Unit 4 Quizzes / Checkpoint exam
Which of the following is not traded on any exchange? A) ETFs B) Futures contracts C) Closed-end funds D) Forward contracts
D Forward contracts are nonstandardized and, as such, do not trade on any exchange. LO 4.d
An investor buys five put contracts with a strike price of $55 per share. The current price of the underlying stock is $60 and the option premium is $7. The commission schedule is as follows: Trade Amount Commission Rate ≤ $2,500$35 + 0.9% of trade amount $2,501-$11,999$35 + 0.7% of trade amount ≥ $12,000$35 + 0.5% of trade amount Using the information provided, what is the total commission cost for this trade?
$59.50 The cost per contract is $7 × 100 shares, or $700. That makes the total trade amount $700 × 5 contracts, or $3,500, which qualifies for the commission rate of $35 + 0.7% of the trade amount. The math is $35 + (0.7% of $3,500) = $35 + (0.7% × $3,500) = $35 + $24.50 = $59.50 total charge. LO 4.e
You have a client who has sold short 100 shares of RIF, a stock listed on the NYSE. If the client wishes to use options to protect against unlimited loss, you would suggest the client A) buy 1 RIF call. B) buy 1 RIF put. C) sell 1 RIF put. D) sell 1 RIF call.
A Buying a call option on a stock you are short will give you a guaranteed covering cost, thus preventing against unlimited loss. This is the best way to hedge a short position. LO 4.e
Which of the following statements is true? A) A futures contract has standardized terms. B) A futures contract does not involve obligations to buy or sell an asset. C) A futures contract always requires delivery of an asset. D) Unlike forwards, futures are not traded on an exchange
A Futures contracts are traded on exchanges and, therefore, have standardized terms. In forwards, the terms of each contract are separately negotiated. LO 4.d
A client is long 400 shares of ABC common stock. The current market price of ABC is $150 per share. The client is of the opinion that the market is going to be moving sideways for a while and would like to generate additional income from the ABC stock. What strategy might you recommend? A) Write four ABC 150 call options B) Write an ABC 150 call option C) Write four ABC 150 put options D) Buy two ABC 150 put options and write two ABC 150 call options
A Writing call options on a long stock position (a covered call) is a common strategy for generating additional income from a stock holding. If the market moves sideways (neither up nor down), the option will likely expire unexercised and the client will earn the premium and still have the stock. Being long 400 shares would mean writing four contracts. Writing put options would generate premium income, but if the stock price falls, the writer could be exercised requiring the purchase of an additional 400 shares at $150 per share (the client really doesn't want to own 800 shares). If the client buys two options and sells two options, the premiums will likely offset each other and not help the client reach the objective of generating additional income. LO 4.b
An investor purchases two PMJ Dec 16 calls at $0.85. If the commission charge is $8, the total cost is A) $188. B) $178. C) $93. D) $328.
B A premium of 85 cents per share means each contract has a cost of $85. There are two of them, making that $170. Adding the $8 commission brings the total to $178. LO 4.e
Which type of contract obligates both parties to act? I. Forward contract II. Futures contract III. Options contract IV. Warrant A) II and III B) I and II C) I and IV D) I, II, and III
B It is only in the case of forward and futures contracts that both parties are obligated to fulfill the terms of the contract. Only the seller of an options contract is obligated, and in the case of a warrant, it is the issuer of the warrant who is obligated to deliver the underlying shares if the owner exercises. LO 4.d
Buying a put option on a security one currently owns allows an investor to A) receive the premium for the purchase of the put. B) participate in additional gains if the security continues to increase in price. C) increase his profit if the security declines in price. D) buy more stock if he exercises the put.
B This is an example of a protective put, that is, purchasing a put option on a stock the investor already owns. This allows the stockholder to lock in a sale price (the strike price of the put). If the market price of the stock continues to rise, the investor would not exercise the put. The put would expire, and the long stock would remain in the account at the higher market price. The investor could hold the stock or sell it at the higher market price. In either case, the investor would continue to participate in the additional gains. The protection (the hedge) occurs if the price of the stock falls. Then the investor would be able to exercise the right to sell the stock at the strike price. That would offset the loss on the long position, not generate additional profit. Remember that options buyers pay the premium; they do not receive it. Exercising a put gives the holder the right to sell the stock, not buy it. Perhaps reviewing an example will help. The investor owns 100 shares of ABC stock currently trading at $50 per share. Since he wants to protect against a drop in price, the investor purchases an ABC put option with a strike price of 50 and pays a premium of 3. If the stock's price rises to $60 per share by the expiration date, the put option will expire worthless. (Who wants to put [sell] stock at $50 when it is selling for $60?) In this case, the investor has paid a premium of 3 points to ensure that the stock can always be sold (during the life of the option) for a price of $50 while still having the opportunity to participate in future price increases of the stock. In our example, the investor has gained $7 per share (the difference between the increase from $50 to $60 less the premium paid for the option). LO 4.b
An investor is long stock in a cash account and does not expect the price to change in the immediate future. His best strategy to generate income may be to A) buy a put. B) sell a call. C) buy a call. D) sell a put.
