Unit 10 (options) practice questions

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) $342. B) $339. C) $340. D) $346.

d. $346 -To determine a call spread, add the net premium to the lower strike price to find the breakeven point. The net premium is the difference between the premium paid (5) and the premium received (16), or 11 (335 + 11 = a breakeven point of 346).

The premium on the XYZ Jan 30 calls is 3 - 3.15, while the premium on the XYZ Jan 30 puts is quoted at 2.25 - 2.35. A customer establishing a short straddle receives total premiums of A) $545. B) $537. C) $550. D) $525.

d. $525. -To establish a short straddle, the customer sells a call and a put at the bid price. The premiums received are $300 for the call and $225 for the put, for a total of $525

In early September, a customer buys 100 shares of MCS stock for $83 per share and simultaneously writes 1 MCS Mar 90 call for $4 per share. The customer will break even when MCS stock is at A) $86. B) $87. C) $94. D) $79.

d. $79 -Breakeven is the cost of stock purchased minus premiums.

If a customer buys 1 ABC Jan 60 put at 6 and writes 1 ABC Jan 75 put at 13, the maximum loss is A) $700. B) $900. C) $1,500. D) $800.

d. $800. -This is a credit spread. (More premium was received than was paid.) The maximum gain to a seller is the premium received (net credit of 7). In a spread, the maximum gain plus the maximum loss equals the difference in strike prices (75 − 60 = 15). Therefore, 15 minus the maximum gain of 7 equals the maximum loss of 8 multiplied by $100, or $800.

If a client bought 100 shares of GM at $88.50, and on the same day, he went long a put at 90 for 4.25 on GM due to expire within the month, what is the breakeven point? A) $85.25 B) $90.25 C) $84.25 D) $92.75

d. $92.75 -The stock is the dominant position. The breakeven point is calculated by adding the cost of the option to the cost of the stock. The stock must rise to $92.75 to break even.

IBM sold computers to a Soho retailer and agreed to accept payment of 10 million British pounds in 65 days. In which of the following ways could the company protect the payment against adverse foreign currency fluctuations? A) Buy U.S. dollar puts B) Buy pound calls C) Buy U.S. dollar calls D) Buy pound puts

d. Buy pound puts -If the company wants to protect its investment, it has to protect against the payment going down in value relative to the cost. To protect against the value of the payment going down in relation to the cost, the company would buy puts on the payment currency. To offset the cost of the puts, the company will also sell calls. The calls will be covered by the ownership of the actual currency. Remember the acronym EPIC: Exporters buy Puts and Importers buy Calls.

If the holder of a call tenders an exercise notice after the ex-dividend date for a cash dividend, which of the following statements is true? A) He is entitled to the dividend only if he sells the underlying stock. B) He is entitled to the dividend. C) He must pay the dividend to the writer. D) He is not entitled to the dividend.

d. He is not entitled to the dividend. -If the holder of a call exercises before the ex-date, the trade settles on or before the record date, and he is on record for the dividend. If the holder exercises on or after the ex-date, the trade settles after the record date, and he is neither on record for the dividend nor entitled to it.

If your customer writes a combination of a DWQ JUL 45 call at 3 and a DWQ JUL 50 put at 3.50, the customer breaks even when the price of the underlying stock is I. $43.50. II. $50.50. III. $51.50. IV. $56.50. A) I and IV B) II and IV C) III and IV D) I and III

d. I and III -Combinations (and straddles) have two breakeven points. There is a breakeven for the call position and a breakeven for the put position. To calculate these two breakeven points, add the combined premiums to the call strike price and subtract the combined premiums from the put strike price. In our question, the combined premiums are 6.50 (3 + 3.50). With a call strike price of 45, the breakeven is $51.50 (45 + 6.50). With a put strike price of 50, the breakeven is $43.50 (50 minus 6.50).

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) $700. C) $2,300. D) $200.

a. $1800 -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.

What options trading program would be most appropriate for a retired customer with a portfolio of low-cost basis blue-chip stocks who is seeking income from his portfolio? A) A covered call writing program B) An uncovered call writing program C) An option purchasing program D) Selling straddles

a. A covered call writing program -The most conservative option strategy is writing covered calls. In addition to the income from the call premium, this client could also receive dividends on his stock if any were paid. Purchasing options brings no income to the account, and uncovered call writing and short straddles have unlimited risk.

Which of the following would be in compliance with the Chicago Board Options Exchange and Options Clearing Corporation rules concerning the nondiscriminatory assignment of an option exercise notice by a firm to one of its customers? A) Assignment to the customer with the oldest position in the option B) Assignment to the customer with the largest position in the underlying security C) Assignment to the customer with the largest position in the option D) Assignment to the customer with the smallest position in the option

a. Assignment to the customer with the oldest position in the option -You cannot discriminate between large and small customers. First-in, first-out is not considered to be discriminatory.

A customer sells short 1,000 ZOO at $30 per share. If the ZOO stock declines to $25 per share, and the customer is worried the stock may reverse its trend, what should the customer do? A) Buy 10 ZOO calls B) Write 10 ZOO calls C) Write 10 ZOO puts D) Buy 10 ZOO puts

a. Buy 10 ZOO calls -To protect the profit on the short stock position, the customer must be able to buy stock at the existing low price if the market moves up. By purchasing calls (say, at a $25 strike price), the customer can capture existing profit by exercising and buying stock at $25, regardless of how high the market moves.

A firm may assign option exercises using which of the following methods? I. First-in, first-out (FIFO) II. Last-in, first-out (LIFO) III. Random assignment IV. Based on holders of the smallest positions A) I and III B) II and III C) I and IV D) II and IV

a. I and III -A firm may assign an exercise either randomly or using the FIFO accounting method. LIFO is not permitted, nor is assigning by position size, smallest, or largest.

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) II and III C) II and IV D) I and II

a. I and III -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.

To create a credit calendar spread, an investor should I. buy the near expiration. II. buy the distant expiration. III. sell the near expiration. IV. sell the distant expiration. A) I and IV B) II and IV C) II and III D) I and III

a. I and IV -A credit calendar spread occurs when premium received exceeds the amount paid out. An investor creates a credit spread by selling the distant expiration and buying the near expiration. The distant expiration has more time value, and therefore, a higher premium.

Which of the following investors are bearish? I. Buyer of a call II. Writer of a call III. Buyer of a put IV. Writer of a put A) II and III B) I and II C) I and IV D) III and IV

a. II and III -Buyers of puts and writers of calls are bearish investors. Buyers of calls and writers of puts are bullish investors.

