Complex Option Strategies

An individual purchases 10 ABC June 90 calls @ 4 and writes 10 ABC June 95 calls @ 2. The individual's maximum loss is: a. $2,000 b. $3,000 c. $4,000 d. $6,000

A. $2,000 This is a debit spread since the investor is paying more (4) for the purchased call than he receives (2) for the call that was written. The maximum loss for a debit spread is the amount of the debit. A simple way to look at a debit spread is to focus in on the buy side of the spread. This is the more valuable option contract and, therefore, defines the investment strategy. Approach the questions as if the investor purchased the 90 call at the net debit of 2 ($2,000 for 10 contracts). The maximum loss when purchasing an option is the premium (net premium).

Mr. Smith sells an ABC Corporation April 30 put for $5 and an April 30 call for $3. ABC Corporation is selling in the market at $28. ABC Corporation subsequently declines to $25 per share. The call option expires and the put side of the straddle is exercised. Mr. Smith then sells the 100 shares of ABC Corporation put to him, at the current market price of $25. The overall profit or loss for Mr. Smith is a: a. $300 profit b. $300 loss c. $500 profit d. $500 loss

A. $300 profit Mr. Smith received $800 in premiums. The call option expires. The put side of the straddle is exercised. Mr. Smith must buy 100 shares of ABC Corporation that is put to him at the exercise price of $30. He then sells the shares purchased for $30 at the current market price of $25, realizing a loss of $5. However, he has received $8 in premiums. Therefore, he will have an overall $300 profit ($8 premium received for the straddle minus the $5 loss on the sale of 100 shares of ABC Corporation equals a $3 profit).

An investor purchases 100 shares of XYZ at 60 and also writes an XYZ 65 call @ 3. What is the investor's maximum potential loss? a. $5,700 b. $6,300 c. $6,500 d. $6,800

A. $5,700 The investor will suffer a loss if the price of XYZ declines. XYZ could go bankrupt and the price of the stock would decline to zero. The investor will have a loss of $6,000 (his original cost) on the stock, which will be partly offset by the $300 premium received from writing the call. His net loss is then $5,700.

A customer sells an XYZ April 30 put for $5 and an XYZ April 30 call for $3. If the put is repurchased at $4 and the call is repurchased for $1, the customer will have: a. A profit of $300 b. A loss of $300 c. A profit of $800 d. A loss of $800

A. a profit of $300 The customer sold a straddle and received $500 for the put and $300 for the call or a total of $800 for the straddle. The put was repurchased for $400 and the call for $100, or a total cost of $500. The difference between the amount of premiums received from the sale of the straddle ($800) and the cost of repurchasing the straddle ($500) is a profit of $300 for the customer.

An investor established the following positions. Long 100 shares of XYZ at $37 per share Long 1 XYZ 35 put at 1.75 This investor prefers XYZ to: a. Appreciate significantly b. Depreciate significantly c. Fluctuate d. Not change

A. appreciate significantly The investor purchased the stock at $37 per share and protected it by purchasing the right to sell XYZ at $35, paying a 1.75 premium (long XYZ 35 put). The investor loses money if the stock falls below the breakeven price of $38.75 ($37 purchase price of the stock + the 1.75 premium on the purchase of the put). The investor prefers XYZ to appreciate significantly since there is the potential for unlimited gains

An individual who is short stock and wants protection against an upside move in the market will probably: a. Buy a call option b. Sell a put option c. Buy a put option d. Buy a defense stock

A. buy a call option An individual who is short stock will buy a call option. If the market advances, the individual will exercise the call option to limit the loss if the market value of the short stock increases.

Which of the following option positions is an example of a spread? a. Buy an XYZ June 60 call and sell an XYZ June 65 call b. Buy an XYZ June 60 call and buy an XYZ June 60 put c. Buy an XYZ June 60 call and buy an XYZ June 65 put d. Sell an XYZ June 60 call and sell an XYZ June 60 put

A. buy an XYZ June 60 call and sell an XYZ June 65 call A spread is defined as the simultaneous sale and purchase of two options of the same class (same stock and same type of option), but it will have different strike prices and/or expirations. A long straddle is defined as the simultaneous purchase of two options that have the same expiration and strike price, but consist of one call and one put. A short straddle is defined as the simultaneous sale of two options that have the same expiration and strike price, but consist of one call and one put. Choice (b) is a long straddle and choice (d) is a short straddle. A combination is similar to a straddle, however, the strike prices and/or expirations must be different. Choice (c) is a long combination.

A customer is considering writing an XYZ April 90 put for an $8 premium but is concerned about the risk of a large loss. Which of the following positions, when added, provides the BEST protection? a. Buying an XYZ April 80 put for a premium of 2 b. Buying an XYZ April 95 call for a premium of 5 c. Selling an XYZ April 85 put for a premium of 5 d. Selling an XYZ April 90 call for a premium of 8

A. buying an XYZ April 80 put for a premium of 2 The short put position has a maximum risk of $8,200 if the stock declines to zero. If, in addition, the customer buys an XYZ April 80 put for 2, it becomes a credit spread. The maximum risk is reduced to $400, which is the difference between the strike prices (10) and the net premium received (6).

