Part 2, Unit 10
If the Swiss franc is trading at 0.69, and a customer buys 1 Sep SF 70 put and writes 1 Sep SF 65 put, this position is A) a bear spread. B) a calendar spread. C) a diagonal spread. D) a bull spread.
A) a bear spread Explanation: The 70 put is dominant because it will have a higher premium than the 65 put. Buying puts is bearish; this is a debit put spread.
All of the following subject an investor to unlimited risk except A) short 100 ABC, buy 1 ABC call. B) short 100 ABC, write 1 ABC put. C) 1 ABC uncovered (short) call. D) short 100 shares ABC stock. ** look for the long option to protect a short stock
A) short 100 ABC, buy 1 ABC call. Investors use long calls to protect short stock positions. If the market value of the stock needed to cover the short position begins to rise, the investor can exercise the long call position to buy the stock. Short stock positions, short uncovered calls, and short stock combined with short puts all subject investors to unlimited risk.
An investor buys a yield-based Sep 70 call on a 30-year T-bond for a premium of 2.50. At expiration, if the yield on the most recently issued T-bond is 7.95%, what is the investor's gain or loss? A) $950 gain B)$700 gain C) $700 loss D) $950 loss
B) $700 gain Explanation: A Sep 70 call means that the holder is buying a 7% yield. The investor can close the option at its intrinsic value (7.95 − 7.00 = 0.95; 0.95 × 10 × $100 = $950 received upon close). Subtract the $250 premium paid for a total profit of $70
John purchased a DMF May 90 call and simultaneously sold a DMF Jun 80 call. Which of the following best describes John's position? A) A bull spread B) A bear spread C) A debit spread D) A long spread
B) A bear spread Explanation: This investor has established a net credit diagonal call spread. He bought the lower premium call (higher strike and earliest expiry) and sold the higher premium call (lower strike and longest expiry). He hopes the spread will narrow to zero (if the market falls below 80 and both calls expire worthless) so he can keep all of the premiums. He is a bear, and so is the spread.
If an investor buys 300 shares of FLB, and one month, later buys 1 FLB Jul 50 put, how does this affect the holding period on his stock? A) It erases the holding period on 300 shares. B) It erases the holding period on 100 shares. C) It has no impact on the holding period for any of the shares owned by the investor. D) It ends the holding period on the put.
B) It erases the holding period on 100 shares. Explanation: Because the stock has not been held more than 12 months, the put purchase erases the holding period for any shares the put subsequently allows the holder to sell. Because the holder owns one put, this erases the holding period on 100 shares owned. The other 200 shares are unaffected.
An option investor might do all of the following except A) make an opening sale. B) hedge a long stock position with a short put. C) make a closing purchase. D) hedge a short stock position with a long call.
B) hedge a long stock position with a short put. Explanation: Writing a put does not reduce the risk of a long stock position. The short put creates an obligation to purchase additional shares if the put is exercised (which will happen if the stock falls). A long call is an effective hedge against a short stock position
__________ is a basic option strategy used when one is bearish on a stock.
Buying a put
In early September, a customer buys 100 shares of QRS stock for $83 per share and simultaneously writes 1 QRS Mar 90 call for $4 per share. If the QRS Mar 90 call was exercised and the QRS stock delivered, what would be the customer's per-share profit? A) $4 B) $7 C) $11 D) $0
C) $11 Explanation: If the stock rises above $90, the writer will be exercised and make $700 on the stock (buy at $83, deliver at $90) and keep the $400 received in premiums. Alternatively, the breakeven point is $79 ($83 − $4), and the stock was sold (delivered) at $90 for an 11-point gain.
Which of the following would be the least considered factor in determining if a particular type of options trading is suitable for a customer? A) Understanding maximum gain or loss potential B) Understanding the strategy being employed C) Ability to meet margin calls D) Willingness to assume risk
C) Ability to meet margin calls Explanation: Remember that while most firms require that options trades be done in margin accounts, options purchases are not marginable. Therefore, of the choices listed, the ability to meet margin calls would be the least considered factor regarding suitability.
Which of the following would not be a concern for an investor writing a naked option? A) The loss potential B) The risk/reward ratio C) The premium the investor must pay for the contract D) The possibility of exercise
C) The premium the investor must pay for the contract Explanation: The writer of any option contract receives the premium; she does not pay it. A naked option writer would consider the risk/reward ratio, the loss potential, and the possibility that the contract would be exercised by the party who purchased it.