A foreign company that exports its products to the United States wishes to protect itself during a time in which the U.S. dollar is expected to be devalued. The company should I. buy U.S. dollars. II. sell U.S. dollars. III. buy foreign currency. IV. sell foreign currency. A) II and III B) III and IV C) I and III D) II and IV

a. II and III -If the company expects the U.S. dollar to become devalued, that means that the foreign currency will increase in value. It would make sense at this time, therefore, for the company to get rid of its U.S. dollars, which are expected to decline in value, and acquire the foreign currency, which will appreciate relative to the U.S. dollar.

If an investor is bearish on the overall market, with no particular opinion on any individual stock, he will most likely I. buy index calls. II. buy index puts. III. write index calls. IV. write index puts. A) II and III B) I and III C) I and IV D) II and IV

a. II and III -Index options are useful for investors who have few opinions about individual stocks and who look at the market overall. If they are bearish, they choose short calls or long puts. Investors who are bullish on the overall market buy calls or sell puts.

Which of the following entities guarantees a listed yield-based option? A) Options Clearing Corporation (OCC) B) Federal Reserve Board (FRB) C) U.S. government D) Broker-dealer

a. Options Clearing Corporation (OCC) -The OCC guarantees the performance of listed option contracts.

A customer wishes to close a short option position. The order ticket must be marked as A) a closing purchase. B) a closing sale. C) an opening purchase. D) an opening sale.

a. a closing purchase -The investor opened with a sale, so the position must close with a purchase.

An investor sells short 100 shares at 50 and sells a 50 put at 5. If the put is exercised when the stock is trading at 45, the investor realizes A) a gain of $500. B) neither a gain nor a loss. C) a gain of $1,000. D) a gain of $1,500.

a. a gain of $500 -When the short put is exercised, the investor buys stock at $50 that she can use to cover the $50 short sale. The investor realizes no gain or loss on the stock, but she collected $500 in premiums, for a gain of $500.

A customer creates a long straddle by buying 5 ABC Nov 50 calls and 5 ABC Nov 50 puts, paying a total premium of $3,750. If ABC is at 56.50 at expiration, the customer has A) a loss of $500. B) a gain of $500. C) a loss of $1,000. D) a gain of $1,000.

a. a loss of $500. -When an investor goes long a straddle, the expectation is that the stock's price will be volatile, but the direction (up or down) is uncertain. In this question, the stock's price increased putting the calls in the money. At expiration, the call positions would be closed by selling them for their intrinsic value ($56.50 market value minus the $50 strike = $6.50). With each contract representing 100 shares, the $6.50 equals $$650 and because there are five contracts, the total sale proceeds are $3,250. Compare that to the $3,750 initial cost and the result is a loss of $500. What about the put options? When the market price is higher than the strike price, the puts are worthless and expire unexercised.

An investor would sell a put A) because he is bullish. B) because he is bearish. C) as an inflation hedge. D) as a substitute for a short sale.

a. because he is bullish. -A put seller (writer) will benefit as long as the market price of the underlying security does not drop substantially. His position is bullish.

If your customer owns 100 shares of a volatile stock and wants to limit downside risk, you may recommend A) buying puts. B) buying calls. C) shorting the same stock. D) writing calls and selling puts.

a. buying puts. -Downside risk is reduced by purchasing a put with a strike price at or close to the stock's purchase price. Should the stock decline below the strike price, the investor can exercise the put at the strike price. Selling put options will increase the downside risk. Buying calls is a bullish strategy that increases downside risk. Shorting stock will lock in the current price but will limit upside potential.

All of the following are call buyers' objectives except A) hedging a long stock position against falling prices. B) delaying a decision to buy stock. C) diversifying holdings. D) speculating for profit on the rise in price of stock.

a. hedging a long stock position against falling prices. -Long stock positions are best hedged with the purchase of a long put. Call buyers protect short stock positions, speculate on the upward movement of a stock's price, diversify their holdings, and delay the decision to buy stock because of the expiration period.

An investor opens a long position in one XYZ Nov 140 put @7. Disregarding any commissions on settlement date, the investor A) must pay $700. B) receives $14,000. C) receives $700. D) must pay $14,000.

a. must pay $700 -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. With a premium of 7, the total purchase price (disregarding any commissions) is $700 ($7 times the contract size of 100 shares). If the investor exercises this put, it will result in a sale of 100 shares at $140 per share. That means the investor will receive $14,000 when and if the put option is exercised.

All of the following are suitable objectives for a covered call writer except A) profiting from an increase in the price of stock. B) providing downside protection for a long stock position. C) speculating that a stock will not rise in price. D) increasing return on a long stock position.

a. profiting from an increase in the price of stock. -Covered call writers are not able to benefit from an increase in the price of the underlying stock. For example, you buy stock at $40 and write a 40 call. Now, the stock is 80. Isn't that great? Your long stock position has doubled. Not so fast. With the stock at 80, it is certain that the 40 call will be exercised. So no matter how high the stock goes, the covered writer can't benefit because the call will be exercised and the stock will be sold at the $40 strike price. Why sell covered calls? This strategy provides downside protection to the extent of the premium received, and it increases the rate of return on a long stock position (because of the premium collected).

Royal Duck Manufacturing Company (RDMC), located in the United States, exports about 25% of its high-quality down overcoats to distributors in Canada. To protect against currency risk, RDMC should A) purchase put options on the Canadian currency. B) purchase call options on the U.S. currency. C) sell put options on the Canadian currency. D) purchase call options on the Canadian currency.

a. purchase put options on the Canadian currency. -EPIC: U.S.-based Exporters buy Puts and Importers buy Calls. If the question is dealing with a foreign firm, it is the opposite: foreign based Importers buy Puts and Exporters buy Calls (IPEC). As far as this exam is concerned, there are no options on the U.S. dollar.

If a customer buys 1 ABC Jan 60 put at 6 and writes 1 ABC Jan 75 put at 13, the maximum loss is A) $900. B) $800. C) $1,500. D) $700.

b. $800 -This is a credit spread. (More premium was received than was paid.) The maximum gain to a seller is the premium received (net credit of 7). In a spread, the maximum gain plus the maximum loss equals the difference in strike prices (75 − 60 = 15). Therefore, 15 minus the maximum gain of 7 equals the maximum loss of 8 multiplied by $100, or $800.

What is the size of one LEAPS contract? A) 1,000 shares B) 100 shares C) No standard LEAPS contract size D) More than 1,000 shares

b. 100 shares -Like a standard options contract, the size of a LEAPs contract is 100 shares.

