Hedging Strategies

A customer buys 100 shares of ABC at $50 and buys 1 ABC Jan 50 Put @ $5. This position results in a profit when the market: I rises II falls III is stable A. I only B. II only C. I and III D. II and III

A. If the market falls, the customer will exercise his put which he purchased for a premium of $5. He bought the stock at $50 and bought the right to sell the shares at $50. The loss would be the $5 per share ($500 total) premium paid. If the market remains stable, the put expires "at the money" and the customer loses the $500 premium. If the market rises, the long put expires "out the money." However, the stock can be sold at the higher market price creating a profit. The maximum potential gain comes from the stock position and is unlimited - the put would expire and the stock could be sold at the higher market price. The maximum potential loss is $500 - the premium paid in this case. Breakeven is at $55 - the customer has paid $5 in premiums and $50 per share for the stock, for a total outlay of $55 per share. The stock must be sold for this amount to breakeven.

A customer sells short 100 shares of PDQ at $61 and buys 1 PDQ Jul 60 Call @ $3. The customer's maximum potential loss is: A. $200 B. $300 C. $400 D. unlimited

A. The long call allows the customer to buy in the stock position at $60. Since the stock was sold at $61, exercise results in a net gain of $1 on the stock. Since the customer paid $3 for the call, there is a net loss of 2 points or $200.

A customer buys 100 shares of XYZ at $49 and buys 1 XYZ Jan 50 Put @ $5. The maximum potential loss is: A. $400 B. $500 C. $4,400 D. unlimited

A. The long put gives the stock owner the right to sell at $50. Since he bought the stock at $49, exercising results in a 1 point stock profit. However, the premiums paid of $5 are lost, for a net loss of 4 points or $400 maximum.

Which of the following option positions is used to hedge a short stock position? A. long call B. short call C. long put D. short put

A. When one has a short stock position, borrowed shares have been sold with the agreement that the customer will buy back the position at a later date. If the market rises, the loss potential is unlimited. The purchase of a call allows the stock to be bought in at a fixed price, limiting upside risk.

A customer sells short 100 shares of ABC stock at $52 and buys 1 ABC Mar 55 Call @ $5. The maximum potential gain is: A. $500 B. $4,700 C. $5,700 D. unlimited

B. If the stock falls, the customer gains on the short stock position. The customer sold the stock for $52. If it falls to "0," the customer can buy the shares for "nothing" to replace the borrowed shares sold and make 52 points. The customer lets the call expire "out the money" losing 5 points, so the maximum potential gain is 47 points = $4,700.

A customer sells short 100 ABC at $43 and buys 1 ABC Jan 45 Call @ $5. ABC goes to $33 and the customer lets the call expire and closes out the stock position at the market. The customer has a: A. $500 loss B. $500 gain C. $700 gain D. $1,000 gain

B. The customer has sold short shares of stock at $43 thinking that the market is going to go down. To protect his stock position from going up, the customer buys a call as well (which allows him to buy the stock at the strike price, if needed, in a rising market). Here, the market does what the customer wants it to do and goes down. As the market goes down, the call contract will expire "out the money." The stock that was sold for $43 can be purchased in the market for $33 and replaced, for a 10 point gain. However, since $5 was paid in premiums for the call, the net gain is $5 per share or $500.

A customer who is short stock will buy a call to: A. hedge the short stock position in a falling market B. protect the short stock position from a falling market C. protect the short stock position from a rising market D. generate additional income in a stable market

C. A customer who has shorted stock is bearish on the market. However, the potential loss for a short seller of stock is unlimited if the market should rise, forcing the customer to replace the borrowed shares at a much higher price. To limit this risk, the purchase of a call allows the stock position to be bought at a fixed price (by exercising the call), if needed, in a rising market.

A customer sells short 100 shares of ABC stock at $38 and buys 1 ABC Mar 40 Call @ $5. The stock rises to $80 and the customer exercises the call. The gain or loss is: A. $500 gain B. $500 loss C. $700 loss D. $4,200 loss

C. If the market rises, the customer can exercise the call and buy the stock at $40. These shares can be used to replace the "borrowed" shares sold short at $38 for a $2 per share loss. The customer also loses the $5 per share paid in premiums, for a total loss of 7 points or $700.

A customer buys 100 shares of ABC stock at $56 and buys 1 ABC Jul 55 Put @ $2.50 on the same day. The maximum potential loss is: A. 0 B. $250 C. $350 D. unlimited

C. If the market should fall, the customer will exercise the put and sell the stock at the strike price, limiting potential loss. The put contract gives the customer the right to sell the stock at $55. Since the stock was purchased at $56, 1 point will be lost on the stock. In addition, 2.50 points were paid in premiums for a maximum potential loss of 3.50 points or $350.

