7.3 Types and Characteristics of Derivatives

When would you Buy Put LEAPS? [A] An investor would buy a put if he expected the value of the stocks to decline, and he wants to lock in the price of selling shares in the long-term future [B] An investor who feels in the stock market will go up and he wants to lock in the price of buying shares in the long-term future [C] An investor expects the value of the stock to remain stable and is looking for income [D] An investor would buy a put if he expects the value of the stocks to decline, and he wants to lock in the price of selling shares in the short-term future

A. LEAPS are long term option contracts. A bearish investor would Buy Put options when they expect the stock market to go down.

All of the following are characteristics of a market strategy of using options to hedge investment risk EXCEPT: [A] Long puts are used to hedge or protect short stock positions. [B] Long calls are used to hedge or protect short stock positions. [C] Investors generally buy options to hedge risk. [D] Investors generally do not sell options to hedge risk.

A. Long puts are used to hedge or protect long stock positions (e.g. an investor owns ABC stock. He's bullish and will make money if the price of ABC rises. But what if the price of ABC declines? He can offset his loss in ABC by buying an ABC put which will increase in price if the price of ABC declines.)

The purchaser of a call option would have which of the following? I.A leveraged position II.Protection against a short stock position III.Limited risk

ALL Buying a call option allows the investor leverage because they could buy more options than shares of stock with the same amount of money. If you sell stock short you expect the market price of the stock to go down, but if it goes up you would be losing money and you could exercise you long call, buy the stock from the exercise and then use that stock to cover you short stock position. When you buy a call you have limited risk because the most you can lose is the premium you paid to buy the call.

Call options carry which of the following features? I.A call option is typically purchased by an investor who believes that the market price of the underlying security is going to go up. II.Call options can have American-style exercises or European-style exercises. III.The premium carried by a call option is tied to several factors, including supply and demand, market sentiment, and the value of the underlying security. IV.Call options are generally considered to carry a higher level of risk than other types of investments like common stock and bonds.

ALL Call options are purchased by investors who expect to see the market price of the underlying security go up. The call allows the buyer the ability to "lock in" an exercise price at which the buyer of the call could choose to buy the underlying stock. Exercise style on call options can be American (any time) or European (at expiration). The premium on a call derives its value from several factors which include supply and demand, market sentiment, and the value of the underlying security among other things. All things considered, options are derivative securities and therefore carry more risk than other types of investments such as common stock and bonds.

The buyer of a put option expects that the price of the underlying security will: [A] increase significantly in value [B] decrease significantly in value [C] remain unchanged or with little change in value [D] fluctuate greatly during the life of the option

B. A put is an option to sell the underlying security. A buyer of a put expects the price of the underlying security to decline significantly in value. If the price does decline significantly, the investor can profit.

Which strategy gives the best downside protection for a long stock position? [A] Sell a put [B] Buy a put [C] Sell a call [D] Buy a call

B. For an investor who is long the stock, the best downside protection you would be buying a put. Buying a put gives the best protection because you are protected all the way down to 0. (Selling a call only gives you protection up to the amount of the premium received, therefore you only have limited protection).

An investor regularly likes to speculate using options. Her advisor recommends that she use American-Style options when speculating. Why would the advisor make this recommendation? [A] The advisor would make this recommendation because American-Style options always carry more profit potential than all other types of options. [B] The advisor would make this recommendation because American-Style options can be exercised at any time all the way up to expiration. [C] The advisor would make this recommendation because other styles of options are not available to American investors. [D] The advisor would make this recommendation because the investor shouldn't be speculating and American-Style options carry little or no risk.

B. Options which have American-Style exercise can be exercised at any time up until expiration. European-style options can only be exercised at expiration. American-style options are better suited for speculators, while European-style options are better suited for hedging purposes.

Joe is long ABC common stock in his account. He expects the market price of ABC to remain neutral or go down modestly over the next few months. Joe does not want to sell his stock because he feels it is a good long term investment, but he would like to increase his income on his portfolio. Which of the following would be the best recommendation for Joe? [A] Buy Call options on ABC [B] Sell Call options on ABC [C] Buy Put options on ABC [D] Sell Put options on ABC

B. Since Joe is long the stock, he would be considered to be a "covered call writer" which is the most conservative option position possible and would provide him with premium income from the sale of the call.

The seller of a put option is obligated [A] sell the underlying security . [B] buy the underlying security. [C] short the underlying security. [D] defer a taxable gain.

B. The seller of a put option (short the option) is obligated to buy the underlying security if the option is exercised.

All of the following are characteristics of a call option EXCEPT: [A] It gives the buyer or holder the right, but not the obligation, to buy an underlying asset at a fixed price for a limited period of time. [B] The underlying asset may only be a security. [C] It may be traded on an options exchange. [D] It obligates the seller or writer to sell the underlying asset if the holder exercises his option.

B. The underlying asset does not have to be a security as in equity options ((e.g. stock). The underlying assets for options on futures contracts are often commodities such as wheat or pork bellies.

