdiscloseinformationthatsomeoneelsemaytradeon.Youdbeintroubleforthat,

evenifyouyourselfdidnotactontheinformation!Afirmshouldannuallyletyouknowwhatinsideinformationisandyouaresupposedtosignsomethingannuallytoshowthatyouareawarethatinsidertradingisillegal.Onsite,yourfirmshouldhaveyourlasttwoyearsattestations.Thirdyearmaybeataremotelocation.

Yourfirmshouldalsogetallofyourbrokerageaccountstatements.Again,threeyearstotal,andtwoyearsonsite.

PeoplewithnonpublicinfoFirmswithaccesstomaterialnonpublicinformationshouldbedocumentingwhoisworkingonsuchdealstohavedocumentationinplacetofigureoutwhomaybeaculpritincasethereisabreachofinsideinformation.

ChineseWallViolations

TherearetwotypesofChinesewallviolations.Thefirstisabreachofbarrier.Thisoccurswhensomeoneinthefirmwithsensitivematerialinformationsharesinformationwithanothermemberofthefirm.Thesecondisalackofbarrier,whichiswhenthemembersofafirmthathavesensitivematerialinformationarenotseparatedfromeveryoneelse.Assuch,informationisallowedtobeaccessedbyanyone,evenwithoutdirectintent.

AfirmisresponsibleforsettinguppropersafeguardssuchthatChineseWallsarerespected.AChineseWallviolationMUSToccurbetweentwopeoplethatworkforthesamefirm.

NOThavingaDoNotTradeListisaviolationofChineseWallprotocols.

Thatsaid,ifyouaccidentallytradesomethingonaDoNotTradelist,youshouldcontactyourcomplianceofficerimmediately.DONOTTRADEOUTOFIT!Tradingoutofsomethingyouwerentsupposedtotradeinthefirstplaceonlydoublestheliability.

FrontRunningvs.TradingAhead

FrontRunningreferstothepracticeofhavinginformationaboutalargetradethatisabouttotakeplaceandusingyourpositionasaBROKERtomaketradespriortothelargetradebeingexecutedandimpactingthemarket.

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TradingAheadisthesamethingasabove,exceptthatitisdonebyANYONE.

RegulationFD(FairDisclosure)Thisregulationwasestablishedtoprohibitselectivesharingofmaterialinformation.

RegulationFD(FairDisclosure)ComesunderissuersIfIamanissuerofstockandIreleasenewstoasmallgroupthatissensitivetomycompany,IneedtoissueapressreleaseASAP.Youcannotselectivelygiveoutmaterialinformation.

AbrokeragefirmthatismakingachangeinrecommendationofastockandstartstoinformclientsdoesnotrepresentaviolationofRegulationFD(FairDisclosure)becausethebrokeragefirmisnotanissuer.

Sixspecificprohibitedtradingactivities:

NochangeinbeneficialownerTradingwithyourself MisleadingappearanceofactivetradingTradingbackandforthtocreatefalse

volume InducingPurchaseorSalebyOthersTradingtomovepricestogetotherstoact.It

mustinvolveatransactionorsetoftransactions! Sendinginformation(trueORfalse)withintenttomoveastockSpreadingaRumor

(doesnotrequiretransactions). DisseminationofInformationforConsiderationSameasabove,butformoney. Pegging,Fixing,orStabilizingGroupofTraderstrytogetanunderlyinginstrumentto

closeatastrikeYoushouldreallyKNOWtheabovedefinitionsandyoushouldhaveanexampleinyourheadregardingeachofthedefinitions

Ifthereisatenderoffer,forexample,ifalargeholderwantstobuyacompany,theyrenotsupposedtoputanyunduepressureorsolicitpeopletotendertheirshares.

KnowthattheRegulationisdesignedtopreventselectivedisclosurebytheissuer.

Specifically,Reg.FDpertainstoISSUERSreleasinginformation.Thecompanyistheissuerofastock.Therefore,anysensitiveinformationreleasedbythecompanyisgovernedbyReg.FD.

Brokersarenotissuers.Therefore,anystatementstheymaketotheirpreferredclients(suchasissuingaresearchreportonastock,orupgrading/downgradingastock)arenotconsideredviolationsofReg.FD.Inaddition,TreasurySecuritiesarenotcoveredunderReg.FD.