Abigail is long 500 shares of GHI at $18 per share. In November, GHI is trading at $24 per share, but is expected to decrease in value over the next few months. Abigail wants to protect as much of her gain as possible and is willing to sacrifice upside potential to reduce her cost. Which of the following positions would you recommend to her to accomplish her goal? a. Purchase 5 GHI Jan 25 puts and sell 5 GHI Jan 30 calls b. Sell 5 GHI Jan 25 puts and sell 5 GHI Jan 25 calls c. Purchase 5 GHI Jan 25 puts and purchase 5 GHI Jan 30 calls d. Sell 5 GHI Jan 25 puts and purchase 5 GHI Jan 25 calls

A. purchase 5 GHI Jan 25 puts and sell 5 GHI Jan 30 calls In order to protect some of the gain, Abigail will need to purchase 5 puts that expire in January. To reduce the cost of purchasing the 5 GHI Jan 25 puts, Abigail can sell 5 GHI Jan 30 calls to generate income from the premiums she receives and margin will not be required since Abigail owns 500 shares of GHI that could be called away should the short calls be exercised.

An investor purchased stock at $40/share that currently has a market price of $60/share. The investor thinks that the long-term prospects for the stock are attractive, but that the price will decline temporarily. The customer could take advantage of the temporary decline, by: a. Selling a call b. Buying a call c. Selling a put d. Setting up a spread in the underlying stock

A. selling a call If the investor were to sell a call and the price declined, the call will expire and he will generate premium income. The long stock position will still be maintained, and the investor will profit if the anticipated price advance occurs.

An investor is long 1,000 shares of XYZ at $32 per share and the current market value of XYZ is $38. The investor believes the stock is not likely to fluctuate over the next few months and actually has a long-term bullish outlook. Which of the following positions will allow the investor to increase the portfolio's yield without increasing the downside risk? a. Short 10 XYZ 40 calls b. Long 10 XYZ 40 calls c. Short 10 XYZ 40 puts d. Long 10 XYZ 40 puts

A. short 10 XYZ 40 calls This investor is a perfect candidate to establish a covered call position. Since she owns 1,000 shares of XYZ, 10 XYZ calls could be sold in her account without exposing her to the risk of having to enter the market and purchase stock in the event that the calls are exercised. The total premiums received will reduce the amount she needs in order to recover her initial investment ($32 per share) if she is obligated to sell XYZ shares. Also, since she believes the stock is not likely to fluctuate over the next few months, she is not overly concerned that XYZ will appreciate to a point at which the short calls will be exercised (at the $40 strike). If the investor had purchased either the calls, choice (b), or the puts, choice (d), it would have cost her money. Although selling the puts, choice (c), would generate income it would greatly increase her downside risk.

A client wants to purchase 10 RSR July 45 calls and 10 RSR July 45 puts. This transaction: a. Should be executed on one order ticket b. Should be executed on two order tickets c. Should not be executed d. Must be approved in advance by a registered options principal

A. should be executed on one order ticket This type of option transaction is a long straddle. Advanced option strategies such as spreads and straddles should be executed on one order ticket. They do not need to be approved in advance by a registered options principal (ROP).

Your client owns a portfolio of blue-chip equity securities and wants to increase the overall rate of return through the use of options. The most conservative strategy to achieve this objective is to: a. Write covered calls b. Buy calls c. Write covered puts d. Buy puts

A. write covered calls The most conservative strategy for the investor to achieve her objective is to write covered calls. The call premium received will increase the yield on her portfolio of stocks because it will add to the income generated by the dividends received from the stock.

An individual purchases 10 ABC June 90 calls @ 4 and writes 10 ABC June 95 calls @ 2. The individual's maximum profit is: a. $2,000 b. $3,000 c. $4,000 d. $6,000

B. $3,000 The investor has established a debit spread and will profit if the spread (difference in premium) widens. The widest the spread can get is the difference in strike prices (95 - 90 = 5). The maximum profit is the difference in the strike prices ($5,000) minus the net debit ($2,000) or $3,000.

An investor buys 100 shares of XYZ at $50 per share and, at the same time, writes an XYZ May 50 call option for a $5 premium. Excluding commissions and dividends, at what price would XYZ need to be selling for the writer to break even? a. $42 b. $45 c. $50 d. $58

B. $45 The breakeven point for the writer of a covered call is the original cost of the stock minus the premium received on the option (50 - 5 = 45). If the market price were at 45 at expiration, the call would expire and the writer would keep the $500 premium. However, the stock purchased at $50 would be worth only $45, which is equal to the investor's cost.

