2.4 Derivative Securities

Options positions can either create rights or obligations. In which option position has the investor created the possible obligation to purchase stock? A) Selling a put. B) Purchasing a put. C) Purchasing a call. D) Selling a call.

Answer: A When you sell, (write, go short) an option, you create an obligation. In the case of a put, you are obligated to purchase stock that is "put" to you. In the case of a call, you are obligated to sell stock that is "called" away from you. Option buyers have rights, they can choose what they wish to do - there are no obligations.

Which of the following statements is most accurate when describing equity straddle options? The option buyer is looking for market volatility. The option buyer is looking for market stability. The option seller is looking for market volatility. The option seller is looking for market stability. A) II and IV. B) I and IV. C) I and III. D) II and III.

Answer: B A straddle is the combination of a put and a call on the same stock with the same strike prices and expiration dates. The solution to the question is the same for any option position in that option buyers need price movement and option sellers make money from stability. In the case of a straddle, a buyer is expecting sharp movement but does not know the direction of the move. The seller of the straddle will benefit if there is no significant price movement. Reference: 2.4.3.5 in the License Exam Manual.

Due to an escalating trade war, the portfolio manager of an equity mutual fund anticipates a negative impact on his fund's assets. To protect his investment portfolio, the fund manager would: A) sell S&P 500 index puts. B) buy S&P 500 index puts. C) buy S&P 500 index calls. D) sell S&P 500 index calls.

Answer: B A portfolio manager who expects a decline in the market as a result of a trade war (or any factor that might hurt stock prices) would buy puts on a broad market index such as the S&P 500 to protect his position. Selling calls limits upside potential, and only protects the portfolio to the extent of the income received from the sale of the calls.

Which of the following is a multi-option strategy? A) protective put. B) straddle. C) long call. D) short call.

Answer: B A straddle consists of a put and call on the same stock with the same strike price and the same expiration date. If the investor has purchased both options, it is known as a long straddle; if they've both been sold (written), it is known as a short straddle. Therefore, with two option positions, it is a multi-option strategy.

Which of the following strategies would be considered most risky in a bull market? A) Writing naked puts. B) Buying a put. C) Writing naked calls. D) Buying calls.

Answer: C Writing naked calls provides unlimited liability and the most risk. Buying a call would be an attractive strategy in a bull market with risk limited to calls paid. Writing naked puts risks only the difference between the strike price and zero, less any premium received. Buying a put is a bearish strategy with risk limited to the amount paid for the put.

You have a client who has sold short 100 shares of RIF, a stock listed on the NYSE. If the client wished to use options to protect against unlimited loss, you would suggest the client: A) buy 1 RIF call. B) buy 1 RIF put. C) sell 1 RIF call. D) sell 1 RIF put.

Answer: A Buying a call option on a stock you are short will give you a guaranteed covering cost, thus preventing against unlimited loss. This is the best way to hedge a short position.

If an investor purchases 500 shares of an aggressive growth stock, which strategy would limit his downside risk? A) Writing 5 puts on the stock. B) Writing 5 straddles. C) Buying 5 puts on the stock. D) Buying 5 calls on the stock.

Answer: C A put gives the investor the right to sell stock at a set price (the strike price) for a period of time, and protects against losses below the strike price. Buying calls can protect a short stock position. If the customer is long stock, the purchase of calls on that security increases leverage and risk. Writing a put creates the obligation to buy more stock at the strike price, which increases downside risk.

Which one of the following option positions would generally command the greatest time value? A) puts B) straddles C) LEAPS D) calls

Answer: C LEAPS, the acronym for Long-term Equity Anticipation Securities, have expiration dates that can run more than 3 years compared to the 9 months for standard option contracts. Because time value is a direct function of the length of the option, the longer the time until expiry, the greater the potential time value.

All of the following positions expose a customer to unlimited risk EXCEPT: A) Short 2 XYZ uncovered puts. B) Short 200 shares of XYZ. C) Short 2 XYZ uncovered calls. D) Short 200 shares of XYZ and short 2 XYZ puts.

Answer: A A put writer will lose money if the stock goes down, but the furthest it can drop is to zero. Therefore, the potential loss is not unlimited. All of the other positions expose the client to unlimited risk because a loss will occur if the stock price rises.

