OPTIONS ON EQUITY SECURITIES

The term "stock options" is used broadly in this booklet to include not only options on common stocks but also options on all other types of equity securities, such as limited partnership interests, "American Depository Receipts" and "American Depository Shares" representing interests in foreign entities, and preferred stocks. Options are available on exchange-traded equity securities, on unlisted equity securities traded in the FINRAAQ stock market and designated as national market system securities, and on equity securities traded both in the FINRAAQ stock market and on exchanges. the FINRAAQ stock market is primarily an inter-dealer trading system as contrasted with exchange auction markets.

Issuers of underlying equity securities do not participate in the selection of their securities for options trading (although some options markets may determine not to select an underlying security without the consent of the issuer of that security). Issuers of underlying equity securities have no responsibility regarding the issuance, the terms, or the performance of options, and option holders have no rights as security holders of such issuers.

The principal risks of holders and writers of stock options are discussed in Chapter X. Readers interested in buying or writing stock options should carefully read that chapter.

FEATURES OF STOCK OPTIONS

Each stock option generally covers 100 shares of the underlying security, although, as described below, the number of underlying shares may be adjusted as a result of certain events.

The exercise prices of the stock options that are traded at the date of this booklet are stated in U.S. dollars per share. The exercise price of an option must each be multiplied by the number of shares underlying the option in order to determine the aggregate exercise price and aggregate premium of that option.

EXAMPLE: An XYZ 40 call gives the buyer the right to purchase 100 shares of XYZ stock at a price of $40 per share, or a total price of $4,000.

In the future, stock options may, with regulatory approval, be introduced that have exercise prices in a foreign currency.

Adjustments may be made to certain of the standardized terms of outstanding stock options when certain events occur, such as a stock dividend, stock distribution, stock split, reverse stock split, rights offering, distribution, reorganization, recapitalization, reclassification in respect of an underlying security, or a merger, consolidation, dissolution or liquidation of the issuer of the underlying security. In the following discussion, there is a brief description of a number of general adjustment rules applicable to stock options that are in effect at the date of this booklet. Such rules may be changed from time to time with regulatory approval. An adjustment panel has the authority to make such exceptions as it determines to be appropriate to any of the general adjustment rules.

As a general rule, no adjustment is made for ordinary cash dividends or distributions. A cash dividend or distribution by most issuers will generally be considered "ordinary" unless it exceeds 10% of the aggregate market value of the underlying security outstanding. The options markets are considering an amendment to the general rules which, if adopted and approved by the regulators, would provide that a cash dividend or distribution by an issuer that is a closed-end investment company may not be considered to be "ordinary" if it exceeds 5% of such aggregate market value. Determinations whether to adjust for cash dividends or distributions in excess of those amounts are made on a case-by-case basis.

Because stock options are not generally adjusted for ordinary cash dividends and distributions, covered writers of calls are entitled to retain dividends and distributions earned on the underlying securities during the time prior to exercise. However, a call holder becomes entitled to the dividend if he exercises the option prior to the ex-dividend date even though the assigned writer may not be notified that he was assigned an exercise until after the ex-date. Because call holders may seek to "capture" an impending dividend by exercising, a call writer's chances of being assigned an exercise may increase as the ex-date for a dividend on the underlying security approaches.

As a general rule, stock dividends, stock distributions and stock splits can result in an adjustment in the number of underlying shares or the exercise price, or both.

EXAMPLE: An investor bought an XYZ 60 option-either a call or a put-and XYZ Corporation subsequently effected a 3 for 2 stock distribution. Instead of covering 100 shares of stock at an exercise price of $60 a share, each outstanding option could be adjusted to cover 150 shares at an exercise price of $40 per share.

However, when a stock distribution results in the issuance of one or more whole shares of stock for each outstanding share-such as a 2 for 1 stock split-as a general rule the number of underlying shares is not adjusted. Instead, the number of outstanding options is proportionately increased and the exercise price is proportionately decreased.

