Unit 10 - Options
Two years ago, your client purchased 100 shares of ULA common stock at $40 per share. Today, the client buys one ULA Apr 60 put at $2, when the stock's price is $65. At expiration, the ULA stock is selling for $56, and the client exercises his put, delivering the long stock to cover the sale. The client has a gain of A) $1,800. B) $2,300. C) $200. D) $700.
The best answer is A. $1,800 Exercise of the put enables the client to sell the stock at the strike price of $60. The stock was originally purchased at $40, so the result is a $2,000 gain in the stock minus the $200 premium paid for the put, for a net gain of $1,800.
Which of the following statements regarding index options are true? I Exercise is settled in cash. II Exercise settlement value is based on the value of the index at the time exercise instructions are received. III Exercise settlement value is based on the closing index value on the day exercise instructions are tendered. IV Exercise settlement is T+2. A) I and III B) I and II C) II and III D) II and IV
The best answer is A. I and III I. Exercise is settled in cash III. Exercise settlement value is based on the closing index value of the day exercise instructions are tendered. All index option exercises are settled in cash. The amount a writer owes the holder is known as the intrinsic value of the option, and the settlement value is based on the closing index value on the day exercise instructions are tendered. Exercise settlement is the next business day.
Which of the following positions would create the most risk for an investor? A) Sell short 100 shares of SSS and sell 1 SSS put B) Sell short 100 shares of SSS and buy 1 SSS call C) Buy 100 shares of SSS and sell 1 SSS call D) Buy 100 shares of SSS and buy 1 SSS put
The best answer is A. Sell short 100 shares of SSS and sell 1 SSS put A short sale of SSS stock has unlimited loss potential. Selling a put obligates the customer to buy the stock at the strike price in return for premium. A short sale, coupled with a sale of a put, is equivalent to selling an uncovered call and creates the most risk.
A client approved to trade options has taken the opinion that a company's stock might be extremely volatile in the wake of upcoming earnings reports and new product reviews currently being mixed. The client does not own the stock but asks what might be a cost-efficient way to gain if that volatility occurs. You recommend A) purchasing straddles. B) both purchasing and shorting the stock simultaneously. C) either purchasing or shorting the stock. D) selling all spreads.
The best answer is A. purchasing straddles. A straddle is the purchase of a call and put; or the sale of a call and a put; with the same strike prices and expirations Long (purchasing) straddles are an appropriate strategy when volatility is expected, with potential gain occurring for moves in either direction. Costs are limited to the premiums paid.
All of the following are fixed option contract terms except A) the premium in a stock option. B) the multiplier in an index option. C) the expiration month in a debt option. D) the units of currency in a currency option
The best answer is A. the premium in a stock option The premium is not a predetermined characteristic of the option contract. The premium continually changes throughout the life of the option, reflecting changes in the price of the underlying security, dividends (if any), and interest rates.
A customer goes long an MMM Jan 40 put at 5 and writes an MMM Jan 50 put at 13. The customer will break even or profit when the market price is at all of the following except A) $45 B) $35 C) $48 D) $42
The best answer is B. $35 Step 1: Net premiums Long 1 MMM Jan 40 put @ $5 Write 1 MMM Jan 50 put @ $13 => $8 Credit Net Debit = Max Loss Net Credit = Max Gain = $8 or $800 Step 2: Net Strikes This step doesn't provide an answer but but will provide answers to the next steps Net Strikes = $50 - $40 Net Strikes = $10 Step 3: Net Strike - Net Premiums Since step 1 found Max Gain, step 3 finds Max Loss Max Loss = $10 - $8 = $2 or $200 Max Loss Step 4: Strike Price +/- Net Premiums = Breakeven Call Spreads = Low Strike + Net Premiums Put Spreads = High Strike - Net Premiums Put Spread Breakeven = $50 - $8 = $42 Thus, at $42 the investor breaks even. Above $42 the investor profits
If a customer buys 1 FLB Oct 50 call at 3 and she exercises the option to buy 100 shares when the market is at 60, what is the cost basis of the 100 shares? A) $5,000 B) $5,300 C) $6,300 D) $6,000
The best answer is B. $5,300 The cost basis of the 100 shares is the total amount the investor spent to acquire them. She paid $300 to purchase the call option. When she exercised the call, she purchased 100 shares of FLB at $50 per share for $5,000, so the cost basis is $5,300.
Which of the following options transactions settles T+2? A) Exercise of long index option B) Exercise of a long equity put option C) Opening purchase of a long equity put option D) Closing sale of a long equity put option
The best answer is B. Exercise of a long equity put option 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.