In April, a customer sold short 100 shares of QRS stock at $50 and simultaneously wrote 1 QRS Jan 50 put for a premium of $7. If the January put is exercised when the market value of QRS is 43 and the stock acquired is used to cover the short stock position, what is the customer's profit or loss per share? A) $14 loss B) $0 C) $7 loss D) $7 gain
D) $7 gain Explanation: Because the stock is purchased on exercise of the short put for $50 and is used to cover the $50 short sale, the investor incurs no gain or loss on the stock. The customer keeps the $700 collected in premiums for a profit of $7 per share.
An option investor might do all of the following except A) make an opening sale. B) hedge a short stock position with a long call. C) make a closing purchase. D) hedge a long stock position with a short put.
D) hedge a long stock position with a short put. Explanation: Writing a put does not reduce the risk of a long stock position. The short put creates an obligation to purchase additional shares if the put is exercised (which will happen if the stock falls). A long call is an effective hedge against a short stock position.
gains/ losses and taxes when calls are exercised
Gains or losses are not determined at the time that calls are exercised. Once exercised, there are no tax consequences until the underlying stock is sold. Then the owner of the call would calculate her profit or loss, taking into account the premium paid, what she paid for the stock (the strike price), and what she subsequently received on the sale of the security.
It is only the ___________options where it is possible to hold a long option position for more than 12 months. That is the only case where a long option can realize long-term treatment.
LEAPS
__________ will generate income and protect the downside to the extent of the premiums received.
Selling calls
Example of decay risk
The risk that time value may erode the premium of an equity option, even while the underlying issuer remains financially sound
What is decay risk?
Time decay is the loss of time value as an option nears its expiration date. At the expiration date, the time value is zero. The only value to the option is intrinsic value, if any.
definition of hedging
Using listed options to reduce the market risk in a stock position by taking an opposing position in the options that represent an equivalent number of shares
Individuals with diversified stock holdings in their portfolios write covered calls to
increase their rate of return on the stocks held in their portfolio
Can a call buyer hedge a long stock against falling prices?
no!
The self-regulatory organization (SRO) that issues, standardizes, and clears options is
the Options Clearing Corporation (OCC).
The put is in the money when__________________.
the underlying instrument's market price is below the put's strike price
What type of loss do short and long straddles have?
unlimited
What type of loss do short and long uncovered calls have?
unlimited
What type of loss do short stock or short stock/short put hedge have?
unlimited
Uncovered short calls carry _________
unlimited risk.
A couple in retirement wants to add income to their account. What is not a suitable investment strategy?
writing uncovered calls
An investor takes a long position in a put option with an exercise price of $45. The premium paid is 8 points and the market price of the underlying security is $38 per share. It is correct to state that the put A) is a covered put. B) is out of the money by one point. C) has no time value. D) is in the money by seven points.
D) is in the money by seven points. Explanation: A put option with intrinsic value is in the money. A long put has intrinsic value when the market price of the underlying asset is less than the exercise (strike) price. With a market price of $38 and a strike price of 45, this put is in the money by seven points. It may help to remember the "put down" rule. When figuring intrinsic value, the premium is irrelevant (we're not speaking about the investor). It is the option that is in (or out) of the money.
If a 50% stock dividend is declared, the owner of 1 XYZ Jul 30 call owns A) two contracts for 150 shares with an exercise price of 30. B) two contracts for 100 shares with an exercise price of 20. C) one contract for 100 shares with an exercise price of 20. D) one contract for 150 shares with an exercise price of 20.
D) one contract for 150 shares with an exercise price of 20. Explanation: When a company pays a stock dividend or effects a fractional stock split, the number of contracts remains the same, but each contract is adjusted by increasing the number of shares the contract covers (100 × 150% = 150 shares). The effective strike price is adjusted so that the position value remains the same before and after the adjustment—in this case, 20 ($3,000 / 150 shares = $20).
An investor opens a long position in one XYZ Nov 140 put @7. Disregarding any commissions, if the option is exercised, on settlement date the investor A) must pay $14,000. B) receives $700. C) must pay $700. D) receives $14,000.
