INDEX OPTIONS: ABOUT INDEXES

As referred to in this booklet, an index is a measure of the prices of a group of securities or other interests. (Some indexes reflect values of companies, rather than securities, by taking into account both the prices of constituent securities and the number of those securities outstanding.) Although indexes have been developed to cover a variety of interests, such as stocks and other equity securities, debt securities and foreign currencies, and even to measure the cost of living, indexes on equity securities (which are called stock indexes) are among the most familiar, and they are the only indexes that underlie options trading at the date of this booklet. The following discussion refers only to stock indexes and stock index options.

Stock indexes are compiled and published by various sources, including securities markets. An index may be designed to be representative of the stock market of a particular nation as a whole, of securities traded in a particular market, of a broad market sector (e.g., industrials), or of a particular industry (e.g., electronics). An index may be based on the prices of all, or only a sample, of the securities whose prices it is intended to represent. Indexes may be based on securities traded primarily in U.S. markets, securities traded primarily in a foreign market, or a combination of securities whose primary markets are in various countries.

A stock index, like a cost of living index, is ordinarily expressed in relation to a "base" established when the index was originated.

EXAMPLE: On the starting or "base" date for a new value-weighted index, the total market values of the component securities (market price times number of shares outstanding) is $50 billion. The publisher of the index will assign an arbitrary index level say 100 to that base value. If the total market value of the component stocks increases by 2% the next day (i.e., to $51 billion), the index level would rise to 102 (102% of the base level of 100).

The base may be adjusted from time to time to reflect such events as capitalization changes affecting the constituent securities of the index (e.g., issuance of new shares) or to maintain continuity when securities are added to or dropped from the index. These adjustments are generally designed so that the index level will change only as a result of price changes of constituent securities during trading.

Securities may be dropped from an index because of events such as mergers and liquidation's or because a particular security is no longer thought to be representative of the types of stocks constituting the index. Securities may also be added to an index from time to time. Adjustments in the base level of an index, additions and deletions of constituent securities, and similar changes are within the discretion of the publisher of the index and will not ordinarily cause any adjustment in the terms of outstanding index options. However, an adjustment panel has authority to make adjustments if the publisher of the underlying index makes a change in the index's composition or method of calculation that in the panel's determination, may cause significant discontinuity in the index level.

Different stock indexes are calculated in different ways. Accordingly, even where indexes are based on identical securities, they may measure the relevant market differently because of differences in methods of calculation. Often the market prices of the securities in the index group are "capitalization weighted." That is, in calculating the index value, the market price of each constituent security is multiplied by the number of shares outstanding. Because of this method of calculation, changes in the prices of the securities of larger corporations will generally have a greater influence on the level of a capitalization weighted index than price changes affecting smaller corporations.

Other methods may be used to calculate stock indexes. For example, in one method known as "equal- dollar weighting," the index is established by establishing an aggregate market value for every constituent security of the index and then determining the number of shares of each security by dividing such aggregate market value by the then current market price of the security. The base level of the index is established by dividing the total market value of all constituent securities by a fixed index divisor. Thereafter, the number of shares of the constituent securities and the index divisor are adjusted at periodic intervals in order to have each constituent security continue to represent an approximately equal dollar value in the index without distorting the level of the index.

Another method of calculation is simply to add up the prices of the securities in the index and divide by the number of securities in the index, disregarding numbers of shares outstanding. Another method measures daily percentage movements of prices by averaging the percentage price changes of all securities included in the index.

Investors should keep in mind that an index can respond only to reported price movements in its constituent securities. An index will therefore reflect the stock market as a whole, or particular market segments, only to the extent that the securities in the index are being traded, the prices of those trades are being promptly reported, and the market prices of those securities, as measured by the index, reflect price movements in the relevant markets. The index level will be affected by all of the factors that may at the time affect prices in the relevant markets for the constituent securities of the index, including, among other things, applicable laws, regulations and trading rules, the market-making and order processing systems of those markets, the liquidity and efficiency of those markets, and the prices and price behavior of futures contracts on that index or a related index.

Certain trading strategies involving purchases and sales of index options, index futures, options on index futures or portfolios of certain of the securities in an index can affect the value of the index, the prices of the index futures, and, therefore, the prices of index options. These transactions and the resulting impact may occur at any time-and may accompany significant changes in the prices or volatilities of the stock and derivative markets-including at or shortly before an expiration. For example, traders holding positions in expiring index options or futures contracts hedged by positions in securities included in the index may attempt to liquidate their securities positions at or near the time for determining the final exercise settlement value of the options or futures contracts. The resulting orders to liquidate these securities might result in significant changes in the level of the index. Index options investors should be aware of the potential impact that these trading strategies can have on index levels at or near expiration, and the possibility that the values of index option positions will be affected accordingly.

