Equity Options--Fundamentals and Basic Strategies
Which TWO of the following financial products are defined as derivatives? I. Collateralized mortgage obligations II. Commercial paper III. Call options IV. Corporate high-yield bonds
I and III Explanation: A derivative is a financial product that derives its value from movements in another financial product. If the price of the underlying security changes in value, the price of the derivative will fluctuate. For example, a CMO is a security backed by other mortgage-backed securities. If changes occur to the prices of these securities due to fluctuating interest rates and other factors, the price of the CMO will change. The price of an option contract is based on changes in the underlying security. A call option provides the holder the right to buy a security at a specified price. If the underlying security increases in value, the value of the call option will rise. Other types of derivatives include warrants and convertible bonds.
A writer of an uncovered call option will profit in which TWO of the following circumstances? I. The underlying common stock goes up II. The underlying common stock goes down III. The call expires unexercised IV. The call is exercised
II and III Explanation: A writer or seller of an uncovered call option does not own the underlying stock. If the underlying stock goes down, the call will not be exercised. If the call option expires, the writer will keep the premium paid by the buyer of the option and will no longer be exposed to a possible loss if the stock goes up. If the underlying stock goes up, the option will be exercised and the writer will be obligated to deliver stock. The writer will need to purchase the stock at the current market value and will incur a loss due to the difference between the market value and the strike price less the premium received. The answer, therefore, is a writer of an uncovered call option will make money if the underlying common stock goes down and/or the call expires unexercised.
An investor writes an uncovered RST May 25 put for a premium of 4. The maximum loss the investor could sustain is: a. $2,100 b. $2,500 c. $2,900 d. $3,500
a. $2,100 Explanation: If RST Corporation's market price declines to pennies per share, the owner of the put could buy the RST stock for pennies and put it to the writer for $25 per share, or $2,500. This is the price that the writer would be required to pay for the stock. However, since the writer received $400 in premium, the maximum loss he could have will be $2,100 ($2,500 loss - $400 premium = $2,100 loss).
An investor writes an uncovered ABC March 50 call for a premium of 4. At expiration, ABC is at $56 per share and the call option is exercised. If the stock is purchased by the writer at the current market price for delivery, what is the writer's profit or loss? a. $200 loss b. $400 loss c. $1,000 loss d. $1,000 profit
a. $200 loss Explanation: When the stock is called away from the writer, he is obligated to sell the stock at the strike price of 50, receiving $5,000. The writer also received the premium of $400. Since the stock cost $5,600 to buy in the market, the writer incurs a loss of $200 ($5,600 cost - $5,400 received).
An investor writes an uncovered RST May 25 put for a premium of 4. At what market price will the investor break even? a. $21 b. $25 c. $29 d. $35
a. $21 Explanation: The writer calculates his breakeven point by deducting the $4 premium from the $25 exercise price. The writer will, therefore, break even at $21.
An investor writes an uncovered RST May 25 put for a premium of 4. When RST is at 16, the put option is exercised. If the stock is immediately sold at the current market price, what is the investor's profit or loss? a. $500 loss b. $500 profit c. $900 loss d. $900 profit
a. $500 loss Explanation: If the stock is put to the writer, he would have to buy the stock for $2,500. His cost basis for tax purposes would be $2,100 ($2,500 strike price - $400 premium received). Since he then sold the stock for $1,600, he would have a net $500 loss ($2,100 - $1,600).
An individual who is bearish or wants protection against a downside move in the market will probably: a. Buy a put option b. Sell a put option c. Buy a call option d. Write an uncovered call
a. Buy a put option Explanation: An individual who is bearish will buy a put option. If the market declines, the individual will purchase the security in the market at a lower price and put (sell) it to the writer at the higher agreed-upon strike price.
What is the intrinsic value and the time value of the call premium if ABC is trading at 43 and the ABC April 40 call is trading at 4.50? a. Intrinsic value is 3 and the time value is 1.50 b. Intrinsic value is 3 and the time value is 4.50 c. Intrinsic value is 1.50 and the time value is 3 d. Intrinsic value is 4.50 and the time value is 0
a. Intrinsic value is 3 and the time value is 1.50 Explanation: The call is in-the-money (has intrinsic value) since the market price is above the strike price. The in-the-money amount of 3 points is intrinsic value, and the balance of the premium is time value (1.50).
