Mastery Exam #2
What is the maximum maturity of an equity LEAP?
28 months
A customer owns 100 shares of ABC stock and owns 1 ABC Put option. The customer wishes to sell the stock by exercising the put, but wishes to retain a recently declared cash dividend. In order to receive the dividend, the customer must exercise the put: Aon the ex date Bon the record date Cbefore the ex date Dbefore the record date
The best answer is A. Because exercise settlement of listed stock options occurs 2 business days after trade date, in order to retain the cash dividend, the holder of the shares cannot sell them before the ex date (which is 1 business day prior to record date). If the put is exercised on the ex date or later, the trade will settle after the record date, and the customer will be on record to receive the cash dividend. On the other hand, if the long put were exercised before the ex date, the trade would settle on the record date or before, and the customer would be selling the stock, taking him- or herself off the record book on the record date or before, so that client would not receive the dividend.
Which of the following create a straddle? I Long 1 ABC Jan 50 Call Long 1 ABC Apr 50 Put II Short 1 ABC Jan 50 Call Short 1 ABC Jan 50 Put III Short 1 ABC Jan 50 Call Long 1 ABC Jan 50 Put IV Short 1 ABC Jan 50 Call Short 1 ABC Jan 60 Put A II only BI and III CII and IV DIII and IV
The best answer is A. A straddle is the purchase of a call and a put; or the sale of a call and a put; on the same underlying security with the same strike price and expiration.
A customer sells 1 ABC Jul 40 Put at $6 when the market price of ABC is $38. ABC stock rises to $60 and stays there through July. The customer: Agains $600 Bloses $600 Cgains $1,400 Dloses $1,400
The best answer is A. If the market rises to $60, the put expires "out the money" (since the strike price is $40). The writer keeps the $600 collected in premiums.
On the same day a customer buys 100 shares of ABC stock at $30 and sells 1 ABC Jan 30 Call @ $3 and sells 1 ABC Jan 30 Put @ $2. This strategy is known as a: Acovered straddle Bcovered call writer Cratio write Dbutterfly spread
The best answer is A. The customer has created a long stock/short straddle position. This is termed a "covered straddle," however this name is not really accurate. The short call is covered by the long stock position, however the short put is naked.
Which of the following option positions is used to generate additional income against a long stock position? Along call Bshort call Clong put Dshort put
The best answer is B. A covered call writer owns the underlying stock position. The customer sells the call contract to generate extra income from the stock during periods when the market is expected to be stable. If the customer expects the market to rise, he or she would not write the call against the stock position because the stock will be "called away" in a rising market. If the customer expects the market to fall, he or she would sell the stock or buy a put as a hedge. The customer would not sell a put to generate extra income against the long stock position, because if the market falls, the customer would be exercised on short put, and thus would have to buy another 100 shares at the strike price. Thus, in a declining market, the customer would lose double.
Which of the following positions are profitable in bull markets? I Debit Call Spread II Credit Call Spread III Debit Put Spread IV Credit Put Spread AI and III BI and IV CII and III DII and IV
The best answer is B. Long Calls are profitable in rising markets, as are Long (Debit) Call Spreads. In a Long Call Spread, the lower strike price call is purchased and the higher strike price call is sold. This is a debit spread because the lower strike price call being purchased is more expensive than the higher strike price call being sold. If the market rises, the long call is exercised and the stock is purchased at the lower price. If the market keeps on rising, the short call is exercised and the stock is sold at the higher price, for a profit. Short Calls are profitable in falling markets, as are Short (Credit) Call Spreads. In a Short Call Spread, the lower strike price call is sold and the higher strike price call is purchased. This is a credit spread because the lower strike price call being sold is more expensive than the higher strike price call being purchased. If the market falls, both positions expire and the credit is kept. Long Puts are profitable in falling markets, as are Long (Debit) Put Spreads. In a Long Put Spread, the higher strike price put is purchased and the lower strike price put is sold. This is a debit spread because the higher strike price put being purchased is more expensive than the lower strike price put being sold. If the market falls, the long put is exercised and the stock is sold at the higher price. If the market keeps on falling, the short put is exercised and the stock is bought at the lower price, for a profit. Short Puts are profitable in rising markets, as are Short (Credit) Put Spreads. In a Short Put Spread, the higher strike price put is sold and the lower strike price put is purchased. This is a credit spread because the higher strike price put being sold is more expensive than the lower strike price put being purchased. If the market rises, both positions expire and the credit is kept.