A customer writes an XYZ June 60 straddle for a 5-point premium. At expiration, the market price of XYZ is 50 and the put side is exercised. The customer then sells the stock that was put to her at the current market price. The customer has realized a: a. $500 profit b. $500 loss c. $1,000 profit d. $1,000 loss

B. $500 loss The customer has received a total of $5 in premiums or $500 for the straddle. The call side of the straddle expires, but the put is exercised. The writer must buy the stock at $60 per share (the exercise price). The stock is then sold at the $50 market price, which results in a $1,000 loss ([$60 - $50] x 100 shares). However, since the customer initially received a premium when she wrote the straddle, the loss is only $500 ($1,000 loss from exercising the put - $500 premium).

An investor purchases 100 shares of XYZ at 60 and also writes an XYZ 65 call @ 3. If the call is exercised when the market price of XYZ is 70, what is the investor's profit? a. $700 b. $800 c. $1,000 d. $1,200

B. $800 If the call is exercised, the investor will be required to sell his stock at the strike price of 65 (not the market price of 70). The proceeds of the sale will be $6,800 ($6,500 strike price plus $300 premium received). Since his original cost is $6,000, he will have a profit of $800.

In April, a customer purchased 1 ABC July 85 call for 5 and purchased 1 ABC July 90 put for 8. ABC stock is currently trading at $87. If both options are sold for the amount each is in-the-money, the investor will realize a(n): a. $500 profit b. $800 loss c. $1,000 loss d. $1,100 loss

B. $800 loss The call is in-the-money by $200 and the put is in-the-money by $300. If the call is sold for $200, the loss on the call would be $300. If the put is sold for $300, the loss would be $500.

A customer sells short 100 shares of XYZ at $40 and sells one XYZ October 40 put at 5. If the put is exercised when the market value of the stock is $35 and the stock received due to that exercise is used to cover the short stock position, what is the customer's profit or loss per share? a. A $10 profit b. A $5 profit c. 0 d. A $5 loss

B. a $5 profit This customer has created a covered short put option position (short stock + a short put). In order to determine the customer's gain or loss, begin with the amount that he has received (i.e., cash in) and subtract the amount that he has paid (i.e., cash out). The customer received $4,000 for selling the stock short ($40 x 100 shares) and also received $500 for selling the puts ($5 premium x 100 shares); therefore, the customer has received $4,500 in total. Now, since the put was exercised, the customer is obligated to buy the stock for $4,000 ($40 strike price x 100 shares). Notice that the current market price is not a factor in this question, since the customer is obligated to buy the stock at the strike price when exercised against. Ultimately, the customer's profit is $500 ($4,500 received - $4,000 paid).

An investor who sells a July 50 put and buys a July 60 put on the same stock is establishing a: a. Bull spread b. Bear spread c. Long straddle d. Short straddle

B. bear straddle A bear spread always involves buying the higher exercise price and selling the lower exercise price. This applies to both call spreads and put spreads. A bull spread always involves buying the lower exercise price and selling the higher exercise price. This applies to both call spreads and put spreads.

An investor has sold stock short at $60. The current market price of the stock is $40 and the investor believes the stock will recover somewhat before going lower. The investor should: a. Buy a put b. Buy a call c. Write a call d. Write a straddle

B. buy a call The stock is currently trading at $40 and the investor is concerned that the price will rise. An investor who wants to limit the losses on an underlying short stock will buy a call.

A customer is considering writing an XYZ June 70 call for a $4 premium but is concerned about the risk of an unlimited loss. Which of the following positions, when added, provides the BEST protection? a. Buying an XYZ June 70 put for a premium of 4 b. Buying an XYZ June 75 call for a premium of 1 c. Selling an XYZ June 65 put for a premium of 2 d. Selling an XYZ June 75 call for a premium of 3

B. buying an XYZ June 75 call for a premium of 1 The short call position has unlimited risk since there is no limit to where the underlying stock can increase to. If, however, in addition, the customer buys an XYZ June 75 call for 1, it creates a credit spread. The maximum risk is reduced to $200, which is the difference between the strike prices 5 (75 - 70) and the net premium received 3 (4 - 1).

A covered call writer can be described as being: a. Short the call, and short the stock b. Short the call, and long the stock c. Long the call, and short the stock d. Long the call, and long the stock

B. short the call, and long the stock When writing (or selling) the call, the investor is said to be short the call. A covered call writer will currently own the underlying securities, and hence be long the stock.

An investor is short 100 shares of QRS stock at $25 per share, and sells one QRS July 25 put at 2. The investor will make money in all of the following situations, EXCEPT: a. The price of QRS stock remains at $25 per share b. The price of QRS stock rises to $30 per share c. QRS files for bankruptcy and the stock is now worthless d. The July 25 put expires worthless

B. the price of QRS stock rises to $30 per share The investor is bearish on the stock, and has taken in additional income by selling a put. By selling the stock and the put, the investor has taken in a total of $27 per share. A profit will be realized as long as the stock price remains below $27 per share. But, since the hedge is limited to the amount of the premium, the investor's maximum loss is still unlimited.