The covered call writing strategy would be most suitable for which of the following investors? A) An 28-year-old who is saving to buy a house before turning 30 B) A 65-year-old who is attempting to increase the yield of a portfolio containing equity securities C) A married couple that is saving for a grandchild's higher education D) An investor whose market outlook for the next three years is strongly bullish

b. A 65-year-old who is attempting to increase the yield of a portfolio containing equity securities -Covered call writing is selling calls on stock held in the portfolio. The premium received from the sale represents income. This income adds to whatever other income (dividends) the portfolio is generating. It is a low-risk strategy because the downside movement of the stock is protected to the extent of the premium received. The 28-year-old saving to buy a house within the next two years should have little exposure to equities. Writing covered calls is an active strategy (calls always expire in nine months or less) and keeping up with them is probably something grandparents are not interested in doing. A much better idea for them is the Coverdell ESA or a 529 plan, both of which offer tax benefits. Writing covered calls is a neutral strategy, tilted very slightly bullish. The strategy would not serve a strongly bullish investor well because the increasing prices to the underlying assets would lead to exercise of the options. In general, those who write options want them to expire unexercised.

After selling ABC short at 70, a customer holds the position as ABC gradually falls to $53 per share. Which of the following strategies would best protect her gain? A) Write 55 calls B) Buy 55 calls C) Write 55 puts D) Buy 55 puts

b. Buy 55 calls -If the investor buys the 55 calls, she has the right to purchase the stock at $55 per share. If exercised, the investor has a 15-point gain, less the premium paid.

A customer is short 100 shares of DFI at 35, and the market price is 35.25. If she believes a near-term rally will occur, which of the following strategies would best hedge her position? A) Write a DFI put with an exercise price of 40 B) Buy a DFI call with an exercise price of 35 C) Buy a DFI call with an exercise price of 40 D) Write a DFI call with an exercise price of 40

b. Buy a DFI call with an exercise price of 35 -The best hedge for a short stock position is to buy a call, not sell a put. If the stock price rises, the investor has the right to exercise the call and use the stock to close out the short position. To obtain the most protection, the call's strike price should equal the short sale price.

In which of the following strategies would the investor want the spread to widen? I. Buy 1 RST May 30 put, write 1 RST May 25 put II. Write 1 RST Apr 45 put, buy 1 RST Apr 55 put III. Buy 1 RST Nov 65 put, write 1 RST Nov 75 put IV. Buy 1 RST Jan 40 call, write 1 RST Jan 30 call A) I and IV B) I and II C) III and IV D) II and III

b. I and II -Buy 1 RST May 30 put, write 1 RST May 25 put => Buy 30 put is more expensive than sell 25 put = debit spread, so widen Write 1 RST Apr 45 put, buy 1 RST Apr 55 put => Buy 55 put is more expensive than sell 45 put = debit spread, so widen Buy 1 RST Nov 65 put, write 1 RST Nov 75 put => Sell 75 put brings in more than buy 65 put = credit spread, so narrow Buy 1 RST Jan 40 call, write 1 RST Jan 30 call => Sell 30 call brings in more than buy 40 call = credit spread, so narrow

If a customer establishes a debit spread, the customer profits if I. the spread widens. II. the spread narrows. III. the option expires. IV. the options are exercised. A) II and IV B) I and IV C) I and III D) II and III

b. I and IV -Because debit spreads are closed as credits, the customer profits if the spread widens. In addition, to realize maximum profit, both contracts must be exercised. If they expire, the customer loses the net debit paid for a maximum loss.

Which of the following strategies is intended to be profitable with either a significant upside or significant downside move in the underlying stock? A) Horizontal spread B) Long straddle C) Vertical spread D) Short straddle

b. Long straddle -If the stock moves sharply up or down, the customer will profit from owning a long straddle.

If an investor buys 1 DWQ Apr 70 call at 5, giving him the right to buy 100 shares of DWQ at $70 per share, which aspect of the transaction is not set or standardized by the Options Clearing Corporation (OCC)? A) Contract size of 100 shares B) Premium of 5 C) Expiration date in April D) Exercise price of 70

b. Premium of 5 -The OCC sets standard exercise prices and expiration dates for all listed options, but the options premiums that buyers pay are determined by the market.

Which of the following strategies would be considered most risky in a bull market? A) Buying calls B) Writing naked calls C) Buying a put D) Writing naked puts

b. Writing naked calls -Writing naked calls provides unlimited liability and the most risk. Buying a call would be an attractive strategy in a bull market with risk limited to calls paid. Writing naked puts risks only the difference between the strike price and zero, less any premium received. Buying a put is a bearish strategy, with risk limited to the amount paid for the put.

A customer shorts 100 XYZ at 51 and buys 1 XYZ Aug 50 call at 4. The stock falls to 45, at which time, the customer closes the options contract at 1 and covers his short position at the current market price for A) a $300 loss. B) a $300 gain. C) a $400 gain. D) a $400 loss.

b. a $300 gain. -The customer shorted stock at 51 and covered at 45 for a $600 gain, and then he bought a call at 4 and sold it at 1 for a $300 loss. Overall, the gain is $300.

Covered call writing normally occurs in A) a volatile market. B) a stable market. C) a rising market. D) a falling market.

b. a stable market. -Covered call writing normally occurs in a stable market. In a rising market, writing calls against a long stock position limits upside potential. In a falling market, the calls only provide downside protection to the extent of the premium received.

All of the following are credit spreads except A) write 1 ABC Nov 35 put, buy 1 ABC Nov 30 put. B) buy 1 ABC Jul 50 call, write 1 ABC Jul 60 call. C) buy 1 ABC Apr 40 call, write 1 ABC Apr 30 call. D) buy 1 ABC Jan 50 put, write 1 ABC Jan 60 put.

b. buy 1 ABC Jul 50 call, write 1 ABC Jul 60 call.

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) is 1 point out-of-the-money. B) is 3 points in-the-money. C) is 3 points out-of-the-money. D) has no time value.

b. is 3 points 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.

An investor opens a short position in one XYZ Nov 140 put @7. Disregarding any commissions, if the option is exercised, on settlement date, the investor A) receives $14,000. B) must pay $14,000. C) receives $700. D) must pay $700.

b. must pay $14,000. -When an investor takes a short position in an option, it means the investor has sold, or written the option. In the case of a put option, the investor is obligated to accept 100 shares at the strike price if the holder of the option chooses to exercise. In this case, that would mean paying $140 per share for 100 shares, or $14,000 on the settlement date.