An investor writes an uncovered XYZ June 15 put for a premium of 2. What is the maximum loss the investor could incur? a. $200 b. $1,300 c. $1,700 d. Unlimited
b. $1,300 Explanation: The lowest XYZ could decrease is to zero. The owner of the put could buy the stock for pennies and put (sell) it to the writer for $15 per share ($1,500). This is the price at which the writer will be required to buy the stock. However, since the writer received the $200 premium, the maximum loss is $1,300 ($1,500 loss - $200 premium received = $1,300 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? a. $300 b. $3,700 c. $3,800 d. Unlimited
b. $3,700 Explanation: 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 investor's profit is $4,000 minus the $300 premium paid for the put, which equals $3,700. The $3,700 is the maximum profit the investor can have since the share's price cannot go lower than zero.
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? a. $400 loss b. $500 loss c. $400 profit d. $900 profit
b. $500 loss Explanation: 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 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: a. 44 b. 46 c. 52 d. 56
b. 46 Explanation: Buying two calls with different strike prices is a bullish strategy. In this example, since one of the strike prices is higher and out-of-the-money, it is less expensive than buying two calls with the same strike price. 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). This is the amount at which the individual would need to sell XYZ stock to break even. If the market price of the stock is trading at any other value, the client would either have a profit or loss. For example, if the market price at expiration is $52, the client will have a $1,200 gain on the 40 call (52 - 40) and a $200 gain on the 50 call (52 - 50). The total gain of $1,400 less the combined $600 premium equals an $800 profit.
If 70 Ford Motor option contracts were traded on a particular day, how many shares of Ford Motor Corporation common stock does this represent? a. 700 b. 7,000 c. 70,000 d. 700,000
b. 7,000 Explanation: The number of shares would be 7,000, as each contract represents 100 shares. There were 70 contracts traded (70 contracts x 100 shares = 7,000 shares).
Which of the following choices is NOT TRUE about buying listed put options versus selling the underlying stock short? a. Buying a put will require a smaller capital commitment b. Buying a put has a larger potential loss than selling the stock short c. The put has time value that gradually dissipates d. Buying a put is not subject to the Regulation SHO requirement to borrow shares
b. Buying a put has a larger potential loss than selling the stock short Explanation: Choice (b) is not true. Buying a put has a smaller potential loss than selling the underlying stock short. The maximum loss when buying a put is limited to the premium paid. The loss when selling short is unlimited. All of the other statements are true. The cost for the premium of a put is substantially less than the Regulation T margin requirement for a short sale. The purchase of puts is not subject to the borrowing requirements of Regulation SHO, whereas short sales of equities are. An option's premium consists of intrinsic value and/or time value. Time value gradually dissipates as an option nears its expiration.
If an ABC July 40 put option is exercised, the writer: a. Is obligated to deliver 100 shares of ABC stock b. Is obligated to purchase 100 shares of ABC stock c. Pays the in-the-money amount d. Receives the in-the-money amount
b. Is obligated to purchase 100 shares of ABC stock Explanation: If the ABC put option is exercised, the writer is obligated to purchase 100 shares of ABC stock.
One of your clients anticipates a significant decline in XYZ stock. The client wants to establish a position to take advantage of a large decline, but not expose himself to significant risk. Which of the following actions best satisfies your client's needs? a. Short XYZ stock b. Purchase an XYZ put c. Purchase an XYZ straddle d. Establish an XYZ debit put spread
b. Purchase an XYZ put Explanation: A long put will allow your client to realize a gain determined by the amount the stock falls below the option's strike price, less the premium. The investor is at risk only for the amount paid for the put, i.e., the premium. In selling XYZ short, an investor exposes himself to unlimited risk. When purchasing a straddle, the investor pays a premium greater than when purchasing only one put on the stock. While the debit put spread is bearish, the gain is limited to the difference between the strike price on the long put and the strike price on the short put, less the net premium.
It is most beneficial to the holder of a call if the price of the underlying security is: a. Falling b. Rising c. Remaining the same d. Fluctuating
b. Rising Explanation: The holder (purchaser) of a call expects the market price of the underlying security to rise and, therefore, will profit from a rise in the security.
Which one of the following events will NOT result in a profit to an uncovered call writer? a. The price of the underlying security falls below and remains below the exercise price of the option b. The call is exercised and the underlying security price is greater than the exercise price plus the premium received c. The price of the option contract declines d. The option contract expires without being exercised
b. The call is exercised and the underlying security price is greater than the exercise price plus the premium received Explanation: An uncovered call writer does not own the underlying stock. If the market price of the underlying stock rises above the exercise price, the stock will be called away. If the market price rises above the exercise price by an amount exceeding the premium, the difference in prices will represent the loss to the writer. For example, if an individual writes 1 XYZ July 50 call for 5 and the market price rises to 60, the stock will be called away. The writer will be required to buy the stock at 60. Since the investor received only 55 (exercise price of 50 plus premium of 5), there will be a 5-point loss.