A customer buys 1 ABC Feb 45 Call @ $3 when the market price of ABC is 44. The stock moves to $54 and the customer exercises. The gain or loss to the customer is: A$300 gain B$600 gain C$900 gain D$5,400 gain
The best answer is B. The holder has bought the right to buy the stock at $45 per share. She bought this right at a premium of $3 per share. By exercising, the customer buys the stock at the strike price of $45 and then sells the stock at the prevailing market price of $54. $54 - $45 = $9 gain on the stock position, offset by the $3 premium, gives a profit of $6 per share, or $600 for the contract covering 100 shares.
A customer buys 2 ABC Jan 60 Puts @ $4 when the market price of ABC is $59. The maximum potential loss for the customer is: A$400 B$800 C$11,200 D$12,000
The best answer is B. The holder of a put buys the right to sell at a fixed price. If the contract expires "out the money," the maximum loss is the premium paid. $400 was paid per contract ($800 for 2 contracts), so $800 is the maximum potential loss. This occurs if the market price rises above the strike price.
Which statements are TRUE about option contracts? I Long puts go "out the money" when the market price rises above the strike price II Long puts go "out the money" when the market price falls below the strike price III Short puts go "out the money" when the market price rises above the strike price IV Short puts go "out the money" when the market price falls below the strike price A.I and III B.I and IV C.II and III D.II and IV
The best answer is A. An "out the money" contract is one, that if exercised, would result in an unprofitable stock trade to the holder. These contracts are left to expire unexercised. Puts go "out the money" when the market price rises above the strike price - it makes no difference if the contract is "long" or "short." Being "out the money" is bad for the contract holder and good for the contract writer. The put holder would not exercise and sell the stock at a strike price that is lower than the current market. Calls go "out the money" when the market price falls below the strike price. The call holder will not exercise and buy stock at the strike price that is higher than the current market price.
If the market price is below the strike price on a put contract, the difference is termed the: A In the money amount B at the money amount C out the money amount D time value amount
The best answer is A. An option contract is "in the money" if exercise would be profitable to the holder, ignoring any premiums paid. This occurs if the market price is below the strike price on a put contract. For example, 1 ABC Jan 50 Put, when the market price is $45, is in the money by 5 points. The holder would be able to exercise this contract and sell the stock at $50 per share when the market price is $45 per share.
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 AI only BII only CI and III DII and III
The best answer is 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.
On the same day in a margin account, a customer buys 5 ABC January 40 Calls @ $6 and sells 10 ABC January 50 Calls @ $1 when the market price of ABC is at $43. If the market moves to $48 and the contracts are closed at intrinsic value, the gain or loss is: A$2,000 gain B$2,000 loss C$2,500 gain D$2,500 loss
The best answer is A. If the market moves to $48, and the contracts are closed at intrinsic value, the short 50 calls expire since they are "out the money." On the long 40 calls, the customer will have a gain of 8 points per contract. Thus, the customer will gain $800 per long call x 5 contracts = $4,000. Since the customer paid a true net debit of $400 per contract (5 points per spread - 1 point received on each of the naked calls) x 5 contracts = $2,000 paid, the net profit is $2,000.
On the same day, a customer: Sells 1 ABC Jan 65 Call@ $6Sells 1 ABC Jan 65 Put@ $6 At that time, the market price of ABC is $65. If the market rises to $78 and the call is exercised (the put expires out the money), the gain or loss is: A$100 loss B$100 gain C$1,200 gain D$1,300 gain
The best answer is A. If the market rises to $78, the put expires "out the money" and the call will be exercised. The writer is obligated to deliver the stock at $65 on the short call. Since the price in the market is $78, the customer loses 13 points. After deducting the 12 points of premiums collected, the net loss is 1 point or $100.
A customer holds 10 ABC Jan 100 Call contracts. ABC Corporation is paying a $1 per share cash dividend. On the ex date, the customer will hold: A10 ABC Jan 100 Calls covering 100 shares each B10 ABC Jan 99 Calls covering 100 shares each C10 ABC Jan 101 Calls covering 100 shares each D10 ABC Jan 101 Calls covering 99 shares each
The best answer is A. Listed option contracts are not adjusted for cash dividends. They are adjusted for whole share splits and stock dividends.