With no other securities position, a customer sells short 100 shares of ABC at $40 and sells 1 ABC October 40 put for $500. The customer will break even when the price of the stock is at: a. $35 b. $50 c. $45 d. $40

C. $45 An individual who sells short risks a loss if the price of the stock rises. If the price rises to $50 and the stock is bought in the open market to cover, the loss will be $1,000 minus the premium, for a net loss of $500. If the market price rises to 45, the loss of $500 is exactly matched by the premium income of $500 and the investor breaks even. The breakeven point for a short seller who writes a put is the market price of the short sale plus the premium.

In May, a customer sells an STC July 40 listed call for a $6 premium and buys an STC July 30 listed call for $10. Near expiration, STC is selling at $39. The 40 call expires and the customer closes out the 30 call at its intrinsic value. The net result is a: a. $100 loss b. $100 profit c. $500 profit d. $500 loss

C. $500 profit When the market price of STC is at $39, the July 30 call has an intrinsic value of 9 points. Since the investor paid a debit of $400, this will result in a profit of $500 ($900 intrinsic value - $400 debit).

An investor buys an STC May 30 call @ 8 and sells an STC May 40 call @ 2. The investor's maximum potential loss is: a. $200 b. $400 c. $600 d. $800

C. $600 This is a debit spread since the investor paid a net premium of $600. The maximum potential loss for a debit spread is the net premium ($600).

A customer buys an EK October 50 call paying a $4 premium and an EK October 50 put for a $4 premium. The price of EK increases to $66 per share. The put option expires unexercised but the customer closes out the call option at its intrinsic value. The customer has a net: a. $700 profit b. $700 loss c. $800 profit d. $800 loss

C. $800 profit The customer paid $800 in premiums ($400 for the call and $400 for the put). The call is liquidated for its intrinsic value of $1,600 (the in-the-money amount). After deducting the $800 paid in premiums from the $1,600 proceeds, the customer has a net $800 profit.

An investor buys an STC May 30 call @ 8 and sells an STC May 40 call @ 2. The investor's breakeven point is: a. 30 b. 34 c. 36 d. 40

C. 36 The breakeven point for a call spread is the lower strike price plus the net premium (30 + 6 = 36). If the market price is 36 at expiration, the May 30 call purchased will be in-the-money by 6 points and the May 40 call sold will expire. The investor will make six points on the May 30 call, which is equal to the amount paid for the spread.

Mrs. Smith is short 100 shares of DEF stock. She is concerned that the stock is going to increase in price temporarily, but does not want to cover the short position. Which option position gives Mrs. Smith the BEST protection? a. Long 1 DEF put b. Short 1 DEF put c. Long 1 DEF call d. Short 1 DEF call

C. Long 1 DEF call The best possible upside protection can be accomplished with the purchase of 1 DEF call. If Mrs. Smith is long a call, this allows her to buy the stock from the writer if the stock goes up, thus protecting the short position.

An investor expects the market price of a security to fluctuate widely over a short period. The investor will most likely: a. Buy a put b. Buy a call c. Buy a straddle d. Sell a straddle

C. buy a straddle The investor should buy a straddle, which consists of a put and a call at the same exercise price and same expiration. The investor could exercise or sell the call side of the straddle if stock prices increase, and could exercise or sell the put side of the straddle if stock prices decrease.

An individual who adds an option to an existing position to create a straddle is said to have: a. Straddled into the position b. Combined into the position c. Legged into the position d. Settled into the position

C. legged into the position When an individual buys or sells an option to add to an existing position to create a more complex option position, such as a straddle or spread, it is said the individual has legged into the position. For example, if a customer who is long an XYZ March 55 call then purchases (adds) a March 55 put, it is referred to as having legged into a long straddle.

Which of the following positions best enables an investor to take advantage of a significant appreciation in DEF stock? a. A debit DEF call spread b. A credit DEF put spread c. Long a DEF straddle d. Short a DEF straddle

C. long a DEF straddle The long straddle offers an investor the ability to realize unlimited gains since the client is long a call option. The gains are determined by the amount the stock appreciates. While a debit call spread is bullish, the gain is limited to the difference between the strike price on the long call and the strike price on the short call. The credit put spread is also bullish, but the gain is limited to the net premium received. The short straddle exposes an investor to unlimited risk if the stock rises.

An investor is long one ABC Jan 40 call at 10 and long one ABC Jan 60 call at 2.50. The investor is also short two ABC Jan 50 calls at 5. The investor's strategy is: a. Bullish b. Bearish c. Neutral d. Unable to be determined

C. neutral An investor who creates a butterfly spread is utilizing a neutral strategy. In other words, the investor believes that the underlying security will not vary greatly in price by expiration. The maximum profit is realized when the price of the underlying security (ABC in this question), is at the middle strike price. This type of strategy has both limited risk and limited profit potential.