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UnderReg.FD,ifacompanyofficialmistakenlysharesinformationwithalimitednumberofpeople,thatofficialshouldremedytheerrorbyquicklysharingthatinformationpublicly.Thiscouldmeanholdingapressconference,orissuingapublicstatementassoonaspossible.

Example:IfyouareatdinnerwiththeCEOofacompanyandheleakssensitivematerialinformationtoyou,youshouldDONOTHING!DoNOTtradethestock,donottradederivativesonthestock,anddonottellanyoneelsewhomaythentradeonthatinformationbecauseitcouldlandyouintrouble.

ENDOFREGULATIONFD.

DutchAuctionYoumustunderstandhowtheseauctionswork.Inatypicalauction,thereisareservepricefromwhichthingstypicallybegin.Thegoodsarethenbidupandtheyaresoldtothehighestbidder.InaDUTCHAUCTION,however,theprocessisdifferent.Theparticipantsentertheirbidsandquantitiespriortothestartoftheauction(e.g.,thisishowmuchImwillingtopayandthisishowmuchIwantatthisprice).

TheauctioneerthenhaseveryonespricesandeveryonessizeANDhehasareserveprice,thatis,apricebelowwhichhewillnotsellanymoreofhisasset.

Theauctioneerthenbeginstheauctionatthehighestprice.Ashelowerstheprice,thenumberofbidsnaturallyincreases.TheauctioneercontinuestolowerthepriceuntileitherhisentireorderisfilledORhisreservationpriceismet.

Iftheauctiongetstothepointwheretheentirebalanceoftheorderisfilled,atradewilltakeplaceandALLshareswilltradeatthelowestbidpricethatqualifiedfortheauction.

Ifthereservationpriceismetbeforeatotalfillisachieved,thenthequantityofsharesthatwerebidforatthereservationpriceorhigherwilltradeatthereservationprice.However,thisimpliesthatnotallauctionedshareswillbetraded.Therefore,whateverthetotalpercentageofsharesthattrades,thatisthepercentagethateachmarketparticipantwillreceiveatthereservationprice.

AntiMoneyLaundering

EveryMemberFirmshouldhaveanantimoneylaundering(AML)policyinplace.Whilethereisnosetcriteria,MemberFirmsshouldfollowtheguidelinesissuedviatheBankSecrecyAct.FirmsshouldofferAMLtrainingonanannualbasis.TheBankSecrecyActhastheguidelinesfortheserules.Youwanttomonitoryourfirmandindividuals.YoucomeupwithyourownAMLrulesatyourfirm,buttheyhavetofollowtherulesoftheBSA.TheyMUSTbeinwriting!

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Youhavetohavepoliciesinplacetocheckformoneylaundering.Youmayhaveoutsideinvestigatorscomeinandmakesurepeoplecantslipthingsbyyou.Thereshouldbeannual,writtentestingofemployees.Thereshouldbeonepersonatthefirminchargeofimplementingthisprogram.

AspartofAMLprotocol,MemberFirmsshouldroutinelychecktheOfficeofForeignAssetControls(OFAC)Listtocheckforfirms,countries,andindividualswithwhichwedoNOTconductbusiness.Newclientsshouldalwaysbecheckedagainstthatlist.Thelistmaychangefromtimetotime.Thislistshouldbecheckedperiodically,sinceonceacountry,firm,orindividualisonthatlist,theaccountmustbeclosedevenifthatentitywasnotonthelistwhentheaccountwasinitiallyopened.

TheantimoneylaunderingprotocolmayalsobereferredtoaspartofthePatriotAct.

WashSaleRuleThisisanIRSRulethatprohibitstaxpayersfromclaimingalossonastockthatissoldandsubsequentlyrepurchasedwithin30days.Itinvolvesatradertryingtotakeadvantageofalongertermlossinastock.Ifyousellastocktotakealongtermloss,youcannotbuythestockbackfor30days.Ifyoudo,itisnolongeralongtermloss.

PaintingtheTapeThisisdefinedastheconstantenteringofbuyandsellordersinanattempttocreatefalsevolumeinordertodrumupinterestinaparticularsecurity.

SpoofingThiscanhappenonthebidortheoffer,butforthesakeofsimplicity,letslookatwhathappensonthebid

Amarketparticipantentersanordertosellontheoffer.HethenentersaSizablebidbelowthecurrentbidwithoutintendingtohavethatbidexecuted.Theparticipantintendstocancelthebigbidifeitherthesellorderisfilledorifthebetterbidisremoved.ThisisSPOOFING.