D) receives $14,000. Explanation: When an investor takes a long position in an option, it means that the investor has purchased the option. When a put is exercised, the holder must deliver the stock on settlement date. At that time, proceeds representing the strike price ($140) for 100 shares ($14,000) are received
The ______________is the ___________ for the options market. It issues and standardizes option contracts, as well as acting at the clearinghouse for buyers and sellers. ______________is the largest securities SRO in the North America and regulates broker-dealers and the people who work with customers. _______________ option rules are largely based on those of the ____________. The ____________writes the rules in the municipal securities market, but other ____________enforce them. The ____________is the regulatory and enforcement wing of the federal government that has authority over all ___________and the organizations and people who work in the securities mar
OCC ; SRO FINRA; FINRA's; OCC MSRB; SROs SEC; SROs
What is Nasdaq PHLX?
The Nasdaq PHLX is a regional exchange operated by Nasdaq where equity securities and options contracts are traded both electronically and on the floor.
Any description of options must include _______________________. This rule applies to all communications with the public—written, electronic, or in person.
a description of the risks
The individual responsible for the overall supervision of all of a firm's options activities on behalf of its customers must be
a registered options principal (ROP).
For a regular standardized option, any gain on the sale of the contract is
a short-term gain Explanation Regular standardized options have a maximum expiration of 9 months, so a gain on these types of contracts can only be short term for tax purposes.
The best way to hedge an unrealized gain on a short stock position is to ___________.
buy a call
The best way to hedge an unrealized gain on a short stock position is to _______________-.
buy a call
To protect against a short put, you
buy calls
What type of loss do short and long spreads have?
defined (limited) loss potentials
When an investor takes a long position in an option, it means the investor has purchased the option. As a buyer, the investor must ____________________________________________.
pay the premium on the settlement date
Customers seeking to open an options account may have the account approved by______________________
the branch manager initially as long as it is subsequently approved by a principal who has a Series 10 registration or is a Registered Options Principal (ROP).
At expiration, unless the customer instructs not to, equity options that are in the money by _______ or more will be automatically exercised. This rule is applicable to both retail and institutional customers.
$0.01
An investor with no other positions buys 1 CDE May 65 put at 3.50. If the investor buys the stock at 63.50 and exercises the put, what is the investor's profit or loss?
$200 loss The investor has the right to sell the stock for 65 when it is currently worth 63.50 for a gain of 1.50. The investor paid a premium of 3.50 minus the gain of 1.50 for a loss of 2 (2 × 100 = $200).
If a customer sells short 100 XYZ at 79 and simultaneously writes 1 XYZ Jan 80 put at 5, the maximum gain potential is
$400 explanation 79 + 5 = 84. 84 - 80 = 4
One of your customers might buy a call option to...
- protect an existing short term stock - diversify an investor's holdings - deferring a stock buying decision
A taxable gain or loss on a long call option transaction would be recognized when
- the option expires. - the option is sold
A customer is short 100 XYZ shares at 26 and long 1 XYZ 30 call at 1. What is the maximum potential loss on the positions? A) $500 B) Unlimited C) $2,500 D) $400
A) $500 Explanation: The customer has protected his short stock position from loss by purchasing a call. If the market rises, the call is exercised, allowing the customer to buy his stock at the option strike price of 30 to cover the short position. The most the customer can lose is $400 on the stock position (the difference between the option strike price and the stock price) plus the premium paid for the option ($400 + $100 = $500).
Which of the following options transactions settles T+2? A) Exercise of a long equity put option B) Opening purchase of a long equity put option C) Closing sale of a long equity put option D) Exercise of long index option
A) Exercise of a long equity put option Explanation: When a long equity put option is exercised, from a settlement standpoint, it is the same as anyone selling stock. That is T+2 settlement date. The trading of options, not the exercise, is T+1. When it comes to index options, because they settle in cash, exercise settlement is T+1 rather than T+2 like equity options
Which of the following positions does not expose a customer to unlimited risk? A) Short 200 shares of XYZ and short 2 XYZ puts B) Short 2 XYZ uncovered puts C) Short 200 shares of XYZ D) Short 2 XYZ uncovered calls
A) Short 200 shares of XYZ and short 2 XYZ puts B) Short 2 XYZ uncovered puts Explanation: The maximum potential loss on a short put position is the market price declining to zero reduced by the premium. Remember, a stock's price can never go below "worthless." For example, if the investor sold 2 XYZ 90 puts and received a premium of 4 point each, the maximum loss would be $8,600 (worthless stock is put to the writer for $9,000 but the writer received the $400 premium) per contract or $17,200. That is a significant loss, but all of the other positions expose the client to unlimited risk because a loss will occur if the stock price rises and there is no upper limit to a stock's price.