Readers who intend to trade index options should familiarize themselves with the basic features of the underlying indexes, including the general methods of calculation. Readers who are attempting to follow a precise and sophisticated strategy involving index options may wish to inform themselves about the exact method for calculating each index involved. Information regarding the method of calculation of any index on which options are traded, including information concerning the standards used in adjusting the index, adding or deleting securities, and making similar changes, is generally available from the options market where the options are traded.

The value level of every index underlying an option-including the exercise settlement value-is the value of the index as reported by the reporting authority designated by the options market where the option is traded as the official source for determining that index's value. Unless OCC directs otherwise, every value as initially reported by the reporting authority is conclusively presumed to be accurate and deemed to be final for the purpose of calculating the cash settlement amount, even if the value is subsequently revised or determined to have been inaccurate.

Most indexes on which options are traded are updated during the trading day, and updated index levels are disseminated at frequent intervals. Investors may determine current index levels from their brokerage firms; in addition, the closing levels of many underlying stock indexes are published in daily newspapers such as "The Wall Street Journal." However, an index option may be traded in the options markets at a time when some, or even a substantial portion, of the constituent securities of the underlying index are not trading or when there is a lag in the reporting of prices in some or all of the constituent securities. In those circumstances, the current reported index level will be based on non-current information, since its calculation will be based on the last reported prices for all constituent securities even though trading or price reporting in some of those securities is not current.

FEATURES OF INDEX OPTIONS

All index options that are traded at the date of this booklet are cash-settled. Cash-settled index options do not relate to a particular number of shares. Rather, the "size" of a cash-settled index option contract is determined by the multiplier of the option. If the option market on which an option series is traded should decrease the multiplier for the series, an adjustment panel may adjust outstanding options of that series.

The exercise prices and premiums of the index options that are traded at the date of this booklet are expressed in U.S. dollars. Subject to regulatory approval, trading in index options whose exercise prices or premiums are expressed in a foreign currency may be introduced in the future. The total exercise price for a single option is the stated exercise price multiplied by the multiplier.

Premiums for index options are expressed in points and fractions of points. Each point of premium of the options trading at the date of this booklet represents an amount equal to one U.S. dollar. In order to determine the aggregate premium for a single index option, the quoted premium must be multiplied by the multiplier.

EXAMPLE: An investor purchases a December 110 index call at 2 1/8. The multiplier for that option is 100. The aggregate dollar amount of the premium is $212.50 ($2 1/8 times 100= $212.50). Had the options market used a multiplier of 200, a premium of 2 1/8 would have meant an aggregate premium of $425.00.

The exercise settlement values of stock index options are determined by their reporting authorities in a variety of ways. The exercise settlement values of some index options are based on the reported level of the index derived from the last reported prices of the constituent securities of the index at the closing on the day of exercise. The exercise settlement values of other options are based on the reported level of the index derived from the opening prices of the constituent securities on the day of exercise. If an option is exercised on a day that is not scheduled as a trading day for the constituent securities of the index, the exercise settlement value is based on the reported level of the index derived from the opening or closing prices (depending on the options series) of the constituent securities on the last prior day that is scheduled as a trading day. If a particular constituent security does not open for trading on the day the exercise settlement value is determined, the last reported price of that security is used. Other means for determining the exercise settlement values of some index options series have been, and may continue to be, established. For example, the exercise settlement values for options on an index of foreign securities may be fixed in relation to a value fixed by a foreign exchange.

Investors should be aware that the exercise settlement value of an index option that is derived from the opening prices of the constituent securities may not be reported for several hours following the opening of trading in those securities. A number of updated index levels may be reported at and after the opening before the exercise settlement value is reported, and there could be a substantial divergence between those reported index levels and the reported exercise settlement value.

Investors should also be aware that there is no single opening or closing price for securities primarily traded in the FINRAAQ stock market. A price of a NASDAQ security that is used in determining the level on a particular day of an index that includes the security will not necessarily be the price at which a majority of opening or closing trades in that security were effected on that day.

The principal risks of holders and writers of index options are discussed in Chapter X. Readers interested in buying or writing index options should carefully read that chapter, particularly the discussions under the headings "Risks of Option Holders," "Risks of Option Writers," "Other Risks," and "Special Risks of Index Options."

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