SelfHelpIfanExchangedeclaresselfhelpagainstanotherExchange,itmeansthattheotherExchangesquotesmaybeunresponsive.Then,thefaultyExchangeisnotifiedbytheotherExchangethatitsquotesareunresponsive.Asaresult,theotherExchangeisallowedtotradethroughthemalignedExchangesquotes.

PositionLimitsForquestionsregardingpositionlimits,youdoNOThavetoknowspecificlimitsforspecificproducts.Youwilltypicallybegiventhepositionlimitsthataquestionwantsyoutouse.HOWEVER,thatamountmaybegiventoyouineitheroptioncontracts(e.g.25,000contracts)oritsshareequivalent(e.g.2.5MillionShares).

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Thetablebelowhas3examplesofpotentialpositionlimitviolations.Thesimplewaytoapproachthesequestionsistoturnthepositionlimitintoshares(e.g.25,000optioncontractsinto2.5Mshares)andseeifthereisanypotentialwayinwhichthesharenumbercanbeexceededatexpiration.ThatbeingthecaseExample1isa25,000contractcallspread.Thispositionfallswithintheguidelinesofthe25,000contractpositionlimit.ItisNOTaviolation.Example2has25,000longcallsand25,000longputs.ThatisALSOok,sincelongcallsandlongputsareonthesamesideofthemarketforpurposesofaggregatingsharepositions.Thereisnowayyoucouldendupwithmorethan2.5Msharesatexpiration.Example3DOESrepresentaviolationbecauseifthestocksettlesbetween$50and$55pershare,youcanseethatthereisawaythatthispositioncanexceedits2.5Msharelimit.NOTEthatpositionlimitsmaybeexceededwithproperdeltahedging.

Calls Strike Puts

+25,000 50 +0

25,000 55 0

Calls Strike Puts

+25,000 50 +25,000

0 55 0

Calls Strike Puts

+12,000 50 +15,000

13,000 55 10,000

BeawarethatPositionLimitsaresetbytheExchanges.Also,ifyouaredeltaneutral,youcanexceedpositionlimitsviasomethingcalledadeltahedgeexemption.

RecordKeeping

Mostrecordsmustbekeptforaperiodofthreeyears,ofwhichtwoyearsmustbeonsite,whilethethirdyearmaybeinaremotelocation.

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MarketMakerrecordsmustbekeptforSIXyears.

Interpositioning

Theinvolvementofathirdpartybetweenabrokerdealerandthebestavailablemarketpricethatresultsinthecustomerpayingabiggermarkupormarkdownthanwouldhavebeenthecaseifthethirdpartyhadnotbeenpresent.

RisklessPrincipalAtransactioninwhichaBD,afterhavingreceivedanordertobuyasecurity,purchasesthesecurityasprincipalatthesamepricetosatisfytheordertobuy,exclusiveofanyexplicitlydisclosedmarkupormarkdown,commissionequivalent,orotherfee,or,afterhavingreceivedanordertosell,sellsthesecurityasprincipalatthesamepricetosatisfytheordertosell,exclusiveofanyexplicitlydisclosedmarkupormarkdown,commissionequivalent,orotherfee.

Basically,itreferstothebrokerholdingtheresultingexecutedorder.Fromthebrokersstandpoint,thatorderisnotatrisk.Itisonlyatriskfromthecustomersperspective,sincetheorderwasexecutedonbehalfofthecustomer.

PrimeBrokerIfyourunahedgefund,youmayuseasmanyexecutingbrokersasyouwant,butyoumayhaveonebrokerthatholdsallyourpositions.ThatsthePrimeBroker.

Reg.NMS(NationalMarketSystem)Thisistheregulationthatcameintoexistencetohaveallthedifferentexchangesquotesunderoneumbrella.Allthenationalexchangesmustsharetheirquoteswitheachotherandmustsharetradereportswitheachother.

Theymustalsorouttoeachotherforpurposesofbestexecution.

PlanProcessorThisispartofReg.NMS.andreferstoanySROorsecuritiesinformationprocessoractingasanexclusiveprocessorinconnectionwiththedevelopment,implementationand/oroperationofanyfacilitycontemplatedbyaneffectivenationalmarketsystemplan.

Rule610(AlsopartofReg.NMS):PricingofAccesstoquotesmustbenondiscriminatorytoProfessionals,especiallythosewhoarenotmembersofyourexchange.Exchangesshouldnothavediscriminatorytermsformarketparticipantswhenitcomestochargingforquotes.