One of your clients is neutral to bearish on a particular stock and would like to sell calls on it to generate some income. Wishing to minimize risk, you would suggest the client cover the call or take other steps to protect against unlimited loss. That could be done in all of the following ways except A) depositing a security convertible into 100 shares of the stock into the account. B) simultaneously purchasing a put on that stock with a strike price lower than that of the short call. C) depositing 100 shares of the stock into the account. D) simultaneously purchasing a call on that stock with a strike price lower than that of the short call.

b. simultaneously purchasing a put on that stock with a strike price lower than that of the short call. -Buying a short put does not cover a long call or offer protection against loss. If the stock price rises, the writer of the call loses and the put expires worthless. There are several ways to cover a call. The most common is being long the underlying stock. Short calls can also be covered by a security convertible into the appropriate number of shares. That would include convertible preferred stock, convertible debt securities, and warrants. They must be convertible without cost (that is generally the case and can be assumed unless the question says otherwise). A third way to cover a short call is with a long call. The strike price has to be the same or lower and the long call cannot expire before the short call. Buying a short put does not cover a long call. However, in this case, although the writer is protected, the long call will cost more than the short, so the objective of income will not be realized. Buying a call with a higher strike price will result in a net credit (income), and the writer is protected to the extent of the difference between the strike prices and the credit. This is your basic credit call spread.

Holders of long straddles would like the underlying stock to do all of the following except A) go up. B) stay the same. C) fluctuate. D) go down.

b. stay the same -In a long straddle, you are buying a put and a call. Holders can only profit if the stock moves farther away from the strike price than the total of the premiums paid.

If a customer believes the Swiss franc will depreciate against the U.S. dollar, which of the following option strategies may best take advantage of the expected depreciation? A) Uncovered put writing B) Debit call spread C) Uncovered call writing D) Credit put spread

c. Uncovered call writing -Call writing is bearish, while credit put spreads, debit call spreads, and uncovered put writing are bullish.

One of your customers exercises a put option. The stock is in the customer's account and your firm makes timely delivery. The proceeds from the sale of the stock will be paid to your firm by A) the writer to whom the exercise notice was assigned. B) the broker-dealer to whom the exercise notice was assigned. C) the exchange where the option exercise took place. D) the OCC.

b. the broker-dealer to whom the exercise notice was assigned. -Look at this as a regular buy and sell. When the customer exercises the put, it is a sale of stock. When customers of member firms sell stock, those firms collect the sales proceeds from the contra party (the other member firm representing the buyer). The OCC assigns the exercise to a member firm that is then responsible for paying the broker-dealer representing the seller of the stock.

If a customer buys 1 ABC Jan 50 call at 2 and 1 ABC Jan 50 put at 4 when ABC is at 49, the maximum potential gain is A) $200. B) unlimited. C) $600. D) $400.

b. unlimited -Maximum gain in a long straddle is unlimited if the market moves up. If the market moves to zero, the gain is $4,400 (50 − 6 = 44).

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) widen. C) fluctuate. D) narrow.

b. widen. -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.

An active options trader establishes the following position: Long 10 ALF Apr 40 calls at 6 Short 10 ALF Apr 50 calls at 2 What is the breakeven point? A) $40 B) $4 C) $44 D) $46

c. $44 -The breakeven on a call spread is determined by adding the difference in premiums (6 − 2 = 4) to the lower strike price. In this case, the net debit is four points. Therefore, 4 plus 40 equals 44.

Which of the following are spreads? I. Long 1 FLB May 40 call, short 1 FLB May 50 call II. Long 1 FLB May 40 call, long 1 FLB May 50 call III. Long 1 FLB Aug 40 call, short 1 FLB May 40 call IV. Long 1 FLB Aug 40 call, short 1 FLB Aug 50 put A) II and IV B) I and II C) I and III D) II and III

c. I and III -Options I and III fit the definition of a call spread because each includes one long and one short option of the same type with different strike prices (I, a price spread) or different expiration dates (III, a time spread). Option II involves options of the same type, but both are long. Option IV involves options of different types.

If a customer writes 1 ABC Jan 35 call at 13.50 and 1 ABC Jan 55 put at 12.50 when ABC is trading at 45, excluding commissions, this position will be profitable if ABC is I. above $29. II. below $29. III. above $61. IV. below $61. A) I and II B) III and IV C) I and IV D) II and III

c. I and IV -This is a short in-the-money combination. To compute the breakeven points, add the combined premiums (26) to the strike price of the call and subtract the combined premiums from the strike price of the put. The breakeven points are 61 (35 + 26) and 29 (55 − 26). With a short combination like a short straddle, the customer makes money if the stock stays inside the breakeven points.

While watching the financial news on TV, you hear an internationally recognized economist say that she expects a significant devaluation of the U.S. dollar. If she is correct, what would be the likely effect on foreign trade? I. The price of foreign goods would decrease, leading to an increase in imports. II. The price of foreign goods would increase, leading to a decrease in imports. III. The price of U.S.-made goods would decrease, leading to an increase in exports. IV. The price of U.S.-made goods would increase, leading to a decrease in exports. A) I and IV only B) II and IV only C) II and III only D) I and III only

c. II and III only -If the dollar is devalued, it becomes less valuable in foreign countries. That means that more dollars are required to purchase the same amount of foreign goods. The increased cost of those foreign goods will reduce imports of them. On the other side, because the foreign currency now goes further in the United States, goods made here become cheaper to buy, so exports will increase.

An investor sells an uncovered GHI Aug 120 call for 5½ points. What is the investor's maximum gain, maximum loss, and breakeven point? A) Maximum gain is unlimited; maximum loss = $550; breakeven point = $125.50. B) Maximum gain = $550; maximum loss = $114.50; breakeven point = $125.50. C) Maximum gain = $550; maximum loss is unlimited; breakeven point = $125.50. D) Maximum gain = $550; maximum loss is unlimited; breakeven point = $114.50.

c. Maximum gain = $550; maximum loss is unlimited; breakeven point = $125.50. -The initial action is a sale resulting in a credit of $550. That credit is the most the investor can make. Because this is an uncovered call, the maximum loss occurs when the stock rises. Because there is theoretically no upper limit on a stock's price, the maximum potential loss is unlimited. Breakeven follows the call-up rule. Add the $550 premium to the $120 strike to arrive at $125.50.

A customer who owns a portfolio of blue-chip stocks believes the securities will provide long-term appreciation but fears that the market will decline over the short term. Which options strategy would likely offer some protection against the expected decline while allowing the customer to generate additional income? A) Sell covered puts B) Buy calls C) Sell covered calls D) Buy puts

c. Sell covered calls -Selling calls will generate income and protect the downside to the extent of the premiums received.