An investor is short stock at $60. The current market price of the stock is $35, and he anticipates it will continue to decline. If he thinks the price will rise temporarily, and if he does not wish to close out his short position, his best strategy to prevent a loss would be to I buy an XYZ 35 call. II sell an XYZ 35 call. III buy an XYZ 35 put. IV sell an XYZ 35 put. A) I or III B) I or IV C) II or IV D) II or III
The best answer is B. I or IV This client is temporarily bullish on the stock, but in the long term, feels that it will continue to decline, so the short stock position is to be maintained. If the client is correct, a near-term rise in the price of XYZ will cause the long 35 call to be in the money, and the investor can sell the call at a profit. Likewise, the short 35 put will be out of the money and will expire, with the investor earning the premium.
Which of the following describes the position in a call option on a Swiss franc with a strike price of 120, a premium of 7, and a current market of 126? A) At parity B) In the money C) Out of the money D) At the money
The best answer is B. In the money In this case, the strike price is less than the market price, so a call option would be in the money by the difference between the strike price and the market price (six points, in this case). At the money means the strike price and the market price are the same. At parity means the premium equals the intrinsic value.
Your customer notices that the exchange rate for the British pound in the spot market is listed at 148.47. What do you tell her when she asks you what this means? A) $1 equals 1.4847 pounds. B) One pound equals $1.4847. C) $1 equals 14.847 pounds. D) One pound equals 14.847 cents.
The best answer is B. One pound equals $1.4847 The exchange rate refers to cents per British pound; 148.47 equals $1.4847.
When determining position limits for listed options contracts and LEAPS contracts on the same side of the market, which of the following statements is true? A) The contracts are added to increase the position limits. B) The contracts must be aggregated. C) The contracts do not have position limits. D) The contracts are considered separately.
The best answer is B. The contracts must be aggregated LEAPS and listed options on the same side of the market, on the same underlying security, must be aggregated and remain within position limits.
An investor long 100 shares of stock writes a call against the long stock position. If the call is exercised, and the investor must deliver the stock, which of the following tax consequences will occur? A) Cost basis is adjusted for the stock. B) The investor's sales proceeds are the strike price plus the premium. C) Both cost basis and sales proceeds must be adjusted. D) There are no adjustments for cost basis or sales proceeds for tax purposes.
The best answer is B. The investor's sales proceeds are the strike price plus the premium When the call is exercised, the owner of the stock will be obligated to sell the shares owned at the strike price. The sales proceeds for the stock will be adjusted upward by the amount of the premium received when the call was sold
Which of the following strategies is considered most risky in a strong bull market? A) Buying calls B) Writing naked calls C) Buying a put spread D) Writing naked puts
The best answer is B. Writing naked calls Writing naked calls gives unlimited risk. If the market rises, naked puts expire. In the latter case, the writer profits from the premiums.
An investor holding a broad-based diversified portfolio of stocks feels that the market, which has slowed recently, may be poised for a brief fall before it continues an upward trend long term. The investor does not want to incur the cost of selling a portion of their holdings or assume the risk of mistiming the market. A possible strategy would be to A) buy an index call option. B) buy an index put option. C) sell an index call option. D) sell an index put option.
The best answer is B. buy an index put option By not liquidating, the client can benefit if the market increases. Because the portfolio is broad-based and diversified, it should move with the market. An index option also moves with the market, and therefore, would be a good hedge vehicle. A long put should be used because it will increase in value if the market should decline.
The put-call ratio can be used to A) determine a stocks beta. B) calculate how many options contracts are needed to hedge a stock position. C) gauge investor sentiment as being either bullish or bearish. D) determine which institutional trading desks are trading options.
The best answer is C. The put-call ratio reflects the current open interest in the trading of put options to call options for a single stock, the broad market, or any market sector. The ratio can be used as a gauge of investor sentiment (bullish or bearish). The higher the ratio is, the more bearish an indicator it is
As a registered representative, you often have customers who are interested in learning about derivative products such as options and different derivative strategies. Of the following customer profiles, which would writing calls be considered least suitable for? A) Roald and Katy Johnson, both young professionals with a combined annual income of $80,000. Both making small annual IRA contributions and participating in company-sponsored 401(k) plans. Katy will also be eligible for pension plan payments after retirement several years away. Current savings total $25,000, and their joint investment account objective is growth. B) Chanice, age 41, able to add to her savings each month after living expenses from her monthly income. Currently building retirement account balances in an IRA and company-sponsored 401(k) plan. Recently investing in an income-producing vacation property. Her savings outside of retirement accounts currently total $70,000. Growth is listed on her investment account as her objective. C) Bernard and Judy Jones, both retired, covering monthly expenses with their Social Security and annual mandatory IRA withdrawals. Savings outside of retirement accounts total $25,000. Income is the investment objective listed on the account. D) DeMarcus, a small business owner nearing the sale of his business to take an early retirement at age 52. A lump-sum annuity has been in place in anticipation of the early retirement, and the business sale proceeds will be more than adequate for his early anticipated living expenses. Current savings total $55,000, and his investment account objective is growth.
