Chapter 12

An investor wrote a 115 index option call. The option was exercised and the index closed at 125. The writer will:

Deliver cash

On the day prior to the ex-dividend date for an ordinary cash dividend, a holder of a call tenders an exercise notice. The investor will be:

Entitled to the dividend

Opening Purchase: Opening Sale: Closing Purchase: Closing Sale:

Establishes a long position Establishes a short position Liquidates an existing short position Liquidates an existing long position

Mike is long a yield-based put option in his account. Mike would like to see interest rates:

Fall

An investor who has owned XYZ stock for two years buys an XYZ October put. This will:

Have no effect on his holding period if the investor owned the stock for more than one year (long-term) at the time the put was purchased, it will have no effect on the holding period.

A client has established the following position: Long 1 DEF May 50 call at 2 Short 1 DEF May 40 call at 6 In which of the following situations will the client have the maximum potential profit?

If both options contracts expired unexercised

A U.S. importer needs to purchase British pounds to pay for a shipment of goods. The exchange of U.S. dollars for British pounds would occur:

In the Interbank market

George has the following position in his account: Long 1 XYZ Nov 45 call By adding which of the following positions creates a combination?

Long 1 XYZ Nov 40 put

An investor selling a combination will profit if the price of the underlying security is:

Neutral

The settlement date between the Options Clearing Corporation and the clearing firm for options transactions is:

One business day from the trade date

What organization acts as the counter-party in all option contracts and provides guarantees in option trading?

Options Clearing Corporation

An investor has purchased 1,000 shares of XYZ stock. Which of the following option transactions will provide the most effective means of reducing the cost of the stock?

Selling 10 XYZ calls

Logan has the following position in his account. Long 1 DEF May 35 call. Logan anticipates a slight bullish move in DEF from which he wants to benefit, but he also wants some income generated to reduce the cost of the position without adding additional risk. He could accomplish this by adding which of the following positions to his account?

Short 1 DEF May 45 call Had Logan added 1 short DEF May 25 call, he may have been required to sell DEF at $25 per share with the risk it would have cost him $35 per share to purchase DEF. If he added either of the short puts, he may have been required to purchase DEF at $25 or $45 per share without a right to dispose of it.

An investor is long 1,000 shares of XYZ at $32 per share and the current market value of XYZ is $38. The investor believes the stock is not likely to fluctuate over the next few months and actually has a long-term bullish outlook. Which of the following positions will allow the investor to increase the portfolio's yield without increasing the downside risk?

Short 10 XYZ 40 calls This investor is a perfect candidate to establish a covered call position. Since she owns 1,000 shares of XYZ, 10 XYZ calls could be sold in her account without exposing her to the risk of having to enter the market and purchase stock in the event that the calls are exercised. The total premiums received will reduce the amount she needs in order to recover her initial investment ($32 per share) if she is obligated to sell XYZ shares. Also, since she believes the stock is not likely to fluctuate over the next few months, she is not overly concerned that XYZ will appreciate to a point at which the short calls will be exercised (at the $40 strike). If the investor had purchased either the calls or the puts, it would have cost her money. Although selling the puts would generate income, it would greatly increase her downside risk.

An employee in the operations department of a broker-dealer asks an Operations Professional what is meant by the term, covered XAM put. The BEST answer would be if it includes a position in which a customer is:

Short XAM stock

_____________________ is the purchase and sale of foreign currencies among large banks. The market helps establish the cash (spot) prices for foreign currencies.

The Interbank market

The strike price is 85 (0.8500) and the premium is .82 ($0.0082). Therefore, the spot rate for the Canadian dollar would need to be _______________ for Mr. Jones to break even.

$0.8582

An investor writes 5 uncovered ABC May 35 puts for a premium of 3 per contract, when ABC has a market price of $36. At what market price will the investor break even?

$32

An investor is short 2,000 XYZ calls. In determining position limits, which of the following choices will be totaled with the short calls?

Long XYZ puts

When an option contract is exercised, the writer:

Must fulfill the obligation to buy or sell the underlying instrument

____________ options are based on the implied volatility of S&P 500 Index options.

VIX

An investor who is long stock and wants to increase her income, but not in the current year, could write:

an American style option that expires in the next year.

