- 12 -
a.m. Pacific time, would agree to an adjustment to conform to the
interest rate in effect at 11 a.m.--the close of the trading in New
York that day. If the discussion took place after 11 a.m., then
the price would be based upon the next day's close. Merit would
adjust the 11 a.m. interest rate by the basis point adjustment the
parties agreed to, and it would price the options accordingly. In
actual practice, premium values stayed the same, while strike
prices were adjusted. Merit calculated its clients' gains or
losses on the basis of changes in premium values over time.3
3 The mechanics of such trading are complex. A
simplified example comes from examining one leg of the T-bond
trading of one of Merit's clients. On Dec. 12, 1980, the client
purchased 285 put contracts each for T-bonds at a strike price of
$815,000, paying a premium of $23,323 per contract. Twelve days
later, on Dec. 24, 1980, the client sold 250 of the put
contracts, receiving a premium of $2,635 per contract. He
declared a loss of $5,172,000, representing the net of the
premiums--a minus $20,688 per contract--times 250 contracts.
Twelve days later, in his next taxable year, the client
permitted the remaining put contracts to lapse at a loss totaling
$816,305 (35 x $23,323 premium). Thus, his total loss on the
purchased put contracts was $5,988,305.
Like all Merit customers, he had balanced each of the above
transactions by maintaining an offsetting position in sold put
contracts. Thus, on Dec. 12, 1980, the client, who had purchased
285 put options, also sold 285 put options on identical bonds.
There were no transactions with these sold contracts until the
exercise date of Jan. 5 in the next calendar year. On that date,
the purchaser of the client's put options elected not to exercise
those options. The client thus retained the premium he had
received ($22,755 x 285), for a gain of $6,485,175. This more
than offset his loss of $5,988,305 on his purchased put option
position.
Like other Merit customers, the client had also hedged the
effects of the put option spread by establishing an offsetting
call option spread. This formed a combination spread. When the
call option facet of the client's combination spread trades is
(continued...)
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