AlsounderRegulationNMS:Thereisa30secondresponse.Ifyoureceivealimitordertosell200contractsandyouarebidfor100contractsatthesameprice,youmay

Buy100contractsandroutebalanceiftheycanbefilledaway

Buy200contracts

Youhave30secondstodecide.

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Aspecialistshoulddisplayacustomerlimitorderanditssizewhenthecustomerlimitorderisequaltothebestbidorbestoffer.

ExplanationofDeMinimischange

IfyouareaSpecialistandyouarebidfor,say,amillionshares,andacustomerordercomesinwitha300sharebidatthesameprice,youdoNOThavetoupdateyourbidtoreflectonemillionthreehundredshares.ThesmallchangeinbidsizerelativetotheexistingbidiswhatisreferredtoasaDeMinimischange.

Ontheotherhand,ifyouareaspecialistandyouarebidfor300sharesandsomeonejoinsyouatthesamebidpricefor200shares,youshouldreflectanewbidof500sharesbecausethechangeislargerelativetotheoriginalbidsize.

Ifyoureceiveanordertobuy100sharesandyouarebidfor100sharesandyoubuyforthecustomerinsteadofyourownaccount,youdonothavetodisplaythe100sharespriortotradingthem.

Oddlotordersdonothavetobedisplayed.

Anycontingentorderdoesnothavetobedisplayed(AON).

Rule605Allthedifferentexchangesmustbeabletoproducealistofordersthathavebeenroutedtothembydifferentbrokersonamonthlybasis.

Rule606Everyquarter,brokershavetogiveareportontheroutingoftheirordersinordertocomplywiththeManningRule.

CustomerrequestonorderroutingUponRequest,theymusttellyouwhereyourorderswent.

Ifyouareaclientofabrokeragefirm,youcansay,Iwanttoseewhereyouroutedordersforthelast6months.Annually,theyhavetotellyouthatyoucangetaccesstothatinformation.

Rule610:PricingofAccesstoquotesmustbenondiscriminatorytoProfessionals,especiallythosewhoarenotmembersofyourexchange.Exchangesshouldnothavediscriminatorytermsformarketparticipantswhenitcomestochargingforquotes.

Youshouldtrytoavoidhavinglockedquotes(wherethebidofonequoterequalstheofferofanotherquoter),oneitherthesameoronseparateexchanges.

Youaresupposedtotrytoprotectagainsttradethroughs.

ENDOFREGULATIONNMS

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OnthesubjectofBroadvs.NarrowBasedIndexes,knowyourstocksymbols.SPX,RUT,DJX,andNDXareBroadBasedIndexes.DOWisNOTthesymbolfortheDow(DJIAorINDU).Rather,itisthesymbolforastockcalledDowChemical.

MarkingtheCloseisillegalanddoesnotnecessarilyhavetoincludeatrade.Forexample,ifaMarketMakeruptickshisbidsontwoconsecutivedaysfiveminutesbeforetheclose,thatsanexampleofMarkingtheCloseevenifnotradestookplaceonthetightermarket.

Riskbasedhaircutappliestoprofessionals.Thereare15%movesinindex.Knowthedifferencebetweenriskbasedhaircutandcustomerportfoliomargining.

CustomerPortfolioMargining(CPM)Firmmustbeauthorizedforit.Knowwhatitis.

TransferPackagesareexchangespecific.

BothparticipantsinaJBO(JointBackOffice)mustberegisteredBD,musthaveaSeries27principalonstaff,andbothparticipantsmusthave$1M.

ENDOFCHAPTER4REVIEW

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Chapter5Review:

Approximately13Questionswillstemfromthischapter.

OrderPriority

Customers:PriceTime

Theyhavefirstoverallpriorityandmustbetradedwithinjustaboutallcaseswheretheyareonaparticularoptionmarket.

BDs:ProRataa.k.aPriceSizeTime

ThereisnopricetimepriorityregardlessofwhentheyenteredtheorderbookUNLESSmultipleBDsshowequalpriceandsizeandthereisanoddnumberofcontractsthatneedstobedistributed.

AdditionalNotes

Eachexchangeshouldmakeavailabletoallofitsmemberswhatallthecustomerpublicordersare,sothatthereisnomistakeregardingpossibletradethroughs.