B Selling a call against a security will generate additional income (the premium). An investor who writes a put receives additional income from the position but must also be willing to increase his position should the put be exercised. An investor who buys a call is speculating that the stock will soon rise dramatically. An investor who buys a put is speculating the stock will soon fall, not staying steady in price. LO 4.b
Options positions can create either rights or obligations. In which option position has the investor created the possible obligation to purchase stock? A) Selling a call B) Selling a put C) Purchasing a put D) Purchasing a call
B When you sell (write, go short) an option, you create an obligation. In the case of a put, you are obligated to purchase stock that is put to you. In the case of a call, you are obligated to sell stock that is called away from you. Options buyers have rights. They can choose what they wish to do; there are no obligations. LO 4.b
An investor who was sure that a stock's price was going to move substantially but wasn't sure in which direction would be able to benefit by A) purchasing the stock and a put on the stock. B) selling the stock short and purchasing a call on the stock. C) purchasing a straddle on that stock. D) writing a straddle on that stock.
C Purchasing a straddle on a stock means going long a put and a call at the same strike price with the same exercise date. If the stock goes up, the investor profits on the call; if the stock goes down, the investor profits on the put. When an investor writes a straddle, a put and a call are sold at the same exercise price and expiration date. Short straddles profit when the stock price remains stable (the opposite of what is presented in this question). Taking a long position in a stock with a long put offers protection to the downside but no profit. Likewise, shorting a stock and taking a long position in a call offers protection to the upside but no profit. LO 4.e
Exercise of which of the following would not result in a change on the issuer's balance sheet? A) Rights B) Warrants C) A call option D) Convertible preferred stock
C When a call option is exercised, the strike price is paid to the seller of the option, not the issuer. The issuer is not involved in any way, so there is no effect on the company's financial statements. When the holder of a convertible preferred stock exercises the conversion privilege, the equity portion of the balance sheet shows a reduction in the preferred stock outstanding and an increase to the common stock outstanding. When rights or options are exercised, assets increase due to the cash paid for the stock and the equity portion of the balance sheet reflects an increase to the number of shares of common stock outstanding. LO 4.c
You have a client who is bullish on XYZ stock and currently owns 100 shares that last traded at $50. He has a CD coming due in March, six months from now, and is afraid that by the time those funds are available, XYZ will have shot up in price. How can he ensure that he'll be able to pick up the stock at today's price six months from now and not miss out on that market appreciation? A) Sell an XYZ March 50 put option. B) Buy an XYZ March 50 put option. C) Buy XYZ stock rights. D) Buy an XYZ March 50 call option.
D A call option gives the holder the right, but not the obligation, to purchase shares of the underlying stock at the exercise price until the expiration date. Owning a March 50 call means that any time between now and the expiration date in March, the investor could exercise the option and purchase 100 shares per contract at $50 per share. If the stock doesn't rise in price, the investor can allow the option to expire. Buying a put option would be a good choice if the question asked, "How can the client protect against a market decline?" Selling a put obligates the client to buy the stock at $50, but that would only be exercised if the stock's price fell; this is not something this client would want to do. Stock rights would never run as long as six months. LO 4.b
Which of the following statements is most accurate when describing equity straddle options? I. The option buyer is looking for market volatility. II. The option buyer is looking for market stability. III. The option seller is looking for market volatility. IV. The option seller is looking for market stability. A) II and III B) II and IV C) I and III D) I and IV
D A straddle is the combination of a put and a call on the same stock with the same strike prices and expiration dates. The solution to the question is the same for any option position in that option buyers need price movement and option sellers make money from stability. In the case of a straddle, a buyer is expecting sharp movement but does not know the direction of the move. The seller of the straddle will benefit if there is no significant price movement. LO 4.b
One of the differences between call options, rights, and warrants is that A) warrants generally have a strike price below the current market value of the underlying stock. B) rights generally have the longest "life" of these three. C) holders of call options stand to profit if the market price of the underlying stock increases. D) a corporation can't issue call options on its own stock.
D Although a corporation can issue stock rights and warrants, they cannot issue call options. Listed call options (the only type that will be on the exam), are issued by the Options Clearing Corporation (OCC). Although there are call options with weekly expiration, most expire in 9 months and rights rarely have a life longer than 45 days. Warrants, which generally have the longest time until expiration, are always issued with a strike price above the current market value of the underlying stock. At issuance, they only have time value. It is true that holders of call options stand to profit if the market price of the underlying stock increases, but so do the other two—they do not differ in that respect. LO 4.c
Many investors with a long position in common stock employ the technique of writing call options on the underlying stock for the purpose of A) protecting the premium. B) participating in the growth of the company. C) increasing the dividend return. D) generating income.
D A covered call option is one where the writer (seller) owns the stock on which the call is sold. There are two reasons to write covered calls. The primary one is that the sale generates income in the form of the premium received from the buyer. A secondary reason is that, at least to the extent of the premium received, there is some downside protection for the long stock. This action has no impact on the amount of the dividends received. It is the uncovered (or naked) call option that has unlimited risk. LO 4.e