One of your customers has established a long position in ABC Jan 50 calls. Which of the following details would not be on the confirmation of the trade? A) The premium B) The name of the underlying security C) The aggregate exercise price D) The exercise price and expiration month

c. The aggregate exercise price -The aggregate exercise price is what it would cost the investor to exercise the option. In this case, it would be the $50 exercise price multiplied by the number of shares in the contract (100). The confirmation does not include that $5,000 number; it isn't necessary.

A customer buys 100 shares of RAN common stock at $62.75 per share and simultaneously buys one RAN Jan 60 put at 1. By January, the market price of the RAN stock has risen to $66.25 per share. The investor allows the put to expire worthless (who would exercise the option to sell stock at 60 when the market price is $66.25?), and the customer sells the RAN at the current price of $66.25 per share resulting in A) a loss of $100. B) a gain of $350. C) a gain of $250. D) a loss of $250.

c. a gain of $250. -$66.25-$62.75= $3.50 $3.50-$1.00= $2.50 ($250)

If a customer buys 1 XYZ Jan 40 call and 1 XYZ Jan 40 put, paying total premiums of $650, and XYZ becomes worthless, the result is A) a loss of $650. B) a loss of $3,350. C) a gain of $3,350. D) a gain of $650.

c. a gain of $3,350. -This is a long straddle in which breakeven points are established by adding and subtracting the combined premiums (6½ points) from strike (breakeven points are 46½ and 33½). The customer makes money if the stock moves above 46½ or below 33½. As the stock becomes worthless, the customer earns a 33½ point gain on 100 shares, or $3,350. Let's do the math. When a stock goes down, the owner of a put option benefits ("put down"). In this question, if the stock is worth zero, the owner of the put can purchase it for nothing and sell the stock for $40 per share by exercising the 40 put. That looks like a $4,000 profit except the investor had to pay for both the put and the call. We are told the total premiums are $650, so the profit is reduced by that cost: $4,000 minus $650 equals a profit of $3,350. What happens to the call option? Calls are worth something only when the stock goes up, so that option will expire worthless.That's the key to a long straddle. This investor doesn't know which way the market price will go, so a position is taken on both sides, sort of like straddling a fence. If the stock price goes up, the call will become valuable and if it goes down, as in this question, it is the put that becomes valuable.

An investor sells one DEF Nov 65 put for 4 and buys one DEF Nov 70 put for 8. This position is known as A) a bull spread. B) a horizontal spread. C) a vertical spread. D) a diagonal spread.

c. a vertical spread. -A spread is the simultaneous purchase of one option and sale of another option of the same class. A call spread is a long call and a short call. A put spread is a long put and a short put. A price spread or vertical spread is one that has different strike prices but the same expiration date. In this question, we have a long put and as short put, both expiring in November but with different strike prices. This is a bear spread because the long option is the one with the higher strike price. A spread is bullish when the option purchased (long) has the lower strike price and the one sold (short) has the higher strike price. We remember that with the letters BLSH (buy low, sell high).

The holder of a foreign currency call option has the right to A) buy U.S. dollars for a fixed amount of the specified foreign currency. B) sell U.S. dollars for a fixed amount of the specified foreign currency. C) buy the specified foreign currency for a fixed U.S. dollar amount. D) sell the specified foreign currency for a fixed U.S. dollar amount.

c. buy the specified foreign currency for a fixed U.S. dollar amount. -The holder of a call option has the right to buy the underlying asset. The asset in the case of foreign currency options is the specified foreign currency. Therefore, a foreign currency call option gives the holder the right to buy the specified foreign currency at the strike price. That strike price is expressed in U.S. dollars. For example, one BP 1.30 call option gives the holder the right to buy 10,000 British pounds at a price of $1.30 per pound, or $13,000.

Call-buying strategies include all of the following except A) an increase in leverage with limited risk. B) covering a long stock position. C) acquisition of a stock position. D) protection of a profit on a short sale of stock.

c. covering a long stock position. -In the world of securities, the term covering applies only to short positions. You can cover a short call or a short put. You cover a short sale of stock by purchasing the stock to replace what was borrowed. The phrase "covering a long position" (stock or otherwise) is not appropriate. The remaining choices are all strategies that could warrant call buying: increased leverage, acquisition of stock, and hedging a short stock position.

For an out-of-the-money equity option expiring in seven months, the time value of the option will most likely be A) less than zero. B) less than the option premium. C) equal to the option premium. D) greater than the option premium.

c. equal to the option premium -An option premium consists of two factors. First is the intrinsic value (the amount the option is in the money). The balance of the premium represents the time value. An out-of-the-money option, by definition, has no intrinsic value. Therefore, the entire premium represents time value. The time value of an option will never be less than zero; it can only be zero or positive.

Your client currently holds XYZ stock in her portfolio. You notice that the put-call ratio for options trading on XYZ stock has been increasing over the past several days. The increase in the ratio would indicate that A) investors are becoming more and more bullish on XYZ stock. B) for the underlying XYZ stock, straddles are being purchased. C) for the underlying XYZ stock, more puts than calls are being traded. D) for the underlying XYZ stock, more calls than puts are being traded.

c. for the underlying XYZ stock, more puts than calls are being traded. -The ratio is a measure of puts traded to calls traded and is calculated by dividing the number of traded puts by the number of traded calls (puts / calls). As the ratio increases, it reflects that more puts than calls are being traded and is therefore a more bearish indicator of investor sentiment.

A jewelry wholesaler imports Swiss watches. The importer could gain the most protection against currency risk by A) going short calls on the Swiss franc. B) going short puts on the Swiss franc. C) going long calls on the Swiss franc. D) going long puts on the Swiss franc.

c. going long calls on the Swiss franc. -When it comes to using options as protection, the strongest protection comes from purchasing rather than selling. Options can be used as insurance, and to protect yourself, you buy insurance. Remember the acronym EPIC, which stands for Exporters buy Puts and Importers buy Calls. Because this wholesaler is importing the watches, buying calls is the proper strategy.

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) has no time value. C) is in the money by seven points. D) is out of the money by one point.

c. is in the money by seven points. -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.

The writer of an equity call option who is assigned A) can enter a closing transaction on the day the exercise notice is received. B) can enter a closing transaction any time before exercise settlement. C) must deliver stock within two business days. D) must deliver stock within one business day.

c. must deliver stock within two business days. -If exercised, the assigned call writer must deliver the underlying stock within two business days (regular way settlement for equity transactions).