AllorNone(AON)orminimumquantityorderslosetheirpricetimepriority. Reserve(Iceberg)orderslosetheirpricetimepriorityonthehiddenpartoftheorder.

LockedandCrossedMarkets ALockedMarketisoneinwhichthebestbidequalsthebestoffer. ACrossedMarketisoneinwhichthebestbidexceedsthebestoffer.

IntermarketSweepOrders(ISOs)andLinkage

Atsomepoint,theregulatorybodiesdemandednotonlymultiplelisting,buttheyalsorequiredamannerinwhichtomakesurethatNBBOwashonoredandthattradethroughswereeliminated.ThiswasthebeginningoftheLinkageProcess.ThroughLinkage,ordersaresenttoALLexchangeswithbetterquotes.Wherevertheorderisfilled,thatiswheretheorderisrecorded.Definition:ATradeThroughisatransactionthattakesplaceoutsideofNBBO.Example:Supposewehavethefollowingmarketsforaparticularoption:CBOE 2.202.40AMEX 2.102.30ISE 2.002.30,2.35(meaningthattheresa2.35offerbehindthe2.30offer)

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AnordercomestotheCBOEtobuy20contracts.Eventhoughotherexchangeshavebetteroffers,thesystemdeliversaFlashtoallCBOEmarketmakerstoseeifanyoneisinterestedinsellingtheoptionsat2.30.Ifso,thetradestaysatCBOE.Ifnot,anISO(IntermarketSweepOrder)isexecuted.TheISOProcessASweeporderisaLIMITorderthatwillsweepthetopofmarketofALLexchangeswithbetterpricesthanCBOE.Forthisexample,thismeansthatthe2.30offerontheAMEXaswellastheoneontheISEwillbehit.Notethatthe2.35offerontheISEwillNOTbehitbecausewhileitisabetterofferthanCBOEsoffer,itisNOTtopofmarket(rather,itisonelevelbehindthetopofmarket).Atthatpoint,theSweeporderreturnstoCBOEandtheprocessrepeatsitselfwitha150msFlashtoseeifanyonewantstoselltheoptionsat2.35.Ifso,theorderremainsatCBOE.Ifnot,asecondsweeporderissenttargetingthe2.35offeronISE,whichisnowtopofmarket.NoLinkageOrders:Forvariousreasons,afirmmaydecidetosendanordermarkedNoLinkage.Ifthatoccurs,marketmakersontheexchangeinwhichtheorderoriginatedwillreceiveaflashtoseeifanyonewantstotradeatNBBO.Ifso,thetradeisexecutedonthehomeexchange.Ifnot,theorderiscanceled.ReminderofAONOrders:Becauseoftheirnonstandardcondition,AONordersareNOTallowedaspartofNBBO.Therefore,therecannotbeatradethroughofanAONorder.

ElectronicCommunicationNetworks(ECNs)AlternativeTradingSystems(ATS)TheydoeverythinganationalsecuritiesexchangedoeswiththeexceptionofSROauthority.Theydonthavespecificrules.Theirwholeideaistofacilitatecrossesamonglargeinstitutions.Theycankickyouout,buttheycannotdisciplineyou.Exampleisdarkpools.

DarkPools,ECNs,a.k.a.AlternativeTradingSystems(ATS)ThereareguidelinesthatmustbefollowedbyDarkPoolparticipants.DarkPoolsandotherECNsrepresentameansforBDstooperateautomatedtradingplatformstocollectandexecuteordersinsecuritieselectronicallyandwithoutregisteringasanationalsecuritiesexchange.

AsanexchangeorECN,youshouldhavearoutingmechanismtosendorderstothebestmarkets.

Tradingcenters(exchanges)andECNsshouldtrytheirbestnottoallowtradethroughs.

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Insofarasregulationgoes,anATSmayNOTsetrulesgoverningtheconductofsubscribers.TheymayNOTdisciplinesubscribersotherthanthroughexclusionfromtrading.Tosetdisciplinaryrules,anECNmustregisterasanationalsecuritiesexchange.

InordertoacquireATSstatus:

1) AfirmmustfirstberegisteredasaBD2) ItmustfileaninitialoperationreportwithrespecttothetradingsystemonformATSat

least20Daysbeforecommencingoperation.NotefurtherthattheSECdoesnotactuallyapprovetheATSfiling.However,thefilingmustcomplywithallapplicablerequirementsunderReg.ATS

3) Theinitialoperationreportmustbeaccurateandmustbekeptcurrent

TheObviousErrorRule

Allexchangetradesarebindingcontracts.Promptlyuponfindingoutabout(an)unmatchedtrade(s),youshouldtrytoreconciletheunmatchedtrade(s).