A VIX call may be purchased in anticipation of:

an abrupt drop in the market.

British pound option premiums are quoted in:

cents per unit.

Premiums for Australian dollar options are quoted in:

cents per unit.

If an investor adds an equity option to an existing option position to create a straddle, she's considered to have:

"legged" into the position.

An individual purchases two BP (British pound) 150 calls @ 7.50. The contract size is 10,000 BP. The total cost for the contracts is:

$1,500.00 The total cost is calculated by multiplying the contract size (10,000) by the premium expressed in dollars ($0.0750), yielding $750.00 per contract. Since the individual purchased two contracts, the total cost is $1,500.00.

An investor writes 3 uncovered November 85 puts and receives a premium of $6 for each contract. What is the maximum profit that the investor can realize?

$1,800 The writer received $1,800 ($600 premium per contract times 3 contracts). If the options expire worthless, the investor will have no obligations, recognizing the entire premium as profit. This entire premium represents the most that the writer could profit.

A customer writes an IBM October 120 call, receiving a $4 premium, and buys an IBM October 100 call, paying a $12 premium. IBM is currently selling at $108. If he exercises the IBM October 100 call just prior to expiration, what should the stock be selling at in order for the customer to break even?

$108 The customer will call away the stock at the $100 strike price, but receive stock worth $108, for an $8 profit. However, to create the spread, it cost the customer $8 ($12 to buy the October 100 call minus the $4 he received on the sale of the October 120 call).

An individual purchases 10 ABC June 90 calls @ 4 and writes 10 ABC June 95 calls @ 2. The individual's maximum loss is:

$2,000 A simple way to look at a debit spread is to focus in on the buy side of the spread. This is the more valuable option contract and, therefore, defines the investment strategy. Approach the questions as if the investor purchased the 90 call at the net debit of 2 ($2,000 for 10 contracts). The maximum loss when purchasing an option is the premium (net premium).

An investor buys a DEF April 35 put at 3 and simultaneously writes a DEF April 30 put at 1. The maximum that the investor can lose on this position is:

$200 This is a debit spread. The investor paid $200 more for the option purchased than he received for the option sold. If both options expire, he will lose the entire $200, which is his maximum potential loss.

An investor purchases 1 XYZ October 40 put when the market price of XYZ is $41 per share, and pays a premium of $3. What is the maximum profit the investor can have?

$3700 XYZ shares could possibly become worthless. The investor can then buy 100 shares for pennies and put (sell) it to the writer for the $40 per share strike price. This equals $4,000 ($40 x 100 shares). The investors' profit is $4,000 minus the $300 premium paid for the put, which equals $3,700.

An investor purchases an ABC Corporation October 50 put and pays a premium of $7. The underlying security declines to $40 per share. For tax purposes, the proceeds of the sale are:

$4,300 The proceeds of the sale for tax purposes are $4,300 ($5,000 strike price minus the $700 premium paid for the option equals the proceeds of the sale). The cost basis of the stock purchased is $4,000. The customer's profit is then $300.

Mr. Jones buys an XRX October 50 put when the market price of XRX is also $50 per share, and pays a premium of $5. If XRX declines sharply and Mr. Jones exercises the put, what is the maximum profit Mr. Jones can have?

$4,500

An investor purchases 200 shares of STC at $35 and subsequently purchases 2 STC Jan 35 puts at 2. If the puts expire, what is the investor's profit or loss?

$400 loss

With no other securities position, a customer sells short 100 shares of ABC at $40 and sells 1 ABC October 40 put for $500. The customer will break even when the price of the stock is at:

$45

An investor makes an opening sale of 10 option contracts when the bid price was $7.00 and the offer price was $7.10. Later in the day, the investor makes a closing purchase of 10 contracts when the bid price was $6.50 and the offer price was $6.55. Assuming both trades were market orders, what is the investor's gain or loss on these transactions?

$450 capital gain An investor who places a market order will normally buy at the offer and sell at the bid. In this case, the investor sold 10 contracts at the bid price of $7.00, for sales proceeds of $7,000 (10 contracts x $700 per contract). To close out the position, the investor bought 10 contracts at the offer price of $6.55, for a total cost of $6,550 ($655 x 10 contracts). The $450 capital gain is based on the difference between the cost basis and sales proceeds.