An investor opens a long position in one XYZ Nov 140 call @7. Disregarding any commissions, if the option is exercised, on settlement date, the investor A) receives $14,000. B) receives $700. C) must pay $14,000. D) must pay $700.

c. must pay $14,000. -When an investor takes a long position in an option, it means the investor has purchased the option. If that option is a call (as is the case in our question), the holder (the owner) has the right to exercise the call option and purchase the stock at the exercise (strike) price. In our question, that strike price is $140 per share. If the holder decides to exercise the option, the exercise (strike) price is paid on the settlement date. Buying 100 shares at a price of $140 per share requires payment of $14,000.

All of the following are suitable objectives for a covered call writer except A) speculating that a stock will not rise in price. B) increasing return on a long stock position. C) profiting from an increase in the price of stock. D) providing downside protection for a long stock position.

c. profiting from an increase in the price of stock. -Covered call writers are not able to benefit from an increase in the price of the underlying stock. For example, you buy stock at $40 and write a 40 call. Now, the stock is 80. Isn't that great? Your long stock position has doubled. Not so fast. With the stock at 80, it is certain that the 40 call will be exercised. So no matter how high the stock goes, the covered writer can't benefit because the call will be exercised and the stock will be sold at the $40 strike price. Why sell covered calls? This strategy provides downside protection to the extent of the premium received, and it increases the rate of return on a long stock position (because of the premium collected).

A client with an options account contacts the registered representative handling the account with instructions to open the following spread: Buy 1 ABC 100 call and Sell 1 ABC 105 call at a 5-point debit. Under FINRA rules, this order A) will be executed at the next available trade meeting the 5-point limit. B) is for a bull call spread. C) should be refused. D) should be turned in immediately.

c. should be refused -The order should be refused because it is impossible for it to be profitable. This is a bull call spread (but that is not the correct answer here because it has nothing to do with FINRA rules) and will become profitable when the spread widens. With strike prices of 100 and 105, it can never widen more than 5 points. If the client paid 5 points for the spread, once commissions are factored in, the client must lose money and certainly cannot profit. FINRA looks at this as an uneconomic position, and the firm should refuse to take the order.

A producer of fine French wines has just signed a contract to export $10 million of wine to a distributor in the United States. Using listed foreign currency options, this producer would have the best protection against currency risk by A) taking a long position in U.S. dollar puts. B) taking a long position in euro puts. C) taking a long position in euro calls. D) taking a long position in U.S. dollar calls.

c. taking a long position in euro calls -There are no listed options in the U.S. dollar. That reduces your choice to a long euro put or call. Because the contract will be paid for in dollars, the producer is concerned that the dollar will fall against the euro. Or, stated another way, the concern is that the euro will rise against the dollar so that the $10 million will not buy as many euros as on the day the contract was signed. When one is afraid the price of asset will rise, such as those who take a short position in a stock, the best protection is buying a call. The easiest way to remember this is through the acronym, IPEC - Importers buy Puts and Exporters buy Calls. This is used when the party involved in the question is in a foreign country. Because we are dealing with a French exporter, buying calls on the local currency offers the best protection.

If a customer is long 10 ABC Jul 50 calls at 4.50, the contracts give the holder A) the obligation to buy stock. B) the obligation to sell stock. C) the right to buy stock. D) the right to sell stock.

c. the right to buy stock. -A long call gives the holder the right to buy stock.

When XYZ stock trades at 40, and an XYZ Oct 35 call trades at 5, which of the following is true? A) The option's time value equals its intrinsic value. B) The option is at the money. C) The time value is zero. D) The option is out of the money.

c. the time value is zero -An option's premium consists of time value and intrinsic value. In this situation, the call is in the money by 5 (intrinsic value is 5), because the market value of 40 exceeds the strike price of 35 by 5. If the total premium is 5, and the intrinsic value is 5, the time value must be zero. The option is at parity, which means the premium equals the intrinsic value. Remember P - I = T (Premium minus intrinsic value equals the time value).

If a customer buys 200 XYZ at $58 and writes 5 XYZ Jan 60 calls at 2, the maximum potential loss is A) $1,400. B) $12,600. C) unlimited. D) $10,600.

c. unlimited -This is an example of ratio writing. Short calls are covered by long stock, but in this example, it would take 500 shares of stock to cover the five calls written. Because there are three uncovered calls, the maximum loss is unlimited.

Your client purchases 100 shares of XYZ common stock at $50 and sells two XYZ Oct 55 calls for a premium of $2 each. This investor's maximum potential loss is A) $4,800. B) $4,600. C) unlimited. D) $600.

c. unlimited. -This is a ratio write. The client is writing more calls than he has stock to cover. The first call is covered by the 100 shares of stock owned, but the second call is uncovered, or naked. A short naked call has unlimited loss exposure.

Which of the following covers a short call? I. Long stock II. Short stock III. Long put IV. Stock rights A) II and IV B) II and III C) I and III D) I and IV

d. I and IV -Covering a short call requires taking action to eliminate the risk of being exercised. If the customer owns the stock or has the right to acquire it, the customer is covered. Stock rights (preemptive rights) give the holder the right to purchase the stock. Short stock and long puts both have the same market attitude as a short call (bearish), and therefore, would not cover the risk associated with a short call.

An investor who believes the U.S. dollar will strengthen against the Canadian dollar should profit from which of the following strategies? I. Buying puts on the Canadian dollar II. Writing puts on the Canadian dollar III. Writing a straddle on the Canadian dollar IV. Establishing a call credit spread on the Canadian dollar A) I and III B) II and IV C) III and IV D) I and IV

d. I and IV -The investor who is bearish on the Canadian dollar should buy puts, write calls, and call spreads. Short straddles pay off when the market does not move either way.

Which of the following statements regarding the exercise of options contracts are true? I. The exercise of equity options settles the next business day. II. The exercise of equity options settles in two business days. III. The exercise of index options settles the next business day. IV. The exercise of index options settles in two business days. A) I and III B) I and IV C) II and IV D) II and III

d. II and III -Listed equity options, if exercised, settle in two business days (regular way settlement for equities). Index options, if exercised, settle on the next business day—and in cash.

If XYZ is trading at 39, and a customer sells 1 XYZ Jun 40 put and buys 1 XYZ Jun 35 put, he will profit if I. the spread widens. II. the spread narrows. III. the contracts expire. IV. the contracts are exercised. A) II and IV B) I and II C) I and IV D) II and III

d. II and III -When a spread's premiums are not available, the more valuable option is found by examining the strike price. A put with a higher strike price has a higher premium because a put represents the right to sell. Because the investor is selling the more valuable put (the one with the higher strike price), this is a credit spread, and profit occurs if the options expire worthless (in this case, the customer keeps the net credit) or the spread narrows between the premiums.