An investor does not expect the price of XYZ stock to change in the immediate future and wishes to generate income. The best strategy is: a. Sell a call b. Sell a put c. Sell a straddle d. Buy a straddle

C. sell a straddle If the market price does not change, neither side of the straddle will be exercised. The premium on both the put and the call will be income to the investor

A customer believes a stock will have a wide fluctuation in price over a short period. If he wants to engage in an option strategy that will be profitable from a sharp movement either on the upside or downside, he will buy a: a. Put b. Call c. Straddle d. Spread

C. straddle The customer will buy a straddle, which is the simultaneous purchase of a put and a call with the same expiration dates and the same strike prices. If the market moved up sharply, the call could be exercised and if it moved down sharply, the put could be exercised, resulting in a profit.

All of the following statements are TRUE of covered call option writing, EXCEPT: a. The writer can increase the overall yield on his portfolio b. It is considered a conservative option strategy c. The premium received guarantees the writer cannot have a loss on the underlying security d. The writer will have a short-term capital gain if the option expires unexercised

C. the premium received guarantees the writer cannot have a loss on the underlying security All of the choices listed are true except the premium received guarantees the writer cannot have a loss on the underlying security. The security can decline in price below the breakeven point (cost price of the stock minus the premium), causing the writer to have a loss on the stock. If the option expires, the writer will always have a short-term capital gain from the premium received.

If an investor had cash and securities in his account, why would the investor write call options against the securities? a. To hedge his position b. To engage in an arbitrage c. To increase the overall rate of return of the portfolio d. To postpone paying taxes

C. to increase the overall rate of return of the portfolio The purpose of writing calls against securities owned is to increase the overall rate of return of the portfolio. The premium the purchaser of the call pays the writer will be added to whatever dividends the writer was receiving to increase the yield of the portfolio to the writer. If the stock declines in value, the writer will make the premium on the expiring call. However, the investor is still exposed to large downside risk in the stock. Therefore, generating income for the portfolio is a better choice than to hedge.

An investor established the following positions. Long 100 shares of XYZ at $37 per share Long 1 XYZ 35 put at 1.75 This investor breaks even when XYZ is at: a. $33.25 per share b. $35.25 per share c. $36.75 per share d. $38.75 per share

D. $38.75 per share The investor purchased the stock at $37 per share and protected it by purchasing the right to sell XYZ at $35, paying a premium of 1.75 (long XYZ 35 put). The investor will break even when the price of XYZ is at $38.75 ($37 purchase price of the stock + the 1.75 premium on the put).

Ms. Green buys 300 shares of RSW at $15 per share. She then writes 3 RSW July 20 calls at 1 and writes 3 RSW July 10 puts at 50 cents. Ms. Green's maximum potential loss on the entire position is: a. Unlimited b. $4,050 c. $4,950 d. $7,050

D. $7,050 This is a tricky and involved question in which Ms. Green has written three covered calls and three uncovered puts. In both cases, the maximum loss occurs if the underlying stock (RSW) becomes worthless. If the market price of RSW is zero, the three covered calls would result in a $4,200 loss (300 shares x $15 purchase price minus the $300 premium received). The three uncovered puts would be exercised if the stock declined to zero, which is the worst case scenario. The maximum loss on an uncovered put is the total or aggregate value of the option less the premium received. The aggregate strike price of $3,000 ($10 x 100 shares x 3 contracts) minus the premium of $150 ($.50 x 100 shares x 3 contracts) equals $2,850. Therefore, the total loss is $7,050 ($4,200 + $2,850). A popular answer is choice (b). Students often arrive at $4,950 by adding the cost of the stock ($4,500), plus the premium received from the sale of the calls ($300), plus the premium received from the sale of the puts ($150). Keep in mind, when an investor is long stock, losses will be realized by the stock declining in value. The answer of $7,050 was determined by assuming that the stock becomes worthless.

An investor purchases 200 shares of STC at $35 and subsequently purchases 2 STC Jan 35 puts at 2. At what market price must STC trade for the investor to have a profit? a. 32 b. 34 c. 36 d. 38

D. 38 If an investor is long stock and long a put, he will have a profit if the market price exceeds the cost of his stock plus the premium for the option. The stock must trade above 37 (35 cost + 2 premium).

An individual purchases 10 ABC June 90 calls @ 4 and writes 10 ABC June 95 calls @ 2. At expiration, the individual will have a profit if the market price of ABC is: a. 90 b. 91 c. 92 d. 93

D. 93 This is a debit spread since the investor is paying more (4) for the purchased calls than he receives (2) for the calls that were written. The maximum loss for a debit spread is the amount of the debit. A simple way to look at a debit spread is to focus in on the buy side of the spread. Approach the questions as if the investor purchased the 90 call at the net debit of 2 ($2,000 for 10 contracts). Therefore, look at the purchase of a 90 call at 2 (net debit). The breakeven point when buying a call is the strike price (90) plus the premium (net debit of 2). Any market price above the breakeven point of 92 will make the position profitable.