Thatsaid,thereareproceduresavailabletoaddressObviousErrors.

OnceamarketparticipanthasfoundreasontocitetheObviousErrorRule,hemustfollowtheensuingtimeline:TimelineforReportingofObviousError

1) 15MinutestoReporttheObviousErrorREMEMBERTHISONE!!!2) 60MinutesfortheCommitteetoReviewtheCase3) 30MinutestoAppealtheDecision

TradeReportingandTRFTradeReportingFacilityThisiswherethingsgetreportedtothetape.ItisanautomatedtradereportingandreconciliationserviceoperatedontheACTtechnologyplatform.ItmaybeusedforNASDAQlistedsecuritiesaswellasforNYSEandotherregionalexchangelistedsecurities.

TheTRFhandlestransactionsthatarenegotiatedbrokertobroker.

Youhave30secondstoreportthesetrades.Duringnormaltradinghours,ifatradeisNOTreportedtothetapewithin30seconds,itshouldbereportedasquicklyaspossibleanddesignatedLATE.

OTCtransactionsthatinvolveatleastoneFINRAmembermustbereportedtothetapewithin30seconds.If2FINRAmembersareinvolved,thentheselleristypicallythereportingparty.

Youcandoequitytradesbetween12a.m.and8a.m.EST.Theygetreportedby8:15am.Ifthemarketisclosed,buttheFINRAreportingfacilityisopen,thetrademustbereportedwithin30

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secondsofexecution.Anythingthattradeslateatnight(after6:30p.m.EST)isreportedthenextdayby8:15

Onthesubjectoftrades,everytradeMUSThavewhatisreferredtoasaBeneficialChangeinOwnership.Thatis,youcannottradewithyourself.Thisincludestwopeopletradingwitheachotherwhentheyshareanaccount.

Furthertothatpoint,ifatradewasmadeinerroranditisallowedtobeundone,itmustbeBUSTEDorADJUSTED.Whateveryoudo,doNOTsimplymakeatradethatdoestheopposite!Thatsimplycreatesfalsevolumeandisillegal.

TheTradeBlotterArecordoftradesandthedetailsofthetradesmadeeachday.Thesedetailsincludethingssuchasprice,timesize,andbuy/sellinformation.TradeBlottersincludeexecutions,NOTunfilledorders.

Onaseparatenote,Firmsshouldrecordalltheirbidsandoffersinthesamewayexchangesrecordtheirs.ThisissoFINRAcancomeinandinvestigate.

AnOfficeSupervisormustreviewtheTradeBlotteronadailybasis.HeshouldalsoreviewInstantMessagesandPhoneCalls.HedoesNOThavetoreviewoutsideresearch.

FastMarkets

Itispossiblethatyoucouldgothroughopeningrotationmiddayincaseofafastmarket.Ifaftertheopeningrotation,youarestillinafastmarket,theoptionsmaybehalted.

Exchangescanhalttradingfor2days.Iftheexchangefeelsthatitcannotrestoreorderafter2days,itmaycontinuetokeepthestockhalted,buttheremustbeareviewafter2days.

Ifthestockishalted,theoptionsarehalted.

Indexoptionsmaybehaltedbasedoncircuitbreakersthatmaybeinplaceatcertainexchanges.CircuitBreakerscomeintoplayaftera10%moveinanindex.

InFastMarketconditions,bidsandoffersmaynotbecorrect.

Theendofafastmarketiswhenorderofficialshavedecidedthatwecanrestorefairandorderlymarkets.Wemaygothroughanopeningrotationandwemaysuspendfirmquoterequirements.

CircuitBreakersIfthereisa10%moveinanindividualstock,theremaybea5minutehalt.

TradingHaltsorCircuitBreakersmaybereferredtoasTradingPausesandtheycantakeplacefrom9:45amto3:35pmEST.

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Ifthereisa10%moveinanindividualstock,therewillbea5minutehaltinthatstock

Ifthereisa10%declineintheoverallmarket,thenthemarketishaltedfor:

ONEHOURprovidedthatthedeclineoccurredpriorto2pmCST 30MINUTESprovidedthatthedeclineoccurredbetween2:00and2:30pmCST NOHALTifthedeclineoccursinthelast30minutesofthetradingday

Inanycase,equipmentfailureonyourenddoesNOTconstituteareasonforafastmarket.