Which of the following strategies would most effectively protect an investor with a short stock position? A) Sell a put. B) Sell a call. C) Buy a call. D) Buy a put.

Answer: C Purchasing a call on the security protects the customer from a loss in excess of the strike price plus the cost of the call should the security rise in price.

Among the benefits of purchasing derivatives would be: leverage. increased income. unlimited potential gain. protection against loss. A) I, II, III and IV. B) I, III and IV. C) III and IV. D) I and II.

Answer: B Any derivative offers the benefit of a small dollar outlay controlling a large investment (leverage). In the case of call options or some other long derivative positions, the gain potential is theoretically unlimited. The purchase of options and certain other derivatives can offer protection against loss. But, in order to generate income, you must sell the derivative, not buy.

For which of the following is there no active secondary market? A) ETFs. B) Forward contracts. C) Futures contracts. D) Options.

Answer: B One of the disadvantages when investing in forward contracts is that there is no active secondary market. Because each contract is between one buyer and one seller and there is no standardization, no exchange trading is possible.

One of your advisory clients indicates that he would like to sell forward contracts in soybeans. It would be wise to warn the client that he will be facing the following risks: liquidity. creditworthiness of the buyer. lack of assurance that the delivery price will remain stable. the location for the delivery may change. A) I and II. B) III and IV. C) I and IV. D) II and III.

Answer: A Because there is no standardization for forward contracts, they are considered to be illiquid. Since there is no entity backing up the contract (as the OCC does with listed options), a seller must always be concerned about the ability of the buyer to pay. Although the market price probably will change, the delivery price is always agreed upon at the time of the contract as is the method, location and time of delivery.

An investor is short stock at 60. The current market price of the stock is 35, and he anticipates it will continue to decline. If he thinks the price will rise temporarily and if he does not wish to close out his short position, his best strategy to prevent a loss would be to: A) Buy an XYZ 35 call B) Sell an XYZ 35 call C) Buy an XYZ 35 put D) Sell an XYZ 35 put

Answer: A This client is temporarily bullish on the stock, but, in the long term, feels that it will continue to decline so the short stock position is to be maintained. If the client is correct, a near-term rise in the price of XYZ will cause the long 35 call to be in the money and the investor can sell the call at a profit. When it comes to hedging a short stock position, buying a call is always the best strategy.

An investor would write a call option to: A) seek long-term capital gain. B) obtain income. C) protect the premium. D) fix the purchase price to add stock to his portfolio.

Answer: B The writing (selling) of an option always generates premium income to the writer. If the call is exercised, the writer must sell the stock so this is not a way to add to your portfolio. In general, option writers only realize short-term gains, not long-term. If the question had said this was a covered call, then the second best choice would have been to protect the long position (not the premium).

An investor is long stock in a cash account and does not expect the price to change in the immediate future. His best strategy to generate income may be to: A) buy a call. B) buy a put. C) sell a call. D) sell a put.

Answer: C Selling a call against a security will generate additional income (the premium). An investor who writes a put receives additional income from the position but must also be willing to increase his position should the put be exercised. An investor who buys a call is speculating that the stock will soon rise dramatically. An investor who buys a put is speculating the stock will soon fall, not stay steady in price. Reference: 2.4.3.2 in the License Exam Manual.

A corporation sponsors a defined benefit pension plan. The assets of the plan are invested in a diversified portfolio of large-cap stocks. Which of the following options positions would be most appropriate if the corporation wished to protect their ability to meet their obligations to employees? A) Buy S&P 500 index calls. B) Sell S&P 500 index calls. C) Sell S&P 500 index puts. D) Buy S&P 500 index puts.

Answer: D In a defined benefit plan, the corporation is assuming the investment risk. Regardless of the security, the best way to protect a long position is to buy a put, either on that security or an index with a close correlation. In this case, with a portfolio of large-cap stocks, the S&P 500 index would seem to be the appropriate option to use.

Writing an option provides all of the following EXCEPT: A) income. B) limited downside protection when long the underlying asset. C) hedging. D) maximum protection against loss.

Answer: D Writing an option provides only limited protection for a long or short position. That protection is limited to the amount of the premium received.