An individual purchases 10 ABC June 90 calls @ 4 and writes 10 ABC June 95 calls @ 2. Above what market price for ABC will there no longer be an effect on the individual's profit? a. 90 b. 92 c. 94 d. 95

D. 95 The spread will widen as the market price rises. The maximum spread occurs at a market price of 95. If it rises above 95, the spread will not widen beyond 5 (the difference between the strike prices).

Which of the following positions exposes an investor to the most risk? a. A bullish call spread b. A bullish put spread c. Owning put options d. A short straddle

D. a short straddle A short straddle consists of a short call and a short put, on the same underlying stock, with the same strike price and expiration month. The investor has an unlimited loss potential on the short call leg of the straddle. Spread positions limit the potential loss to the investor. For debit spreads (i.e., bullish call spreads and bearish put spreads), the loss is limited to the difference between the premiums. For credit spreads (i.e., bearish call spreads and bullish put spreads), the loss is limited to the difference between the strike prices minus the credit. The owner of a put option is only at risk for the premium paid to purchase the option.

An investor is long one ABC Jan 40 call at 10 and long one ABC Jan 60 call at 2.50. The investor is also short two ABC Jan 50 calls at 5. The investor has created a: a. Combination b. Variable hedge c. Strangle d. Butterfly spread

D. butterfly spread This is an example of a long call butterfly spread. It is created with four calls that have three different strike prices. An investor will be long one contract with the lowest strike price, long one contract with the highest strike price, and short two contracts with the middle strike price. To recognize a butterfly spread, look for the 1—2—1 formation

Which of the following option positions is an example of a combination? a. Buy an XYZ June 60 call and sell an XYZ June 65 call b. Buy an XYZ June 60 call and buy an XYZ June 60 put c. Sell an XYZ June 60 call and sell an XYZ June 60 put d. Buy an XYZ June 60 call and buy an XYZ June 65 put

D. buy an XYZ June 60 call and buy an XYZ June 65 put A long straddle is defined as the simultaneous purchase of two options that have the same expiration and strike price, but consist of one call and one put. A short straddle is defined as the simultaneous sale of two options that have the same expiration and strike price, but consist of one call and one put. Choice (b) is a long straddle and choice (c) is a short straddle. A combination is similar to a straddle, however, the strike prices and/or expirations must be different. Choice (d) is a long combination. A spread is defined as the simultaneous sale and purchase of two options of the same class (same stock and same type of option), but it will have different strike prices and/or expirations. Choice (a) is a spread.

An investor selling a combination will profit if the price of the underlying security is: a. Rising b. Falling c. Volatile d. Neutral

D. neutral Selling a call and a put on the same security with different strike prices, or different expiration dates, is a short combination. The client expects the underlying security to trade within a narrow range or be neutral.

An investor who sells 1 GE Dec 50 call and sells 1 GE Dec 40 put has: a. Created a vertical spread b. Created a horizontal spread c. Sold a straddle d. Sold a combination

D. sold a combination Short straddles and short combinations are very similar positions. Both involve selling a call and a put on the same underlying stock. However, short combinations have a short call and short put with different expiration months and/or different strike prices. Short straddles have a call and a put with the same strike price and expiration month.

In which of the following situations does an investor have unlimited risk? a. Sold a call and is long the stock b. Sold a put and is long the stock c. Bought a call and is short the stock d. Sold a put and is short the stock

D. sold a put and is short the stock Selling a put and being short stock would be the only choice given where an investor would have unlimited risk. The short position would be the unlimited risk situation if the stock were to increase in value. If the market value of the stock is increasing, the purchaser of the put will not exercise the option. The short seller will lose money on the increase of the stock price. In choice (c), the short seller is protected against a rise in the stock by owning a call. In choice (a), the investor will have a loss if the price of his stock declined. However, the potential loss is limited since the stock's price can only decline to zero, creating a loss equal to the stock's cost minus the premium received for selling the call. In choice (b), the loss will again be limited to the stock's value declining to zero.

A client buys 100 shares of MTB at $58 per share and writes 2 MTB October 60 calls at 3. Which of the following statements is TRUE? a. The breakeven point is $56 b. The maximum profit is $600 c. The maximum loss is $5,200 d. The maximum loss is unlimited

D. the maximum loss is unlimited This position, which is referred to as ratio writing or a variable hedge, has an objective to increase the income from writing more calls than stock owned. However, this is an extremely risky position and the client's maximum loss is unlimited since two calls were written against a long stock position of only 100 shares. This client is covered on one short call, but uncovered on the second short call, which results in the maximum loss being unlimited. If the market price trades at or below $60 and the options expire, the client will have a $600 profit since two calls were written. The breakeven point is found by taking the purchase price of $58 and subtracting the total premiums of 6, which equals $52. The maximum profit is $800, which is found by taking the difference between the purchase price and the strike price and adding the premiums received from writing the call options (60 - 58 + 3 + 3). A popular answer choice is a maximum loss of $5,200 (choice c), since students simply subtract the total premiums received ($600) from the total cost of the stock ($5,800). It is important in these questions to examine the entire position and to remember that the maximum loss on an uncovered call is unlimited.