EXAMPLE: Before a 2 for 1 stock split, an investor holds an option on 100 shares of XYZ stock with an exercise price of $60. After adjustment for the split, he will hold two XYZ options, each on 100 shares and with an exercise price of $30.

An adjustment panel may make an exception to the general rule to adjust for stock dividends. For example, in cases where the issuer of the underlying security announces or exhibits a policy of declaring regular stock dividends that do not individually exceed 10% of the amount of the underlying security outstanding, an adjustment panel may determine to treat the stock dividends as though they were ordinary cash dividends and to make no adjustment for them.

As a general rule, adjustments in exercise prices are rounded to the nearest 1/8 of a dollar, and adjustments in the number of underlying shares are rounded down to eliminate fractional shares. In the latter case, the exercise price may be further adjusted to compensate for the elimination of the fractional shares.

Distributions of property other than the underlying security may require different adjustments. For example, outstanding options might be adjusted to include the distributed property.

EXAMPLE: If XYZ "spins off" its subsidiary ABC by distributing to its stockholders 2.5 shares of ABC stock for each share of XYZ stock, outstanding XYZ options might be adjusted to require delivery of 100 shares of XYZ stock plus 250 shares of ABC stock.

Alternatively, the exercise prices of outstanding options might be reduced by the value, on a per-share basis, of the distributed property, as determined by the adjustment panel.

Events other than distributions may also result in adjustments. If all of the outstanding shares of an underlying security are acquired in a merger or consolidation, outstanding options will as a general rule be adjusted to require delivery of the cash, securities, or other property payable to holders of the underlying security as a result of the acquisition.

EXAMPLE: If XYZ is acquired by PQR in a merger where each holder of XYZ stock receives $50 plus 1/2 share of PQR stock for each share of XYZ stock held, XYZ options might be adjusted to call for the delivery of $5,000 in cash and 50 shares of PQR stock instead of 100 shares of XYZ stock.

When an underlying security is wholly or partially converted into a debt security or a preferred stock, options that have been adjusted to call for delivery of the debt security or preferred stock may, as a general rule, be further adjusted to call for any securities distributed as interest or dividends on such debt security or preferred stock.

When an underlying security is converted into a right to receive a fixed amount of cash, options on that security will generally be adjusted to require the delivery upon exercise of a fixed amount of cash, and trading in the options will ordinarily cease when the conversion becomes effective. As a result, after such an adjustment is made all options on that security that are not in the money will become worthless and all that are in the money will have no time value. If the option is European-style (as may be the case for a flexibly structured stock option designated as a European-style option), the expiration date of the option will ordinarily be accelerated to fall on or shortly after the date on which the conversion of the underlying security to a right to receive cash occurs. Holders of an in the money option whose expiration date is accelerated must be prepared to exercise that option prior to the accelerated exercise cut off time in order to prevent the option from expiring unexercised. Writers of European-style options whose expiration date is subject to being accelerated bear the risk that, in the event of such an acceleration , they may be assigned an exercise notice and be required to perform their obligations as writers prior to the original expiration date. When the expiration date of a European-style option is accelerated, no adjustment will be made to reflect the accelerated expiration date. There is no assurance that the exercise settlement date for an accelerated option will coincide with the date that the cash payment to the holders of the underlying security becomes available from the issuer of the underlying security. Covered writers of an accelerated option may therefore be required to pay the cash amount in respect of the option before they receive the cash payment on the underlying security.

As a general rule, adjustments are not made for tender offers or exchange offers, whether by the issuer or a third party, and whether for cash, securities (including issuer securities), or other property. This presents a risk for writers of put options, because a successful tender offer or exchange offer (whether by the issuer or by a third party) may have a significant effect on the market value of the security that the put writers would be obligated to purchase if the put options are exercised after the expiration of the offer.

As a general rule, adjustments will not be made to reflect changes in the capital structure of the issuer where all of the underlying securities outstanding in the hands of the public (other than dissenters' shares) are not changed into another security, cash or other property.

As a general rule, an adjustment that is made in an option will become effective on the ex-date established by the primary market for trading in the underlying security.

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