An investor takes a short position in one XYZ Nov 140 call @7. Disregarding any commissions, if the option is exercised, on settlement date, the investor A) must pay $14,000. B) receives $14,000. C) receives $700. D) must pay $700.
B) Receives $14,000 Explanation: When an investor takes a short position in an option, it means the investor has sold, or written the option. When a call option is exercised, the seller is obligated to deliver the stock at the exercise (strike) price. A strike price of $140 for 100 shares results in the seller receiving $14,000 on settlement date.
If a writer of an XYZ equity call option is assigned, which of the following should be delivered to the Options Clearing Corporation? A) Cash equal to the market value of the underlying XYZ security B) The underlying XYZ security C) Any listed security of comparable value to XYZ D) Rights or warrants exercisable to purchase the underlying XYZ security
B) The underlying XYZ security Explanation: When a call is exercised, that specific security must be delivered by the assigned writer. The option contract does not allow for exercise settlement in cash, securities of equivalent value, or securities exercisable to purchase the underlying securities such as rights or warrants.
All of the following can be advantages of buying an option contract except A) to limit risk. B) time value dissipation. C) to position against a written option. D) leverage.
B) time value dissipation. Explanation: The purchase of an option allows an investor to speculate and fully participate in the price movement of the underlying security at a fraction of the cost of the shares involved, thus leveraging his investment. When used to position against a written option (a spread), the purchase of an option will reduce the risk of loss involved with a single written option. Used in conjunction with a securities position, the purchase of an option can act as an insurance policy to reduce the risk of loss (hedging); therefore, options offer all of these advantages but only for a limited time. As the contract gets nearer to expiration, its time value dissipates. Time decay may be the term used on the exam. This is not considered an advantage of owning options contracts.
Japan discovers oil in the Pacific while earthquakes in England cause havoc. A customer who reads this article would be most likely to take which of the following actions? A) Buy yen puts or buy pound puts B) Buy pound puts or buy yen puts C) Buy yen calls or buy pound puts D) Buy pound calls or buy yen calls
C) Buy yen calls or buy pound puts Explanation: Here, the yen will go up, and the pound will fall. Thus, a customer would be most likely to buy yen calls and pound puts.
A registered representative executes the following trades for an options account: Buy 1 FLB Apr 40 call at 9 Sell 1 FLB Apr 45 call at 4 Are these suitable trades? A) Yes, because the trades will result in a small profit. B) It depends on the customer's investment objectives. C) No, because the customer cannot make a profit on these trades. D) It is impossible to tell.
C) No, because the customer cannot make a profit on these trades. Explanation: These trades are not suitable because the customer will not make a profit. In any price spread, the net debit represents maximum loss; in this case, the net debit is five points, or $500. Maximum loss added to maximum gain will always equal the difference between the strike prices. In this example, the difference between the strike price is five points; therefore, the maximum gain is zero.
A customer wishes to buy 1 XYZ Jan 40 call and write 1 XYZ Jan 45 call. At the time the order is placed, the options are trading as follows: Jan. 40 calls - 4.30 bid, 4.35 ask Jan. 45 calls - 2.25 bid, 2.30 ask If the transaction is effected at the market, the spread will be established at A) a 1.85 debit. B) a 1.75 debit. C) a 2.10 debit. D) a 1.50 debit.
C) a 2.10 debit Explanation: The investor establishes a debit spread by purchasing the 40 call at the ask price of 4.35 and selling the 45 call at the bid price of 2.25. The difference is 2.10.
A new customer has been approved for all levels of options trading and has signed the options disclosure document. Even though approved for all levels of options trades, she notes that she will not be employing, and the registered representative (RR) should not recommend, any strategies with unlimited maximum loss potential. Given this criteria, an RR could suitably recommend A) short or long uncovered calls. B) short or long straddles. C) short or long spreads. D) short stock or short stock/short put hedge.
C) short or long spreads Explanation: Of the pairings offered, only short and long spreads both have defined loss potentials. Short stock, short calls, short straddles, and a short stock/short put hedge positions all have unlimited loss potentials.
If the Swiss franc closes at 56, 1 SF 59 put is A) at the money. B) three points out of the money. C) three points in the money. D) without intrinsic value.
C) three points in the money.