An investor purchases an EPG Jan 40 put at 5 and writes an EPG Jan 50 put at 13. The investor would profit in all of the following situations, EXCEPT: a. The spread narrows b. Both options expire c. The Jan 50 put is closed out at 10 and the Jan 40 put is closed out at 4 d. The spread widens

D. the spread widens This is an example of a credit spread (more premium received for the option sold than paid for the option purchased). In a credit spread, the investor will profit if the spread (difference in premium) narrows.

When purchasing a straddle, an investor's maximum profit is: a. The premium b. The strike price minus the premium c. Limited to the narrowing of the spread d. Unlimited

D. unlimited A long straddle consists of purchasing both a call and put with the same expiration and strike price. Since it involves purchasing a call, there is an unlimited profit potential.

The potential loss when writing uncovered straddles is: a. Limited to the premium b. Limited to the exercise price minus the premium c. Limited to the exercise price plus the premium d. Unlimited

D. unlimited A straddle involves the sale (writing) of a call and put with the same expiration and exercise price. Writing an uncovered call involves unlimited loss potential.

What is a client's maximum loss if he is short KNP stock and short a KNP put? a. The difference between the market price and the strike price plus the premium b. The market price plus the premium c. The market price minus the premium d. Unlimited

D. unlimited This is an example of a covered put (short stock + short put). The maximum loss is unlimited since there is no limit as to how high the stock price can rise. For example, if a client sells short at $46 and writes a $40 put for a premium of $3 and the put expires unexercised, the client will have a $3 profit. If the market price of KNP rises, the put option will expire unexercised but the client will still need to cover the short sale (short stock). The maximum loss on a short sale is unlimited, since there is no limit on how high the stock price may rise.

Which of the following positions/strategies is NOT bullish? a. A married put b. A short put c. A long 40 call and a short 50 call d. Writing a straddle

D. writing a straddle Straddle writers expect a neutral market and obtain the maximum gain if each option expires. Each of the other choices has an opportunity for a profit if the underlying security rises in value.

In May, a customer sells an STC July 40 listed call for a $6 premium and buys an STC July 30 listed call for $10. The customer has created a: I. Bullish spread II. Bearish spread III. Debit spread IV. Credit spread

I and III The investor bought the more expensive call. Therefore, this is a debit spread. A call debit spread is a bullish strategy.

Which TWO of the following option positions combined will create a debit spread? I. Buy an ABC June 30 call at 5 II. Buy an ABC June 30 put at 3 III. Sell an ABC June 35 call at 2 IV. Sell an ABC June 35 put at 4

I and III The only choice given that will create a debit spread is the purchase of an ABC June 30 call at 5 and the sale of an ABC June 35 call at 2. This spread is executed for a net debit of 3. This is a debit spread because the option being purchased has a larger premium than the option being sold.

On September 14, a customer purchases an ABC December 60 call and sells an ABC November 60 call. The customer: I. Has engaged in a debit spread II. Has engaged in a credit spread III. Wants the spread to widen IV. Wants the spread to narrow

I and III only To determine whether the customer wants the spread to widen or narrow, it is necessary to determine whether the spread is a debit or credit spread. The premium for an option is determined by two factors: the in-the-money amount of the option (intrinsic value) and the time value. Since both options have the same strike price, the intrinsic values (in-the-money amount) are equal. Therefore, any difference in premium is the result of a difference in time value. Since the December contract has longer to go until expiration than the November contract, it has more time value. Therefore, the premium for the December contract will be larger than for the November contract. Since the customer purchased the December contract (higher premium), it is a debit spread and will profit if the spread widens.

Which TWO of the following statements regarding straddles are TRUE? I. An investor who does not anticipate that the price of the stock will change may sell a straddle II. An investor who anticipates a substantial advance in the price of a stock will buy a straddle III. An investor who anticipates a substantial decline in the price of a stock will buy a straddle IV. An investor who anticipates substantial fluctuations in the price of a stock will buy a straddle

I and IV If investors wish to generate premium income, they will consider selling a straddle in order to generate income on both the put and the call. They will sell the straddle only if they do not anticipate significant price changes in the market price of the underlying security. The investor who anticipates significant changes in the price of a stock, but does not know if the price will advance or decline, will buy a straddle in order to be able to profit on both sides of the market. An investor who anticipates a substantial advance in the price of a stock will buy a call. An investor who anticipates a significant decline in the price of a stock will buy a put. Neither investor will buy a straddle if they anticipate that a price will move in only one direction, since the premium will be lost (assuming they are right) on the other side of the market. For example, an investor anticipates that XYZ stock will advance from $50 to $80. If a straddle is bought and the price did advance, there would be a profit on the call but there would be a loss of the entire put premium.