The best answer is C. The question doesn't say 'covered' calls. Thus, assume naked call writing While these profiles offer some guidance, and any of them could be considered incomplete to some extent, the one for whom writing calls would be considered the least suitable is the retired joint account of Bernard and Judy Jones. Factors to note would be the nominal total savings and that both are in retirement, needing Social Security and mandatory IRA withdrawals to meet current living expenses. Consider that while writing calls brings income into an account, it is a strategy that is high in risk with an unlimited maximum loss potential—not suitable for a retired couple in their position.
A client purchased 500 shares of JSSP common stock at $28 a share in July of 202X. The following June, the client wrote 2 October 35 calls at 5 each against the stock position. If the market price of JSSP was $39 at expiration, what was the client's realized gain? A) $1,700 B) $1,000 C) $2,400 D) $4,300
The best answer is C. $2,400 Investors have a gain or loss only upon the sale of an asset. In this case, the only shares involved are the 200 shares covering the two short call options. The investor paid $5,600 ($28 times 200 shares). With the stock selling at 39 at expiration date of those two calls, they will be exercised because they are 4 points in-the-money. That means the investor will receive $7,000 ($35 times 200). The investor adds to that the $1,000 premium ($500 times 2) when the calls were written. The total credit to the account is $8,000. That is $2,400 more than the $5,600 the investor paid for those 200 shares. Debit = 500 shares x $28 = $5,600 Credit = 1,000 (premium) + 7,000 (200 shares x $35) = $8,000 Credit - Debit = $8,000 - $5,600 = $2,400 credit
The intrinsic value of a 60 call at 4 when the current market value of the stock price is 62 is A) $600. B) $400. C) $200. D) $0.00.
The best answer is C. $200 The intrinsic value for a call is the current market value minus the strike price. It is the amount the contract is in-the-money. In this case it is 62 - 60 = $2 per share. With 100 shares in the contract, the intrinsic value is $200. The premium is $400 and has no impact on the intrinsic value, but it does tell us that the time value is 2 points. The extent to which the premium exceeds the intrinsic value is the time value and that reduces as the option gets closer to expiration (runs out of time).
If a customer buys 1 OEX Feb 350 call at 5, then sells 1 OEX Feb 335 call at 16 when the underlying index is at 344, the breakeven point is A) $340. B) $342. C) $346. D) $339.
The best answer is C. $346 Buys 1 OEX Feb 350 call @ $5 Sells 1 OEX Feb 335 call @ $16 => $11 Credit => Bear Call Spread To find the breakeven price for a Bear Call Spread, add the lower strike price and the net credit Bear Call BE = Strike A + Net Credit Bear Call BE = $335 + $11 Bear Call BE = $346
What is the breakeven point on the following position? Buy 1 QRS Jan 40 call at 2.35 Write 1 QRS Jan 45 call at 0.85 A) $43.25 B) $41.75 C) $41.50 D) $43.50
The best answer is C. $41.50 Because this is a call spread, the breakeven point is calculated by adding the net premium of 1.50 to the lower strike price (40 + 1.50 = 41.50).
Which of the following positions will be profitable if the market price of the underlying asset is equal to the exercise price at expiration date? A) A long call B) Short stock C) A short put D) A long put
The best answer is C. A short put At expiration, if the strike price and the underlying asset price are the same, the option has no value and will expire unexercised. Option writers (short positions) benefit when this happens because they earn the entire premium. Those with long option positions need price movement to profit. While a short option position profits without movement, a short stock position only profits when the market price goes down
If a customer believes the market price of a stock will sharply rise or fall in the near future, which of the following is the best strategy? A) Write a call B) Write a straddle C) Buy a straddle D) Buy a call
The best answer is C. Buy a straddle If the stock goes either up or down sharply, the investor will profit from owning a straddle
In a bull call spread, an investor I buys the lower exercise price and sells the higher exercise price. II buys the higher exercise price and sells the lower exercise price. III anticipates the spread will narrow. IV anticipates the spread will widen. A) II and IV B) II and III C) I and IV D) I and III
The best answer is C. I and IV Bull call spread = Long call spread = Vertical spread For example, Buys 1 Jan 30 XYZ Call @ $4 Sells 1 Jan 35 XYZ Call @ $2 => $2 Debit In a bull call spread (debit spread), a call with a lower strike price is purchased and a call with a higher strike price is sold. Because the long call has a lower strike price than the short call, it is more expensive, resulting in a net debit. In a bull call spread, the investor hopes the market prices rise. Maximum profit occurs if both calls are exercised, and because this is a debit spread, the spread is profitable if it widens.