Which of the following statements is TRUE regarding the purchaser of a call option? a. The purchaser has an obligation to sell stock if exercised b. The purchaser limits the amount of money he could lose if the underlying stock declines c. The purchaser benefits if the underlying stock declines d. The only way to profit is to exercise the option
b. The purchaser limits the amount of money he could lose if the underlying stock declines Explanation: The maximum loss that a purchaser of an option (call or put) can sustain is the amount of the premium paid. The purchaser of a call option will profit if the underlying stock increases in value, and exercises the call only if the stock is above the strike price. The investor can profit by either exercising or liquidating the call. A purchaser of a call option has the right to buy stock, not an obligation to sell stock.
An investor purchases 10 two-year ABC puts @ 12.25. The dollar amount the investor will pay is: a. $122.50 b. $1,225.00 c. $12,250.00 d. $122,500.00
c. $12,250.00 Explanation: The cost of a long-term equity option is found by multiplying the premium quote by $100. The cost of 10 puts quoted at 12.25 is, therefore, $12,250 (12.25 x $100 x 10 = $12,250).
If ABC stock is currently trading at 35.25 and the October 35 put option has a premium of 2.25, what is the time value of this option? a. Zero b. $200 c. $225 d. $250
c. $225 Explanation: Time value is calculated by taking the difference between an option's premium and its intrinsic value. Since the market price of the stock is greater than the strike price of the put option, this option is out-of-the money and has no intrinsic value. The entire premium of this option, $225, is considered the time value.
A customer buys an IBM call option and pays a 2.50 point premium. The aggregate dollar amount paid is: a. $2.50 b. $25.00 c. $250.00 d. $2,500.00
c. $250.00 Explanation: Each option contract is based on 100 shares of common stock. The dollar amount paid is $250 ($2.50 x 100 shares).
An investor purchases 10 XYZ October 40 puts when the market price of XYZ is $41 per share, and pays a premium of $3. What is the maximum loss this investor could incur? a. $300 b. $2,000 c. $3,000 d. $37,000
c. $3,000 Explanation: A buyer of a call or put option pays the premium based on 100 shares of stock. The call option buyer has the right to call (buy) 100 shares of stock at the exercise (strike) price. The put option buyer has the right to put (sell) 100 shares of stock at the exercise price. In both cases, the premium the buyer pays is the maximum amount of money that can be lost if the option expires worthless. The total premium of $3,000 ($300 per contract) is the maximum amount of money the investor can lose.
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? a. $50 b. $500 c. $4,500 d. $5,000
c. $4,500 Explanation: If the stock became worthless, Mr. Jones could then buy 100 shares and put it (sell it) to the writer for the $50 per share strike price, which equals $5,000 ($50 x 100 shares = $5,000). Mr. Jones would then make a profit of $5,000 minus the $500 premium paid for the put, which would be $4,500. The $4,500 is the maximum profit Mr. Jones could have since the stock could go no lower than zero.
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: a. $4,700 b. $5,000 c. $5,300 d. $6,000
c. $5,300 Explanation: 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. The strike price plus the premium equals the cost basis for a buyer of a call who is exercising the option.
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: a. $400 b. $700 c. $800 d. $1,400
c. $800 Explanation: 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.
An investor purchases a British pound 160 put at 4 when the British pound is at 157. The intrinsic value of the option is: a. 10 b. 7 c. 3 d. 0
c. 3 Explanation: Intrinsic value is defined as the in-the-money amount of the contract. A foreign currency put option is in-the-money when the spot price is less than the strike price. Since the spot price (157) is less than the strike price (160), the contract is in-the-money by 3 points.
On September 22, a customer purchases 2 listed XYZ May 70 calls and pays a $4 premium for each call. The current market price of XYZ Corporation is $69 per share. What is the customer's breakeven point? a. 66 b. 73 c. 74 d. 78
c. 74 Explanation: The strike price plus the premium equals the breakeven point for the buyer of a call. The breakeven point is $74 (the $70 strike price + the $4 premium = $74). The fact that the investor bought multiple contracts is not relevant since the breakeven point is a price per share.