A customer has purchased 10 ABC January 50 calls, paying a $2 premium, and 10 ABC January 50 puts, paying a $2 premium. The market price of ABC stock is $50 per share. The buyer's breakeven points are: I.$46 II.$48 III.$52 IV.$54

I and IV The customer has the right to call the stock at $50. He has paid a $400 premium per straddle. The breakeven point on the call is determined by adding the 50 strike price to the premium of 4. This equals a breakeven of $54. The customer also has the right to put or sell the stock to the writer at $50, but has paid a $400 premium. The breakeven point on the put is four points below the strike price of $50, which equals $46. The buyer's breakeven points will, therefore, be $46 and $54.

A customer buys 10 ABC January 50 calls paying a $3 premium and 10 ABC January 50 puts also paying a $3 premium when the market price of the stock is $49 per share. The buyer's TWO breakeven points are: I.$44 II.$47 III.$53 IV.$56

I and IV The customer has the right to call the stock at $50. The customer paid a $600 premium per straddle. The breakeven point on the call is determined by adding the $50 strike price to the premium of $6. This equals a breakeven of $56. The customer also has the right to sell the stock to the writer at $50, but has paid a $600 premium. The breakeven point on the put would be six points below the strike price of $50, which equals $44. The buyer's breakeven points, therefore, will be $44 and $56.

Which TWO of the following statements are TRUE regarding the buyer and writer of a combination? I. The buyer of a combination expects the market to be volatile II. The writer of a combination expects the market to be volatile III. The buyer of a combination expects the market to remain stable IV. The writer of a combination expects the market to remain stable

I and IV The writer (seller) of a combination (a call and a put) believes the underlying security's price will remain stable. The buyer of a combination expects that the market price of the underlying security will be volatile.

Which TWO of the following statements are TRUE regarding the buyer and writer of a straddle? I. The buyer of a straddle expects the market to fluctuate II. The writer of a straddle expects the market to fluctuate III. The buyer of a straddle expects the market to remain stable IV. The writer of a straddle expects the market to remain stable

I and IV The writer (seller) of a straddle (call and put) believes the stock's price will remain stable. The buyer of a straddle expects that the market price of the underlying stock will be volatile.

Evelyn has established the following position. Long 1 DEF May 50 call at 2 Short 1 DEF May 40 call at 6 She expects to profit in which TWO of the following situations? I. Both options expire unexercised II. Both options are exercised III. DEF rises in value IV. DEF falls in value

I and IV This position is referred to as a credit call spread. Evelyn has received more for establishing the position because the short call has a strike price less than the long call. If both calls expire unexercised, Evelyn will keep the difference. If DEF falls below $40 per share, neither call will be exercised, resulting in a profit for Evelyn.

An investor takes the following position. Long 1 GHI Nov 65 put Short 1 GHI Nov 55 put Which TWO of the following statements are TRUE regarding this position? I. The investor paid money to create the position II. The investor received money to create the position III. The investor is bullish IV. The investor is bearish

I and IV This position is referred to as a debit put spread. It cost the investor more than was received since the long put has a strike price greater than the short put. As a result, the long put is exercised first (since it has a higher strike price), allowing the investor to make money if the stock declines in value (a bearish move).

A buyer of a call option is subject to which TWO of the following choices? I. Unlimited risk II. Protection for a short position III. A position that provides leverage IV. An obligation to buy stock

II and III Buying a call option provides leverage because the buyer controls 100 shares of stock for a relatively small cost (the premium). The risk is limited to the premium since that is the maximum potential loss. If an investor is short stock, he risks a loss if the market price of the stock increases. Buying a call provides protection against this situation since he could buy stock at a set price by exercising the call. A buyer of a call option has a right to buy stock, not an obligation.

An investor buys a DEF April 35 put at 3 and simultaneously writes a DEF April 30 put at 1. The investor has created a: I. Bullish put spread II. Bearish put spread III. Put debit spread IV. Put credit spread

II and III Since the investor is paying more for the option purchased than was received for the option sold, it is a debit spread. When analyzing a debit spread, look at the buy side of the spread. Buying a put indicates that the investor is bearish (believes the stock price will decline).

An investor owns stock that has increased in value. To protect his profit, he can: I. Enter a buy stop order II. Enter a sell stop order III. Buy put options on the stock IV. Buy call options on the stock

II and III only A sell stop order can be used to protect a profit or limit a loss on an existing long position. It is not activated until the market declines to or below the stop price. By purchasing put options, the investor will have the right to sell his stock at a set price (strike price) and will establish a specific sales price.

An individual who owns STC stock could provide protection against a decrease in market value by: I. Buying calls II. Buying puts III. Selling calls IV. Selling puts

II and III only In order to protect against a decline in market value, an investor could buy puts or sell calls. If the market price were to fall, the price of the puts purchased would rise and an investor could realize a profit by exercising the puts or selling the puts at the higher premium. The price of the calls would fall and the calls would most likely expire, enabling the seller to keep the premium received.