A customer buys 1 ABC Jan 55 Call @ $4 and 1 ABC Jan 65 Put @ $7 when the market price of ABC is at 58. ABC goes to 62 and the customer closes the positions at intrinsic value. The customer has a: A$100 loss B$100 gain C$1,100 loss D$1,100 gain
The best answer is A. The customer has bought a combination. Buy 1 ABC Jan 55 Call@ $ 4 Buy 1 ABC Jan 65 Put@ $ 7 $11 Debit If the market moves up to $62, the 65 Put is 3 points "in the money" while the 55 Call is 7 points "in the money." Closing the contracts at these premiums results in: Sell 1 ABC Jan 55 Call@ $ 7 Sell 1 ABC Jan 65 Put@ $ 3 $10 Credit The net loss is: $10 Credit - $11 Debit = $1 or $100 on the positions.
On the same day in a margin account, a customer sells 1 ABC Feb 40 Put @ $7 and buys 1 ABC Feb 30 Put @ $4. Later, the positions were closed - the ABC Feb 40 Put was closed at $4 and the ABC Feb 30 Put was closed at $2. The customer has a: A$100 profit B$100 loss C$500 profit D$500 loss
The best answer is A. The opening position is: Sell 1 ABC Feb 40 Put@ $7 Buy 1 ABC Feb 30 Put@ $4 $3 Credit The closing position is: Buy 1 ABC Feb 40 Put@ $4 Sell 1 ABC Feb 30 Put@ $2 $2 Debit The net gain is $100 since the spread between the premiums narrowed from 3 to 2. Remember, credit spreads are profitable if the spread between the premiums narrows.
A customer buys 1 ABC Jul 40 Put at $6 when the market price of ABC is $38. The breakeven point is: A$32 B$34 C$44 D$46
The best answer is B. The holder of the put paid a $6 premium per share for the right to sell ABC stock at $40. The customer's net sale proceeds upon exercise equals $34 per share. To breakeven, the customer must buy the stock in the market at this price. To summarize, the formula for breakeven on a long put is:
An investor has sold short 500 shares of ABC at $60. The stock has since declined to 38. All of the following can be used to protect the gain EXCEPT: Aplace a buy stop order at $40 Bbuy 5 ABC 40 puts Cbuy 5 ABC 40 calls Dsell 5 ABC 40 puts
The best answer is B. The investor has a gain on the short stock position that will evaporate as the market rises. To protect the gain, the stock must be bought in if the market begins to rise. A buy stop order is executed in a rising market, and would be appropriate to close the short position if the market rises. The purchase of a call allows the stock to be bought in at the strike price if the market rises, protecting the gain. If a put is sold and the market rises, the put will expire worthless, and the writer will keep the premium received. This amount of premium received will reduce any loss on the short stock position if the market rises. The purchase of a put will not protect the gain, since it allows the stock to be sold at the strike price. If exercised, the long put will cause the customer to have sold the stock TWICE.
When the Euro is trading at $1.39, a customer takes the following positions: Buy 1 PHLX Jan Euro 140 Put Sell 1 PHLX Jan Euro 135 Put The position is profitable if: I the spread between the premiums widens II the spread between the premiums narrows III both contracts expire IV both contracts are exercised AI and III BI and IV CII and III DII and IV
The best answer is B. The long 140 Put is "in the money" when the market is at 139, while the short 135 put is "out the money." Therefore the premium on the long put must be higher than the premium on the short put so this is a debit spread (long premium higher than short premium). Debit spreads are always closed out with a net credit. To be profitable, the credit must be larger so the spread between the premiums must widen. With a debit spread, the net premium is paid for the potential gain of the difference in the strike prices. If both contracts are exercised, this gain is realized.
The maximum gain for the holder of a call is: A.the premium paid B.unlimited C.strike price minus premium paid D.strike price plus premium paid
The best answer is B. The maximum gain for the holder of a call is unlimited, since the holder can exercise and buy the stock at a fixed price - no matter how high the market price of the stock rises. If the market price falls below the strike price, then the call expires "out the money" and the maximum loss is the premium. To breakeven, the premium paid must be recovered in a rising market. This occurs if the market price rises to the strike price plus the premium paid.