An investor opens the following options position: Long 1 KAP Jul 50 call @ 4½ and short 1 KAP Jul 45 call @8¼. What is the investor's maximum gain, maximum loss, and breakeven point? A) Maximum gain = $125; maximum loss = $375; breakeven point = $46.25. B) Maximum gain = $375; maximum loss = $125; breakeven point = $46.25. C) Maximum gain = $125; maximum loss = $375; breakeven point = $48.75. D) Maximum gain = $375; maximum loss = $125; breakeven point = $48.75.

d. Maximum gain = $375; maximum loss = $125; breakeven point = $48.75. -The first step is to identify the position. This is a credit call spread. It is a credit spread because the option sold brought in a higher premium than the one purchased. The credit of $375 is the most the investor can make. This is a bear call spread. We know that because the investor purchased the option with the higher strike price and sold the one with the lower strike price. The goal is for the stock's price to decline to the point where neither option is expired. That way, the investor keeps the net credit. If the market does not cooperate and the stock rises above $50 per share, the 45 call will be exercised and the investor will be required to sell the stock for $4,500. However, the stock needed for delivery can be obtained by exercising the long position for $5,000. This results in a loss of $500. When the $375 credit received is taken into consideration, the loss of $500 is reduced by the $375 premium, resulting in a maximum loss of $125. The quick way to do this is to subtract the net premium (the $375 credit) from the difference in strike prices (5 points) and the result is the same $125 loss. Breakeven follows the call-up rule; add the net credit to the lower strike price and that is $3.75 + $45 = $48.75.

An investor opens the following options position: Long 1 PKE Apr 60 put @4 and short 1 PKE Apr 55 put @2. What is the investor's maximum gain, maximum loss, and breakeven point? A) Maximum gain is $200; maximum loss is $300; breakeven point is $58.00. B) Maximum gain is $300; maximum loss is $200; breakeven point is $57.00. C) Maximum gain is $200; maximum loss is $300; breakeven point is $57.00. D) Maximum gain is $300; maximum loss is $200; breakeven point is $58.00.

d. Maximum gain is $300; maximum loss is $200; breakeven point is $58.00. -subtract the net premium (the $200 debit) from the difference in strike prices (5 points) and the result is the same $300 profit. The breakeven point follows the put-down rule. Subtract the net premium (the $2 debit) from the higher strike price, resulting in a breakeven point at $58.

A customer opens the following positions: Buy 100 shares of HDH @60; buy 1 HDH Feb 60 put @4. What is the customer's maximum gain, maximum loss, and breakeven point? A) Maximum gain is $400; maximum loss is $5,600; breakeven point is $56. B) Maximum gain is $6,400; maximum loss is $400; breakeven point is $64. C) Maximum gain is unlimited; maximum loss is $5,600; breakeven point is $56. D) Maximum gain is unlimited; maximum loss is $400; breakeven point is $64.

d. Maximum gain is unlimited; maximum loss is $400; breakeven point is $64. -The first step is to identify the position. This is a long stock position with a protective put. That is, the customer has purchased the stock and purchased a put to protect the downside. Using an option as a form of insurance is the primary reason why the industry refers to the price of an option as the premium. On questions with stock and an option, it is usually best to compute the breakeven point first. Breakeven is when the long stock can be sold at the customer's total cost. That cost is the price of the stock ($60) plus the price paid for the option ($4), or $64. If the stock should rise above $64, the customer will let the 60 put expire and maintain the long stock position. An investor with a long stock position has unlimited potential gain. If the stock price should decline, no matter how low it drops, the customer can exercise the long put and sell the stock for $60 per share. That means the maximum loss is the premium paid for the option, $400. Why doesn't the breakeven follow the "put-down" rule? That rule applies when the only positions are options. Once there is a long or short stock position along with an option position, it is the stock controlling the breakeven.

An investor goes long an XYZ May 30 put for 4¼ points. What is the investor's maximum gain, maximum loss, and breakeven point? A) Maximum loss is unlimited; maximum profit is $2,575; breakeven point = $25.75 per share. B) Maximum loss = $425, maximum profit = $2,575; breakeven point is $34.25 per share. C) Maximum loss is $425, maximum profit is unlimited; breakeven point is $25.75 per share. D) Maximum loss = $425; maximum profit = $2,575; breakeven point = $25.75 per share.

d. Maximum loss = $425; maximum profit = $2,575; breakeven point = $25.75 per share. -The initial action is a $425 purchase. That debit is the most the investor can lose. To figure maximum profit, you must think! What kind of strategy is buying a put option—bearish! The investor anticipates a falling market. The maximum profit will be realized when the market price of the stock falls as low as it can, which is zero. If the market price does fall to zero, the investor can sell the put for its intrinsic value. In this case, the 30 put would be in the money by 30 points, or $3,000. Therefore, the maximum profit to the put buyer is the entire difference between the strike price and zero, offset (reduced) by the premium paid (strike price minus premium). Breakeven uses the put-down rule. You subtract the premium from the strike price and that is $30 minus $4.25, which = $25.75.

The Options Clearing Corporation (OCC) uses which of the following methods to assign exercise notices? A) First-in, first-out (FIFO) B) Assign it to the member firm holding a long position that first requests an exercise C) Assign it on the basis of the largest position D) Random selection

d. Random selection -The OCC assigns exercise notices to member firms on a random basis. The members may choose the customers to be exercised on either a random basis or FIFO basis.

When XYZ stock trades at 40, and an XYZ Oct 35 call trades at 5, which of the following is true? A) The option is at the money. B) The option is out of the money. C) The option's time value equals its intrinsic value. D) The time value is zero.

d. The time value is zero. -An option's premium consists of time value and intrinsic value. In this situation, the call is in the money by 5 (intrinsic value is 5), because the market value of 40 exceeds the strike price of 35 by 5. If the total premium is 5, and the intrinsic value is 5, the time value must be zero. The option is at parity, which means the premium equals the intrinsic value. Remember P - I = T (Premium minus intrinsic value equals the time value).

Which of the following transactions would be acceptable investments for a pension fund? A) Writing a put B) Writing a naked call C) Writing an S&P Index option D) Writing a covered call

d. Writing a covered call -Writing a covered call has less risk than writing a naked option. A covered call writer is merely using options to increase the income on his portfolio. Fiduciaries, such as those who invest for pension fund portfolios, should avoid risky transactions.

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 1.50 debit. B) a 1.75 debit. C) a 1.85 debit. D) a 2.10 debit.

d. a 2.10 debit -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.