A customer buys 100 shares of ABC stock at $56 and buys 1 ABC Jul 55 Put @ $2.50 on the same day The breakeven point is: A. $52.50 B. $57.50 C. $58.50 D. $60.50

C. Since the customer paid $56 for the stock and paid a premium of $2.50 to buy the put, the total money outlay is $58.50. To breakeven, the stock must be sold for this price. To summarize, the formula for breakeven for a long stock / long put position is: Long Stock/Long Put Breakeven = Stock Cost + Premium 56+2.50=58.50

A customer buys 100 shares of XYZ stock at $72.25 and buys 1 XYZ Oct 70 Put @ $.50 on the same day in a cash account. The stock rises to $75.38. The put expires and the customer sells the stock in the market at the current price. The customer has a: A. $50 loss B. $175 loss C. $263 gain D. $313 gain

C. The customer buys the put for .50 and buys the stock at $72.25 for a total outlay of $72.75 per share. The put has been purchased as protection if the stock price should fall. In this case, the stock price rises to $75.38, so the customer lets the put expire "out the money" and sells the stock in the market at the current price. The net gain is $75.38 - $72.75 = $2.63 or $263 on 100 shares.

A customer has purchased 200 shares of MNO at $67 per share. When the stock goes to $71, the customer buys 2 MNO Aug 70 Puts @ $6. The puts are exercised when the market is at $64. The customer's gain or loss is: A. $300 loss B. $300 gain C. $600 loss D. $600 gain

C. This is a hedging strategy. The customer paid $67 per share plus she paid $6 in premiums per share for the put contracts, for a total outlay of $73 per share. If the puts are exercised, the stock is sold for $70 per share, resulting in a 3 point loss per share. Since there are 200 shares involved, the total loss is $600.

Buying a put on a stock position held long is a suitable strategy when the market is expected to: I rise sharply II fall sharply III be stable IV be volatile A. I and III B. I and IV C. II and III D. II and IV

D. Buying a put allows the holder to sell a security at a fixed price. Thus, it protects the owner of the underlying stock position in a falling market.

On the same day in a margin account, a customer sells short 100 shares of ABC at $43 and buys 1 ABC Jan 45 Call @ $4. The customer will break even at: A. $49 per share B. $47 per share C. $41 per share D. $39 per share

D. The customer has sold short the stock at $43, hoping to profit if the price should fall. As a hedge, the customer bought the call option to buy in the stock at a price of $45 if the market should rise. This protects the short stock position from unlimited upside loss potential. Since the customer sold the stock at $43 and paid $4 for the call option, the customer has a net sale amount of $39. To break even, the customer must buy back the stock at $39 per share. To summarize, the formula for breakeven for a short stock / long call position is: Short Stock/Long Call Breakeven = Short Sale Price - Premium

A customer buys 100 shares of ABC at $65 and buys 1 ABC Jan 65 Put @ $3. The position is profitable at all of the following market prices EXCEPT: A. $71 B. $70 C. $69 D. $68

D. The customer must recover the $3 paid in premiums and the $65 paid for the stock (total of $68). He must sell the stock in the market above $68 to have a profit - so Choices A, B, and C are profitable for the customer. At $68, the customer breaks even; below $68, the customer will have a loss that is limited to a maximum of $3 (since the put option gives the customer the right to sell at $65 per share). To summarize, the formula for breakeven for a long stock / long put position is: Long Stock/Long Put Breakeven = Stock Cost + Premium 65-3=68

A customer buys 100 shares of XYZ at $51 and buys 1 XYZ Jan 50 Put @ $5. The breakeven point is: A. $45 B. $46 C. $55 D. $56

D. The customer paid $5 for the put and $51 for the stock, for a total outlay of $56. To breakeven, she must be able to sell the stock at $56. To summarize, the formula for breakeven for a long stock / long put position is: Long Stock/Long Put breakeven = Stock Cost + Premium 51+5=56

A customer buys 100 shares of ABC stock at $56 and buys 1 ABC Oct 55 Put @ $3.50 on the same day. The maximum potential gain is: A. $5,150 B. $5,850 C. $5,950 D. unlimited

D. The put is purchased as a hedge. If the market falls below $55, the put will be exercised and the customer can sell the stock at $55. The customer gains, however, if the stock price rises. Then, he or she will let the put expire "out the money" and will sell the stock at the higher market price. Since the market can rise an infinite amount, the potential gain is unlimited.