OPRATheOptionsPriceReportingAuthority.ItprovideslastsaleinformationandcurrentoptionsquotationsfromacommitteeofParticipantExchanges.

OPRAisnotinvolvedintheclearing,settlement,orassignmentprocessofoptiontrades.

OATSOrderAuditTrailSystemthatkeepsupwithEVERYNASDAQbidandoffer.NASDAQMarketMakersandFINRAmembersmusthaveaserveronsitetotrackallquotingdata.

COATSTheoptionsversionofthethingabove.TheCisforconsolidated.

ExerciseandAssignment:

Automaticexerciseoccurswhenanoptionisonecentinthemoney.IfyoudonotwantanoptiontobeexercisedwhenitisonecentinthemoneyORifyouwanttoexerciseanoptionthatisnotinthemoney,youneedtoissueaContraryExerciseAdviceform.

Ifastockishalted,youmayneedtotelltheExchangewhetheryouwanttosubmitacontraryexerciseadviceform.

AlloptionexchangetransactionsshouldgothroughtheOCC.Before9amCentral,theOCCtakesclearingmemberdatafromallexchangemembersanddeliversadailypositionreport.Yes,thisisafterthemarketopen.

IfIhaveexercisedanoptioncontractandtheassignedpartywantstodeliverthesharesearly,Icanrefusethat!ThisisbecauseyouhaveuntilT+3tocomeupwiththemoney.

ExerciseandAssignmentTimesthatNeedtoBeKnown

Exchangehoursare8:30amto3:15CENTRALTIME

Preopeningquotescannotbesubmitteduntilafter8:15a.m.

5:30pmESTIntheeventtheExchangeprovidesadvancenotice,onorbefore4:30p.m.onthebusinessdayimmediatelypriortothelastbusinessdaybeforetheexpirationdate,indicatingthatamodifiedtimeforcloseoftradinginnoncashsettledequityoptionsonthelastbusinessdaybeforeexpirationwilloccur,thedeadlinetomakeafinaldecisiontoexerciseor

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notexerciseanexpiringoptionshallbe1hour30minutesfollowingthetimeannouncedforthecloseoftradingonthatday.

7:30pmESTMembersandMemberFirmsmustdeliveraCEAorAdviceCanceltotheExchangewithin3hours30minutesfollowingthetimeannouncedforthecloseoftradinginnoncashsettledequityoptionsonthatsamedayifsuchTPHorganizationemploysanelectronicsubmissionprocedurewithtimestampforthesubmissionofexerciseinstructions.

5:30pmESTFornoncustomeraccounts,MembersandMemberFirmsthatdonotemployanelectronicprocedurewithtimestampforthesubmissionofexerciseinstructionsarerequiredtodeliveraCEAorAdviceCancelwithin1hourand30minutesfollowingthetimeannouncedforthecloseoftradingonthatday.

8:00pmESTThisisthetimeuptowhichOCCClearingMemberscansubmitexercisenotices

MarketMakerObligations

MarketMakersareexpectedtorefrainfromselling25centsoutsideofparity.

Forcalls,parityismeasuredoffthebidpriceoftheunderlying. Forputs,parityismeasuredofftheofferpriceoftheunderlying.

Thereare4thingsthataMarketMakershoulddo:

Priceyouroptioncontractsfairly Maintainyourmarketquotes Standuptoyourquotes Competewithothermarketmakers

OrderRouting

Youcanroutyourorderstospecificexchanges.

IfanorderisroutedtoaparticularExchangeandthatExchangeisnottheBestBidOffer(BBO),theordershouldbereroutedORexecutedatBBO.

PaymentforOrderflowisnotillegal.Itsimplyneedstobedisclosed.

Itshouldnotbetothedetrimentofaclient.YoucanrouttoyourfavoriteexchangealldayaslongastheyareNBBO.

Ifthelowestofferforanoptioncontractis5cents,andsomeoneentersasellmarketorder,itwillshowupasat5cents

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CabinetOrdersdonothavetobereportedonthetape.Theyareordersthattradeatonecent.

FacilitationOrdersShouldknowsizerules.Minimumincrementis500contractstofacilitateacross(IthinkthatsonlyforAON).

ENDOFCHAPTER5REVIEW