A customer buys an ABC July 50 call, paying a $3 premium. Seven months later, the customer exercises the call when the market price of ABC stock is $60 per share. The customer immediately sells the stock for $6,000. When computing the profit, the customer will use a cost basis of:

$5,300 The customer paid $300 for the call option plus $5,000 when he exercised the option at the $50 strike price. The customer's cost basis is, therefore, $5,300.

A customer owns a JRF October 50 listed call option. JRF has declared a $1.00 cash dividend. When JRF sells ex-dividend, which of the following choices will reflect the price and the number of shares of the JRF October 50 option?

$50 strike price, 100 shares Listed call options are not reduced for cash dividends. The strike price and the number of shares of the JRF October 50 option will remain the same after it sells ex-dividend.

A customer writes an XYZ June 60 straddle for a 5-point premium. At expiration, the market price of XYZ is 50 and the put side is exercised. The customer then sells the stock that was put to her at the current market price. The customer has realized a:

$500 loss The customer has received a total of $5 in premiums or $500 for the straddle. The call side of the straddle expires, but the put is exercised. The writer must buy the stock at $60 per share (the exercise price). The stock is then sold at the $50 market price, which results in a $1,000 loss ([$60 - $50] x 100 shares). However, since the customer initially received a premium when she wrote the straddle, the loss is only $500 ($1,000 loss from exercising the put - $500 premium).

An investor writes an uncovered ABC March 45 put for a premium of 4. At expiration, ABC is at $36 per share and the put option is exercised. If the stock is immediately sold by the writer at the current market price, what is the writer's profit or loss?

$500 loss When the stock is put to the writer, he must buy the stock for $4,500. His cost basis for tax purposes is $4,100 ($4,500 strike price - $400 premium received). Since he sold the stock for $3,600, he has a net $500 loss ($4,100 - $3,600).

An investor is long 200 shares of ABC stock at $58 and short 1 ABC May 60 call at 2. What is his breakeven point?

$57 Since this is a position that involves a stock position PLUS an option position, using the phrase "call up and put down" will not work to calculate breakeven. For positions like this, the first step in determining the breakeven point is to calculate the investor's net investment amount. In this question, the investor paid out a total of $11,600 (200 shares x $58 per share), but received $200 in premium on the sale of the call. Therefore, the investor's net investment amount is $11,400. The second step is to recognize that since the investor has a 200 share position, the $11,400 must be divided by 200 to determine the breakeven point of $57.

Ms. Green buys 300 shares of RSW at $15 per share. She then writes 3 RSW July 20 calls at 1 and writes 3 RSW July 10 puts at 50 cents. Ms. Green's maximum potential loss on the entire position is:

$7,050 This is a tricky and involved question in which Ms. Green has written three covered calls and three uncovered puts. In both cases, the maximum loss occurs if the underlying stock (RSW) becomes worthless. If the market price of RSW is zero, the three covered calls will result in a $4,200 loss (300 shares x $15 purchase price minus the $300 premium received). The three uncovered puts will be exercised if the stock declines to zero, which is the worst case scenario. The maximum loss on an uncovered put is the total or aggregate value of the option less the premium received. The aggregate strike price of $3,000 ($10 x 100 shares x 3 contracts) minus the premium of $150 ($.50 x 100 shares x 3 contracts) equals $2,850. Therefore, the total loss is $7,050 ($4,200 + $2,850). A popular answer is a loss of $4,050 (the $4,200 loss - $150 premium received); however, this answer disregards the investor being exercised against on the short puts. Also, students often arrive at a loss of $4,950 by adding the cost of the stock ($4,500), plus the premium received from the sale of the calls ($300), plus the premium received from the sale of the puts ($150). Keep in mind, when an investor is long stock, losses will be realized by the stock declining in value. The answer of $7,050 was determined by assuming that the stock becomes worthless.