The maximum loss for the writer of a call is: A the premium received B unlimited C strike price minus premium received D strike price plus premium received
The best answer is B. The maximum gain for the writer of a call occurs if the market price drops and the call expires "out the money." In this case, the call writer keeps the collected premium. However, if the market price rises, the call will be exercised and the writer must deliver the stock at a fixed price. Since the stock must be purchased at a higher market price for delivery, the loss potential for the call writer is unlimited. To breakeven, the premium received must be lost in a rising market. This occurs if the market price rises to the strike price plus the premium paid.
When comparing a short put to a short put spread: A both have unlimited loss potential in a rising market B both have ever increasing loss potential in a falling market C the short put spread has a lower gain potential in a rising market D the short put spread has a higher gain potential in a rising market
The best answer is C. A sale of a "put spread" is similar to simply selling a put. In a rising market, the puts expire "out the money" and the profit is the premium received. The difference is that a short put gives ever increasing downside loss potential - all the way to "0" - in return for the premium received. A short put spread gives limited downside loss potential in return for a lower premium received.
A customer who is long 1 ABC Jan 60 Put wishes to create a "long put spread." The second option position that the customer must take is: Along 1 ABC Jan 50 Call Blong 1 ABC Jan 70 Call Cshort 1 ABC Jan 50 Put Dshort 1 ABC Jan 70 Put
The best answer is C. A spread consists of the purchase and sale of the same type of option, with different strike prices or expirations - therefore Choices A and B are incorrect. In a bear put spread (long put spreads are bearish strategies), the customer purchases the higher strike price - the long 60 put - (higher premium since the contract gives the right to sell at the higher strike price) and sells the one with the lower strike price - the short 50 put (lower premium since the contract gives the right to sell at the lower price). The customer wants the market to fall, so that he can exercise the long put with the higher strike price for a profit. However, if the market falls too much, the short put is exercised at the lower strike price, and the customer must buy the stock, locking in the gain of 10 points (sell at $60; buy at $50). Conversely, if the market rises above $60, both puts expire and the customer loses the net premium paid.
A customer buys 1 OEX Jan 550 Put @ $10 when the index is at 548.25. The maximum potential gain for the customer is: A$1,000 B$53,825 C$54,000 D$55,000
The best answer is C. If the index drops to "0," the writer must pay the holder 550 x 100 = $55,000. Since the holder paid 10 points ($1,000) in premiums, the maximum potential gain is $54,000.
A customer sells short 100 ABC at $45 and buys 1 ABC Jan 45 Call @ $3. ABC goes to $30 and the customer lets the call expire and closes out the stock position at the market. The customer has a: A$300 loss B$1,200 loss C$1,200 gain D$1,600 gain
The best answer is C. The customer has sold short shares of stock at $45 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 $45 can be purchased in the market for $30 and replaced, for a 15 point gain. However, since $3 was paid in premiums for the call, the net gain is $12 per share or $1,200.
A customer buys 2 ABC Jan 15 Puts @ 2 when the market price of ABC is $14. The maximum potential gain is: A$200 B$1,300 C$2,600 D$3,000
The best answer is C. The maximum gain for the holder of a put occurs if the market goes to "0." If it does, the customer can sell the stock at $15 and purchase it for nothing. Since the customer paid $200 in premiums for this right, the maximum potential gain is: $1,500 - $200 = $1,300. Since there are 2 contracts, the maximum gain becomes $2,600.
A customer sells 2 ABC Jan 40 Puts @ $9 when the market price of ABC is $36. If ABC stock rises to $41 and the customer closes the positions at $4, the gain or loss is: A$500 gain B$500 loss C$1,000 gain D$1,000 loss
The best answer is C. The puts were sold in an opening sale at $9 and bought in a closing purchase at $4 for a gain of 5 points ($500 per contract). Since 2 contracts are involved, the net gain is $1,000.