Compared to selling short, buying a put option: a. Requires a larger capital commitment b. Has a larger loss potential c. Does not require the client to arrange to borrow the stock d. Requires a margin account
c. Does not require the client to arrange to borrow the stock Explanation: Short selling requires the deposit of margin, whereas the premium on a put is usually substantially less than the Regulation T margin requirement. On a short sale, the seller's risk is unlimited, whereas on a put purchase, the risk is limited to the premium. Although a short sale may be effected only if the stock can be borrowed under Regulation SHO, a put may be purchased at any time. Puts can be purchased in a cash account, while selling short requires a margin account.
Which of the following statements is NOT TRUE regarding the characteristics of options and warrants? a. Warrants are created by the corporation whose stock underlies the instrument, and options are created by contract between an option buyer and an option writer b. Both options and warrants can expire worthless if they are not exercised c. If options are exercised, a set price must be paid for the underlying security and, if warrants are exercised, the securities are received at no additional cost d. Both options and warrants can be bought and sold in the secondary market
c. If options are exercised, a set price must be paid for the underlying security and, if warrants are exercised, the securities are received at no additional cost Explanation: Both options and warrants have a strike price. If exercised, the transactions for the underlying security will occur at that set price. It is in the case of convertible bonds or convertible preferred stock that investors can convert the security into the underlying stock with no additional payment of money.
Which of the following option positions obligates the investor to sell shares if exercised? a. Long a call b. Long a put c. Short a call d. Short a put
c. Short a call Explanation: A short call position obligates the investor to sell shares if the option is exercised.
An investor is convinced that a stock will decline in value. If the investor wishes to act on that conviction, which investment strategy will allow him to take advantage of a decline with the smallest amount of cash outlay? a. The investor should sell the stock short b. The investor should buy a call c. The investor should buy a put d. The investor should sell a put
c. The investor should buy a put Explanation: The investor should buy a put. By buying a put, the investor could go into the market if the stock declined and buy the stock at a lower price. He would exercise the put and sell the stock to the writer at the exercise price. Buying a put costs less money than selling short because the short position requires a 50% deposit with a minimum margin deposit of $2,000. The investor will not sell (write) a put because the writer of a put option would profit if the market price increased above the strike price and the put expired worthless. The purchaser of a call anticipates an increase in market prices and, in this example, there is an anticipation of a decrease in market prices.
When buying listed put options versus selling the underlying stock short, which of the following choices is NOT an advantage? a. Buying a put would require a smaller capital commitment b. Buying a put has a smaller dollar loss potential than selling the stock short c. The put has a time value beyond an intrinsic value that gradually dissipates d. Buying a put is not subject to Regulation SHO
c. The put has a time value beyond an intrinsic value that gradually dissipates Explanation: Choice (c) is a correct statement, but it is not an advantage for the buyer of a put. An options premium may consist of intrinsic value and/or time value. The portion of the premium represented as time value declines over time. For example, if an XYZ July 50 put is purchased for $5 when the market price is $47, the intrinsic value (in-the-money value) is $3 and the time value is $2. As the put nears expiration, the time value gradually dissipates, which is a disadvantage to the buyer. All of the other statements are advantages of buying a put as opposed to selling short. The premium of a put is substantially less than the Regulation T margin requirement for a short sale. In a put purchase, the potential loss is limited to the premium, while the potential loss on a short sale of stock is unlimited. The purchase of puts is not subject to the borrowing requirements of Regulation SHO, whereas short sales of equities are.
Listed options are issued and guaranteed by: a. FINRA b. The company whose stock underlies the contract c. The exchange where the options trade d. The Options Clearing Corporation
d. The Options Clearing Corporation Explanation: Options that are listed on exchanges are issued and guaranteed by the Options Clearing Corporation. The exchange on which the option trades sets the terms of the option contract.
Which of the following statements is NOT TRUE regarding the purchaser of a put option? a. The purchaser has a right to sell stock b. The purchaser limits the amount of money he could lose if the value of the underlying stock increases c. The purchaser benefits if the value of the underlying stock declines d. The only way to realize a profit is to exercise the option
d. The only way to realize a profit is to exercise the option Explanation: Choice (d) is not true. The investor could profit by either exercising or liquidating the put. The other choices are true statements. The purchaser of a put has a right to sell stock. The maximum loss that a purchaser of an option (put or call) can sustain is the amount of the premium paid. The purchaser of a put can profit if the underlying stock declines in value.
All of the following trades may be executed in a cash account, EXCEPT the sale of a(n): a. Common stock b. Preferred stock c. Covered call option d. Uncovered call option
d. Uncovered call option Explanation: All of the trades listed may be executed in a cash account except the sale of an uncovered call option. If the option is exercised, the writer must buy stock at an unknown market price. The sale of uncovered options may be executed only in a margin account.