On December 16, a Mr. Smith purchased 2 listed XYZ May 70 calls and paid a $4 premium for each call when the current market price of XYZ Corporation was $69 per share. If, in May, the market price of XYZ Corporation is $67 and the calls expire, Mr. Smith loses:

$800 Mr. Smith will not exercise the call options. At expiration, the market price of XYZ is $67, which is less than the exercise price. Therefore, the options expire worthless. Mr. Smith loses $800 ($400 per contract times 2), the entire amount of the premium paid.

Mr. Jones purchases 100 shares of IBM at $116 per share and writes an IBM June 115 call option at 5. Mr. Jones' breakeven point is:

111

A customer owns an AMF October 30 call option. If AMF should split 2 for 1, the customer will own:

2 AMF October 15 calls each for 100 shares

An individual purchases one XYZ 40 call for 4 and one XYZ 50 call for 2. The market price of XYZ stock is currently 43. The individual's breakeven price is:

46 The total cost of the XYZ options is 6. The 40 call would be exercised first, resulting in a total cost of 46 (40 + 6).

A firm is not permitted to accept an exercise notice from a customer for a listed equity option after:

5:30 p.m. Eastern Time on the expiration date of the option

A customer buys an ABC July 50 call, paying a $3 premium. Seven months later, the customer exercises the call when the market price of ABC stock is $60 per share. The customer immediately sells the stock for $6,000. If the customer had sold the option at $8 instead of exercising the option, the profit would have been taxable as:

A $500 capital gain If the customer had sold the option at $8 instead of exercising it, the $5 profit per share ($8 sale minus $3 cost equals $5 profit) would be taxable as a capital gain.

In August, an investor sells an uncovered listed option and receives a $600 premium. The following February, the customer makes a closing purchase transaction at 5. The result of the transaction is:

A capital gain of $100

In May, a customer sells an STC July 40 listed call for a $6 premium and buys an STC July 30 listed call for $10. The customer has created which of the following?

A debit spread executed for a cost of $400 which will be profitable if the price of STC increases Since the investor paid more for the purchase than she received on the sale, this is a debit spread which was executed for a cost of $400. Since the dominant leg is the long call, the position will be profitable if the stock price increases.

_______________ consists of purchasing a put and a call, on the same underlying security, with the same strike price and same expiration.

A long straddle

When a firm's customer exercises a call option, the firm will submit an exercise notice to the Options Clearing Corporation. The Options Clearing Corporation, in turn, will select a firm to receive the exercise notice based on:

A random selection basis

_____________________ consists of selling a put and a call, on the same underlying security, with the same strike price and expiration.

A short straddle

An investor who sells a July 50 put and buys a July 60 put on the same stock is establishing a:

Bear spread

An investor bought 5 NJF June 45 puts for a premium of 3 points per contract. For these options to have intrinsic value, the market price of NJF needs to be:

Below $45 A put will have intrinsic value, also known as being in-the-money, when the market price of the underlying security is less than the strike price. In this example, the option gains intrinsic value below $45.

A client buys 5 EW April 75 puts and sells 5 EW April 80 puts. This type of strategy is:

Bullish

A customer wishes to close out a short option position by liquidating the option. The registered representative should mark the order ticket:

Closing purchase

Equity options expire on:

The third Friday of the expiration month at 11:59 p.m. Eastern Time

An exercise limit is the maximum number of options contracts that a customer may exercise in a five-consecutive-business-day period for each:

Underlying stock on each side of the market

A spread involves the purchase and sale of the same type of options (calls or puts). If the contracts differ in expiration, it is: If the contracts differ in exercise (strike) price, it is: If both expiration and exercise price are different, it is:

a horizontal spread. a vertical spread. a diagonal spread.

The sale of uncovered options may be executed only in:

a margin account.

Selling a call and a put on the same security with different strike prices, or different expiration dates, is:

a short combination.

The number of shares can be adjusted for:

a stock dividend or an odd stock split

By buying and selling put options with the same expiration month and different exercise prices, the client is creating:

a vertical (price) spread

Buying a call is more profitable than buying a straddle if the underlying security:

appreciates in value.