Joe recently purchased a Put option on ABC common stock. If Joe decides to exercise the Put option he would: [A] Buy 100 shares of ABC common stock [B] Sell 100 shares of ABC common stock [C] Be closing out his position with an offsetting transaction [D] Become of owner of 100 shares of ABC common stock

B. When an investor Buys a Put option they are in a position where they have the right to "Sell" 100 shares of the underlying stock if they decide to exercise the Put option.

In derivative trading in equity securities, the purchase of a Put option would give the buyer of the Put the right to: [A] Buy 100 shares of the underlying stock upon exercise [B] Sell 100 shares of the underlying stock upon exercise [C] Close the option upon exercise [D] Open a new option position upon exercise

B. When the buyer of Put option decides to exercise a Put, they are in a position where they have the right to SELL 100 SHARES OF THE UNDERLYING STOCK if they choose to exercise.

Which of the following statements about the breakeven prices associated with equity option contracts is TRUE? [A] An investor typically calculates their breakeven price only in relation to closing a position without exercise. [B] An investor should only use the exercise price of the option contract and the market price in order to determine the breakeven price. [C] An investor will have to either add the premium to or subtract the premium from the option's exercise price in order to determine the breakeven price. [D] An investor should only use the premium paid for the option and the market price of the underlying stock in order to determine breakeven price.

C. When determining breakeven prices for option contracts, an investor will add the premium paid to the options exercise price to determine the breakeven price for calls (both sold and purchased) and an investor will subtract the premiums paid from the options exercise price to determine the breakeven price for puts (both sold and purchased). So it is correct to state that an investor will have to either add the premium to or subtract the premium from the option's exercise price in order to determine the breakeven price.

The purchaser of a call option would have which of the following? I.A leveraged position II.Protection against a short stock position III.Limited risk [A] I and II [B] I and III [C] II and III [D] All

D. Buying a call option allows the investor leverage because they could buy more options than shares of stock with the same amount of money. If you sell stock short you expect the market price of the stock to go down, but if it goes up you would be losing money and you could exercise you long call, buy the stock from the exercise and then use that stock to cover you short stock position. When you buy a call you have limited risk because the most you can lose is the premium you paid to buy the call.

One of your clients owns a large block of XYZ Corporation common stock. The investor calls and wants to buy a call option for XYZ Corporation common stock. Why would this investor choose to buy a call on XYZ common stock? [A] The investor wants to generate income from the premiums on the options. [B] The investor believes that XYZ Corporation common stock is going to lose value. [C] The investor wants to ensure that any losses on the XYZ Corporation common stock are limited. [D] The investor wants to ensure a set price on XYZ Corporation common stock in the event that they want to buy more shares.

D. Buying a call option on stock allows the investor to buy at the strike price of the option contract for a specified period of time. This would be the reason for buying the call. The investor is buying the call and paying premiums. If buying a call, the investor is on the upside of the market, which does not protect against losses and is not an action performed in anticipation of losses.

A customer purchased 1 XYZ July 40 Put @3. The customer will breakeven at which of the following market prices for the underlying stock? [A] $40 [B] $3 [C] $43 [D] $37

D. To find the breakeven for an option contract, we first need to see if we are working with a Call or a Put. In this case we have a Put (an option to sell the stock). If we have a Put we would take the exercise (40) and subtract the premium paid to buy the Put (3) to arrive at the breakeven of 37. When an investor buys a Put they expect the market price of the stock to go down, it must go down by the amount of premium paid to recover the cost of buying the Put (3) and then the customer would be profitable if the price of the stock went below 37.

Jane is a conservative investor who doesn't like to take large risks within her portfolio. She feels strongly that over the long term, ABC Incorporated stock is going to be going down. What can Jane do in this scenario to capitalize off of the drop in price of ABC stock while protecting her portfolio from risk? I.Jane can sell ABC stock short in her portfolio and buy call options to hedge her short stock position. II.Jane can sell ABC stock short in her portfolio and buy put options to hedge her short stock position. III.Jane can buy ABC stock in her portfolio and sell covered calls to hedge. IV.Jane can buy ABC stock in her portfolio and sell puts to hedge.

I only In this scenario, Jane is listed as conservative and she doesn't like to take risks. Generally, selling short is a strategy that is reserved for investors with higher risk tolerance, but if Jane wishes to capitalize from a decrease in the market price of ABC stock by selling the stock short, Jane can buy call options to protect her short stock position in the event that the market price of ABC goes up. Each of the other choices would not give Jane downside profit potential with upside protection. Jane should not be buying a stock that she feels will go down in price. As well, selling short and also buying puts is putting two bearish strategies together, essentially doubling down. Remember that for short stock, a long call is the best hedge. Remember that for long stock, a long put is the best hedge.

An investor likes to speculate with derivatives in their account. Which of the following types of investment products would be considered derivatives and might be seen in this investor's brokerage firm accounts? I.Index options on the S&P 500 II.Equity options on a large manufacturing corporation's stock III.Futures contracts on commodities such as corn and grain IV.Warrants to buy the stock of a newly-formed green energy company

I, II, III and IV All of the items listed would be considered derivatives. Each derives its value from another commodity, security, or index.