Which of the following would best describe, "Bought 1 Jan 55 call at 3 and sold 1 Jan 60 call at 1"? A) A bear time spread B) A bear vertical spread C) A bull horizontal spread D) A bull vertical spread

d. a bull vertical spread -The client paid two points out of pocket for a call spread. Break even here is 57. Your client wants the stock to go up; hence, a bull spread. Because the exercise prices are different, it is also a vertical spread.

All of the following accounts are permitted to write calls except A) a custodian in an UTMA account against a long stock position. B) a mutual fund against a long stock position. C) an individual in a margin account. D) a corporation against its own stock.

d. a corporation against its own stock. -Corporations are not permitted to write calls against their own stock. If exercised, they would have to issue shares at the strike price, and this would have a dilutive effect on shareholders.

A client writes 1 Jan 60 put and buys 1 Jan 50 put. This is A) a debit bear spread; the investor wants the price fall below 50. B) a credit bull spread; the investor breaks even at a price less than 50. C) a debit bear spread; the investor breaks even at a price greater than 60. D) a credit bull spread; the investor wants the price to stay above 60.

d. a credit bull spread; the investor wants the price to stay above 60. -This is a put credit spread, and bulls sell puts. The 60 put is worth more because it has a higher strike price. Long the lower put is bullish; short the lower put is bearish.

A customer is short 10 ABC Dec 50 calls at 2.50 and short 10 ABC Dec 50 puts at 3.50. Before expiration, ABC declines to 40.50, and the customer is assigned on his put position while his short calls expire worthless. A month later, he liquidates his long position at 45 for A) a gain of $7,500. B) a loss of $7,500. C) a loss of $1,500. D) a gain of $1,000.

d. a gain of $1,000. -The customer opens two short positions of 10 contracts each. Going short an option contract means selling the option. Therefore, his account is credited with premiums of $2,500 ($250 times 10) for the calls and $3,500 ($350 times 10) for the puts. That is a total credit of $6,000. The calls expire worthless, but the short puts are exercised. When a put is exercised, the seller of the contract is obligated to purchase the stock at the exercise (strike) price. This results in a cost (debit) of $50,000 ($5,000 per contract times 10 contracts). The investor now owns 1,000 shares and then sells them at $45 per share or $45,000, a credit to the account. The net result is the investor paid out $50,000 to buy the stock put to him and received $45,000 from the sale of the stock plus the $6,000 in premiums. That is $51,000 in total credits versus $50,000 in debits for a profit (gain) of $1,000.

An investor would sell a put A) as an inflation hedge. B) because he is bearish. C) as a substitute for a short sale. D) because he is bullish.

d. because he is bullish. -A put seller (writer) will benefit as long as the market price of the underlying security does not drop substantially. His position is bullish.

A UK company exports sweaters to the U.S. and will be paid in U.S. dollars upon delivery. To hedge foreign-exchange risk using listed currency options, the UK company should A) buy British pound puts. B) sell British pound calls. C) sell British pound puts. D) buy British pound calls.

d. buy British pound calls -Normally, exporters buy puts on foreign currency to hedge. There are no listed currency options available on the U.S. dollar, so the British company should buy calls on its own currency.

When comparing a short call to a credit call spread, all of the following are true except A) maximum gain is limited in both positions. B) both positions generate premium income. C) both positions are bearish. D) maximum loss is limited in both positions.

d. maximum loss is limited in both positions. -In any spread, both maximum gain and maximum loss are limited. In a short call, gain is limited to the premium received, but loss is unlimited. Short calls and credit call spreads are bearish, and both generate premium income. The investor who writes a call spread receives premium income (a short call spread is a credit spread).

An investor takes a short position in one XYZ Nov 140 call @7. Disregarding any commissions, on settlement date, the investor A) receives $14,000. B) must pay $14,000. C) must pay $700. D) receives $700.

d. receives $700 -When an investor takes a short position in an option, it means the investor has sold, or written the option. As a seller, the investor receives the premium on the settlement date.

An investor purchased 100 shares of AMNZ stock five years ago at $200 per share. With AMNZ currently selling at a price in excess of $1,000 per share, the investor would like to generate some income. Which of the following strategies would you recommend? A) Buy an AMNZ call B) Buy an AMNZ put C) Sell an AMNZ put D) Sell an AMNZ call

d. sell an AMNZ call -The only way to generate income is to sell something. Because the investor already owns 100 shares of AMNZ, selling a put is probably not the right suggestion. If the stock price goes down, the put will be exercised and the investor will have to buy 100 shares of the stock at the strike price. Selling the call while owning the underlying stock makes this a covered call. It provides income from the premium and offers some downside protection. If the stock goes up, the option will likely be exercised and the investor will have to deliver the stock purchased years ago. This will result in a long-term capital gain equal to the difference between the investor's cost ($200) and the proceeds received (the strike price plus the premium).

In a rising market, all of the following strategies are appropriate except A) long calls. B) short puts. C) debit call spreads. D) short stock/short put.

d. short stock/short put. -Investors who short stock have sold borrowed shares and profit when the market price declines.

All of the following are fixed option contract terms except A) the units of currency in a currency option. B) the expiration month in a debt option. C) the multiplier in an index option. D) the premium in a stock option.

d. 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.

All of the following are advantages of buying a put versus selling stock short except A) buying a put would require a smaller capital commitment. B) one need not locate securities to be borrowed to buy a put. C) buying a put has a lower dollar-loss potential than does selling stock short. D) the put's time value, which gradually dissipates, is added to the intrinsic value.

d. the put's time value, which gradually dissipates, is added to the intrinsic value. -Selling short could result in unlimited loss, whereas buying a put limits loss to the premium and requires a smaller capital outlay than does selling short. Remember that short sales must be done in a margin account, and 50% of the short market value (SMV) must be deposited by the short seller. Short sales require locating the securities to be borrowed; buying a put does not. The time value that erodes in a put option is a disadvantage because for each day that elapses, the option's time value decreases.

All of the following can be advantages of buying an option contract except A) to limit risk. B) leverage. C) to position against a written option. D) time value dissipation.

d. time value dissipation. -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.

If an investor interested primarily in speculation does not expect the price of DWQ stock to change, she will A) buy a straddle. B) write a straddle and buy stock. C) write a straddle and short the stock. D) write an uncovered straddle.

d. write an uncovered straddle -An investor who expects prices to remain stable writes an uncovered straddle (short straddle). In selling the put and call at the same terms, the writer collects double premiums. Both expire if the price remains stable, but if the price moves, one side loses money. Short straddles carry unlimited loss potential because of the uncovered call.