A credit call spread is a ______________ option strategy, but a debit call spread is a ______________ option strategy.

bearish bullish

Buying two calls with different strike prices is a _____________ strategy.

bullish

A credit put spread is a ______________ option strategy, but a debit put spread is a _____________ option strategy.

bullish bearish

Since the individual is bullish, he should: A bearish investor should:

buy calls and/or write puts on the underlying stock. buy puts or write calls.

Because the VIX is a way to predict market declines, some investors call the VIX the fear index. The implied volatility of options, as well as the VIX itself, will increase when the S&P Index:

decreases in value (i.e., an inverse relationship).

If an ETF option is exercised, shares of the ETF will be:

delivered.

Exercise and position limits apply cumulatively to all accounts that a customer maintains at all brokerage firms, not for:

each account at each firm.

As the purchaser of a put option there is more than one way the investor could profit. The investor could profit by:

either exercising or liquidating the put

A foreign company that's selling goods in the U.S. and receiving U.S. dollars may also buy ________________ to hedge.

foreign currency calls

An American company that's buying goods from a foreign country and paying in that country's currency may buy ______________ to hedge.

foreign currency calls

For a stock dividend or an odd split, the number of contracts is kept constant while the number of shares per contract is:

increased.

A diversified stock portfolio can be hedged by purchasing:

index option puts.

Since the investor is bullish on mining stocks, buying ______________________________ on mining stocks is appropriate. Since the investor expects the overall market to fall, buying _______________________ is appropriate.

narrow-based index calls broad-based index puts

This is an example of a credit spread (more premium received for the option sold than paid for the option purchased). In a credit spread, the investor will profit if the spread (difference in premium):

narrows.

A ratio call writing strategy (variable hedge) is an option position in which more call options are written than the number of shares owned by the investor (and available to cover the calls). For example, 2 calls are written against only 100 long shares. The position's strategy is __________________ and investors are exposed to:

neutral unlimited potential risk.

Straddle writers expect a _______________________ and obtain the maximum gain if each option expires.

neutral market

The majority of listed options contracts have a maximum life of:

nine months.

Index options are cash settled, which means that:

no securities are delivered or received at exercise.

Whether an option is in- or out-of-the-money is NOT based on the option's:

premium.

A client with an options account takes the following position: Long GHI Nov 65 puts and Short GHI Nov 55 puts. This position will be:

profitable if the market price of the security declines.

The writer (seller) of a put option is obligated to purchase stock if the buyer of the put option exercises the contract. If a customer is short stock and is short a put, she is said to be covered on the transaction since she is already required to:

purchase the shares to cover the short sale transaction.

A short call position obligates the investor to:

sell shares if the option is exercised.

The purchase of a call will provide protection against a price increase in the short stock. If the stock price increases, the holder can exercise the call and buy the stock at the strike price. This limits Mr. Smith's loss. The breakeven is the:

short sale proceeds minus the premium paid for the call.

The maximum loss for the buyer of an option is equal to:

the maximum gain for the writer of that option (i.e., the premium).

Option trades (simple purchases or sales of calls or puts) settle on:

the next business day (T + 1)

The breakeven formula for call buyers is:

the strike price plus the premium.

European style options may be exercised only on the day the contract expires—the expiration date. The expiration date for standardized option contracts, including European-style options, is the:

third Friday of the expiration month.

An uncovered (naked) call has:

unlimited risk

Sold a put and is short the stock the investor has:

unlimited risk

However, this is an extremely risky position and the client's maximum loss is unlimited since two calls were written against a long stock position of only 100 shares. This client is covered on one short call, but uncovered on the second short call, which results in the maximum loss being _____________.

unlimited.

Call options with lower strike prices are more __________________ than those with higher strike prices.

valuable (dominant)

Put options with higher strike prices are more ________________ than those with lower strike prices.

valuable (dominant)

A butterfly call spread consists of two long calls and two short calls. The two short calls have the middle strike price, while one long call has a higher strike price and the other long call has a lower strike. The maximum gain is found:

when the stock closes at the middle strike price; therefore, the investor's strategy is for the stock's price to remain neutral.

The ____________ of a combination (a call and a put) believes the underlying security's price will remain stable. The ___________ of a combination expects that the market price of the underlying security will be volatile.

writer (seller) buyer