Derivatives are a type of securities that derives its value from an underlying asset. The classification of Derivative includes which two of the following? I.Mutual Funds II.Stock Options III.Commodity Futures IV.Real Estate Investment Trusts

II and III A derivative is a contract that derives its value based upon the value of an underlying asset, index, or security. Derivatives include options, futures, forwards, swaps, warrants, and rights.

When talking about using options as a hedge for stock positions, which of the following are true? I.An investor who chooses to buy stock can hedge their long stock position with a long call. II.An investor who chooses to buy stock can hedge their long stock position with a long put. III.An investor who chooses to sell stock short can hedge their short stock position with a long call. IV.An investor who chooses to sell stock short can hedge their short stock position with a long put.

II and III Remember that when discussing hedging stock positions with options: 1. Long puts protect or hedge long stock positions. 2. Long calls protect or hedge short stock positions. 3. Generally, investors will not sell options to hedge or protect stock positions.

A client at the firm regularly purchases multiple call or multiple put options on securities in which the client has an interest. Which of the following would be reasons that this client would buy options? I.The client can buy options as a means of generating income from premiums for their portfolio. II.The client can buy options as a way to speculate on the underlying securities without actually buying the securities and putting them into their portfolio. III.The client can buy call options to hedge long stock positions and can buy put options to hedge short stock positions. IV.The client can buy the options as a means of leveraging a smaller amount of money and magnifying their gains/losses.

II and IV If an investor is buying options, whether calls or puts, this is not a means to gain premium income, since the investor would be required to pay the premium. This would be investing or speculating on the direction of the market value of the underlying stock. Calls would be purchased if the investor expects upward movement, while puts would be purchased if the investor expects downward movement. Investors use long options to leverage smaller amounts of money. The leverage provided by an option contract allows the investor to pay a lower amount, specifically the premium price instead of the stock price, while working with the largest amount of shares possible (100 shares per contract). This, in turn, magnifies the investor's gains and losses on the position. Investors can hedge using options, but one would hedge a long stock position with a long put, and one would hedge a short stock position with a long call. You wouldn't hedge long stock positions with long calls and you wouldn't hedge short stock positions with long puts.

The buyer of a put option has the right to [A] sell the underlying security. [B] buy the underlying security. [C] short the underlying security. [D] defer a taxable gain.

A. An owner of a put option (long the option) gives that person the right to sell the underlying security if he chooses to exercise the option.

What is the best strategy for a person who feels bullish on the stock market and he wants to lock in the price of buying shares in the long-term future? [A] Buy Calls LEAP [B] Sells Calls [C] Buy Puts [D] Buy Puts LEAP

A. Buying Call option contracts allows the buyer to buy the stock at the specific strike price. So when the stock market price goes up, the investor can buy the stock at the lower strike price. Since the investor is interested in being able to do this long-term they would buy LEAPS Call options.

Which of the following is the primary difference between forwards and futures contract? [A] Forwards are not standardized contracts and futures are. [B] Futures cover financial instruments and forwards cover commodities. [C] Delivery is standardized for forwards and futures require both parties to agree. [D] Forwards trade on an exchange and futures do not.

A. Futures are standardized contracts and trade on an exchange. Forwards are private party agreements and do not trade on an exchange.

Which of the following is the primary difference between forwards and futures contract? [A] Forwards are not standardized contracts and futures are. [B] Futures cover financial instruments and forwards cover commodities. [C] Delivery is standardized for forwards and futures require both parties to agree. [D] Forwards trade on an exchange and futures do not.

A. Futures are standardized contracts and trade on an exchange. Forwards are private party agreements and do not trade on an exchange.

Your client is long 1 cattle contract at $0.4530. He later offsets the position at $0.4840. Ignoring commission, his realized gain is? (40,000 lbs per contract) [A] $3,720 [B] $3,550 [C] $1,240 [D] $1,050

C. S+ 0.4840 less B- 0.4530 = +.0310 X 40,000 = $1,240 Gain

What options strategy provides the best upside protection for investors who short sell common stock? [A] purchasing puts on the underlying common stock. [B] selling puts on the underlying common stock. [C] purchasing calls on the underlying common stock. [D] selling calls on the underlying common stock.

C. When an investor purchases a call, the investor has the ability to buy 100 shares of the underlying security at a specified price. For an investor who is selling common stock short, knowing that they can buy at a specified price helps to provide upside protection and limit losses in the event that the stock increases in price.

The characteristics of a futures contract include all of the following EXCEPT: [A] The terms of the contract are standardized and established by the futures exchanges. [B] The price is established by supply and demand on the floor of a futures exchange. [C] The contract may be traded. [D] Delivery and settlement of the contract occurs presently.

D. Delivery and settlement of the contract will occur on a future date unless the contract is "liquidated" or closed by an equal and opposite trade before the delivery/settlement date.

When trading equity options which two of the following would represent a Bullish strategy? I. Buying a Call II. Selling a Call III. Buying a Put IV. Selling a Put

I and IV Buying calls and selling Puts are both Bullish, the investor would expect the market price of the stock to be rising.