Which of the following create a collar on ABC stock, priced at $60? ABuy 1 ABC 65 Call; Buy 1 ABC 55 Put BSell 1 ABC 55 Call; Sell 1 ABC 65 Put CSell 1 ABC 65 Call; Buy 1 ABC 55 Put DBuy 1 ABC 55 Call; Sell 1 ABC 65 Put
The best answer is C. A "collar" is the purchase of a put at a strike price below that of the underlying instrument (putting a floor on the instrument's price); and the sale of a call at a strike price above that of the underlying instrument (creating a ceiling price, above which the instrument will be called away). By putting a collar on the price, the customer is essentially guaranteeing a minimum and maximum price for the underlying instrument. The net cost of such a collar should be close to "0" since both contracts are "out the money" and the premium received from the sale of the call offsets the premium paid to buy the put.
In September, a customer sells 1 ABC Jan 60 Call @ $4 when the market price of ABC is $61. If the customer closes out the position prior to expiration by buying the call for $7, the gain or loss is? A$300 gain B$300 loss C$700 loss D$1,000 gain
The best answer is B. The customer sold the call (opening sale) at a $4 premium and then closed with a purchase of the contract at a $7 premium, for a net loss of $3 points or $300 on 100 shares covered by the contract.
An option contract that is exercisable only on the expiration date is a(n): Aspot contract BAmerican contract CEuropean contract Dcash contract
The best answer is C
A customer who is short 1 ABC Jan 85 Put wishes to create a "short straddle." The second option position that the customer must take is: ALong 1 ABC Jan 85 Call BShort 1 ABC Jan 90 Call CShort 1 ABC Jan 85 Call DShort 1 ABC Jan 85 Put
The best answer is C. A short straddle is the sale of a call and a put on the same stock, with the same strike price and expiration. Choice C fits this definition. Choice B defines a combination, which is essentially the same as a straddle, except either the strike prices or expirations are different.
A customer sells short 100 shares of PDQ at $58 and buys 1 PDQ Jul 60 Call @ $3. The customer's maximum potential loss is: A$200 B$300 C$500 Dunlimited
The best answer is C. The long call allows the customer to buy in the stock position at $60. Since the stock was sold at $58, exercise results in a net loss of $2 on the stock. The customer paid $3 for the call, so the total loss is $500.
On the Chicago Board Options Exchange, bid and ask quotes for options contracts are maintained by the: ASpecialist (DMM) BFloor Broker CMarket Maker DOrder Book Official (OBO)
The best answer is C. The Specialist (now renamed the DMM - Designated Market Maker) function on the NYSE floor is handled by 2 separate individuals on the CBOE. On the NYSE floor, the Specialist/DMM performs 2 functions. The DMM acts as market maker in a specific security, buying and selling for his own account. The DMM also keeps the "book" of limit and stop orders that are away from the market for other brokers, and executes these orders for a commission. The CBOE splits this "dual function" into two jobs. The market maker on the CBOE buys and sells for his own account but does not hold a book of public orders. The "book" of orders is handled by an exchange employee known as the order book official. Floor brokers on the CBOE are agents, executing orders for customers. They cannot be market makers.
The Standard and Poor's 100 Index has closed at 575.12, up 2 points from the prior day's close. The holder of 5 "deep in the money" OEX Call contracts would have an approximate gain of: A$50 B$200 C$500 D$1,000
The best answer is D. Index option contracts have a multiplier of 100. A change of 2 equals 100 x 2 = $200.00 per contract. Since this person holds 5 contracts, the change in value is 5 x $200 = $1,000.
If an analyst subscribes to the Put / Call ratio and sees that the ratio is much higher than average, which of the following statements are TRUE? I The market is considered to be "overbought" II The market is considered to be "oversold" III The market is ready to move lower IV The market is ready to move higher AI and III BI and IV CII and III DII and IV
The best answer is D. Some analysts gauge strength of market by the put / call ratio. There are usually twice as many calls as puts. If the market is "overbought" - then the ratio is low (more calls than puts) - if the market is "oversold" - then the ratio is high (more puts than calls). If "overbought," the market is ripe for a turnaround and ready to move lower - thus, a bearish sentiment. If "oversold," the market is ripe for a turnaround and ready to move higher - thus, a bullish sentiment.