An investor purchased an XYZ Oct 50 call for a premium of 4. On the expiration date, XYZ is selling for 62, and the investor closes the position at the option's intrinsic value. For tax purposes, the investor has realized A) a $1,200 short-term capital gain. B) $1,200 of ordinary income. C) an $800 short-term capital gain. D) $800 of ordinary income.
The best answer is C. an $800 short-term capital gain With the stock selling at 62, a 50 call has intrinsic value of 12 points (call-up rule). That would represent proceeds of $1,200 to the owner of the call. Subtracting the $400 cost results in a short-term capital gain of $800. How do we know it is short term? Unless the question specifies LEAPS, all options have a maximum term of nine months. Why isn't $800 of ordinary income correct? Aren't short-term gains taxed at ordinary income rates? Yes, they are, but the IRS (and the test) characterize these option trades as capital gains.
The price of DFEC common stock is $32 per share. Your customer owns one DFEC Sep 35 put purchased for a premium of 4. The option A) has no time value. B) is 1 point out-of-the-money. C) is 3 points in-the-money. D) is 3 points out-of-the-money.
The best answer is C. is 3 points in-the-money IV long put = Strike - Current stock price IV long put = $35 - $32 IV long put = $3 Thus, $3 in-the-money If an option has intrinsic value, it is in-the-money. Puts are in-the-money when the market price of the underlying asset is below the exercise price. The difference between the 35 strike and the 32 current market value represents 3 points of intrinsic value. Intrinsic value (the in-the-money amount) ignores the premium. However, the fact that the premium exceeds the intrinsic value by one point represents one point of time value.
If a customer buys 100 XYZ at $52.50 and buys 1 XYZ Aug 50 put at 1.50, what is the customer's maximum possible loss? A) $5,250 B) $5,400 C) Unlimited D) $400
The best answer is D. $400 Stockholders often buy puts to protect long positions. In this case, if the stock falls below 50, the investor will exercise the right to sell it at 50. The loss on the stock is limited to 2.50, which, combined with the premium paid of 1.50, results in a $400 loss
If a customer buys 100 XYZ at 49 and writes 1 XYZ Nov 50 call, receiving $350 in premiums, the breakeven point is A) $52.50. B) $53.50. C) $46.50. D) $45.50.
The best answer is D. $45.50 This is a covered call, so the investor is protected against declining stock prices to the extent of the premium received, and the breakeven is $45.50 $49 − $3.50).
When does a customer have to receive the options disclosure document? A) Within five business days of the first options trade B) With the confirmation of his first options transaction C) Within 15 days of account approval by the firm's registered options principal D) At or before the first order
The best answer is D. At or before the first order When opening an account to trade options, the owner must be told about the risks involved with trading options. By providing the owner with an options disclosure document entitled Understanding the Risks and Uses of Options, the broker-dealer satisfies the risk disclosure requirements. Furthermore, no member or person associated with a member shall accept an order from a customer to purchase or write an option contract, or approve the customer's account for the trading of options unless the broker-dealer furnishes or has furnished to the customer the ODD, and the customer's account has been approved for options trading. The 15-day rule applies to the customer's need to return the options account agreement.
If an investor buys a Jan 30 XYZ call for 4 and sells a Jan 35 call for 2, to become profitable, the spread between the prices of the two options must A) remain the same. B) narrow. C) fluctuate. D) widen.
The best answer is D. Widen Buys 1 Jan 30 XYZ Call @ $4 Sells 1 Jan 35 XYZ Call @ $2 => $2 Debit DEW = Debit/ Exercise / Widen CVN = Credit/ Valueless / Narrow This is a debit spread. A debit spread is profitable when the difference between the premiums widens. A debit spread is closed as a credit, and to be profitable, the credit must be larger than the opening debit.