A customer buys 100 shares of ABC stock at $50 and sells 1 ABC Jan 50 Call @ $4 and sells 1 ABC Jan 50 Put @ $3. The customer's maximum potential loss is: A$700 B$4,300 C$9,300 DUnlimited
The best answer is C. This customer has a long stock position with a short straddle. The customer believes that the market will remain flat for the life of the options; and the customer will retain the total premium of $700 if this occurs. If the market falls, the short put is exercised and the short call expires. The exercise of the short put obligates the customer to buy 100 shares of ABC stock at $50, in addition to the 100 shares already owned at $50. In a falling market, the customer will sustain a loss on the 200 shares of ABC - with the maximum loss occurring if the stock falls to "0." In this case, the customer loses $50 paid per share x 200 shares = $10,000 - $700 collected premiums = $9,300. On the other hand, if the market rises above $50, the short call is exercised and the short put expires. In this case, the customer must deliver the 100 shares owned for $50 received per share. Since the customer paid $50 per share, the only gain is the combined $700 premium received.
The purchase of index puts against a portfolio of listed securities is a: Acovered writing strategy Bnaked writing strategy Chorizontal spread strategy Dhedging strategy
The best answer is D. One would purchase an index put to hedge a portfolio of securities against a falling market. If the market falls, the loss on the portfolio is offset by a corresponding gain on the long put options. This is commonly known as "portfolio insurance."
A customer buys 100 shares of ABC stock at $48 and buys 1 ABC Jan 50 Put @ $7. The maximum potential gain is: A$700 B$4,300 C$5,500 Dunlimited
The best answer is D. The customer has paid $48 for the stock and $7 for the put, for a total outlay of $55. If the stock declines, the customer is hedged, since he or she has the right to sell for $50 with the long put; so only 5 points can be lost (bought at $55 total; sold at $50 upon exercise). However, if the stock rises, the customer lets the put expire "out the money" and he or she can ride the price of the stock up, with theoretically unlimited gain potential.
Euro Jan 144 Calls on the PHLX are quoted at 3. The contract size is 10,000 Euros. What is the total premium for 10 contracts? A $144 B$300 C$1,440 D$3,000
The best answer is D. World Currency options are standardized, using a multiplier of 100 applied to the premium. A premium of 3 x multiplier of 100 = $300 total premium per contract. Since 10 contracts are purchased, 300 x 10 contracts = $3,000 total premium. (Another way of doing this - but not necessarily recommended - is contract size = 10,000 units of currency x a premium of 3 cents ($.03) = $300 per contract x 10 contracts = $3,000.)
If the market price of the underlying security remains the same as the strike price of the option contract, which of the following will have a profit? I The buyer of an "at the money" straddle II The seller of an "at the money" straddle III The seller of an "at the money" call AI only BII only CIII only DII and III
The best answer is D. If the market price remains the same as the strike price, then there is no reason for the holder of an option contract to exercise. The contracts will expire and the holder will lose the premium, while the writer will gain the premium. Sellers of contracts and straddles (the sale of a call and a put on the same stock with the same strike price and expiration) will profit. Holders of contracts and straddles will lose the premiums paid.
Which of the following option positions is used to generate additional income against a short stock position? Along call Bshort call Clong put Dshort put
The best answer is D. 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 customer thinks that the market will remain flat, he can sell a covered put against his stock position to earn extra income during that time period. If the stock is sold short and a put is sold with the same strike price, then if the market stays the same, the put expires "at the money" and the premium collected is retained. If the stock falls, the short put is exercised, obligating the customer to buy the stock at the same price at which it was sold. In this case, only the premium is earned. If the put had not been sold, then the customer would have had an increasing gain on the short stock position as the market fell - so he does not make as much in a falling market. On the other hand, if the market rises, the short put expires "out the money" and the customer is exposed to unlimited upside risk on the short stock position that remains.
The purchase of a put has all of the same characteristics as selling stock short EXCEPT: A unlimited loss potential in a rising market B limited gain potential in a falling market C low liquidity risk if the position is to be liquidated D both are bear market strategies
The best answer is A. The purchase of a put has limited loss potential in a rising market - the maximum that can be lost is the premium paid. In a rising market, the loss potential on a short sale of stock is unlimited, since the stock must be purchased at the higher market price and replaced. The maximum gain for both a long put and a short sale of stock occurs if the market falls to "0." Both have increasing gain as the market falls, all the way to a maximum gain at "0." Because both are profitable in falling markets, they are bear market strategies. Thus, the maximum gain is limited for both, since the market can only fall as far as to "0.". Both options and stocks are actively traded on exchanges, so there is little liquidity risk for either.
