Series 65 Unit 2 Derivative Securities - Options

You have a client who has sold short 100 shares of RIF, a stock listed on the NYSE. If the client wished to use options to protect against unlimited loss, you would suggest the client: A) buy 1 RIF put. B) sell 1 RIF call. C) sell 1 RIF put. D) buy 1 RIF call.

Answer: D Buying a call option on a stock you are short will give you a guaranteed covering cost, thus preventing against unlimited loss. This is the best way to hedge a short position.

A stock currently sells for $75 per share. If a put option on the stock has an exercise price of $70 and currently sells for $0.50, the put option is: A) at-the-money. B) in-the-money. C) at breakeven. D) out-of-the-money.

Answer: D This put option has a zero intrinsic value and is therefore out-of-the-money by the $5 difference by which the market price exceeds the strike price. A put option has intrinsic value or is in-the-money when the current market price of the underlying asset is less than the exercise price (in this example, $70).

An investor is long stock in a cash account and does not expect the price to change in the immediate future. His best strategy to generate income may be to: A) buy a put. B) sell a call. C) sell a put. D) buy a call.

Answer: B Selling a call against a security will generate additional income (the premium). An investor who writes a put receives additional income from the position but must also be willing to increase his position should the put be exercised. An investor who buys a call is speculating that the stock will soon rise dramatically. An investor who buys a put is speculating the stock will soon fall, not stay steady in price.

An investor would write a call option to: A) seek long-term capital gain. B) obtain income. C) protect the premium. D) fix the purchase price to add stock to his portfolio.

Answer: B The writing (selling) of an option always generates premium income to the writer. If the call is exercised, the writer must sell the stock so this is not a way to add to your portfolio. In general, option writers only realize short-term gains, not long-term. If the question had said this was a covered call, then the second best choice would have been to protect the long position (not the premium).

An investor is short stock at 60. The current market price of the stock is 35, and he anticipates it will continue to decline. If he thinks the price will rise temporarily and if he does not wish to close out his short position, his best strategy to prevent a loss would be to: A) Sell an XYZ 35 put B) Buy an XYZ 35 call C) Sell an XYZ 35 call D) Buy an XYZ 35 put

Answer: B This client is temporarily bullish on the stock, but, in the long term, feels that it will continue to decline so the short stock position is to be maintained. If the client is correct, a near-term rise in the price of XYZ will cause the long 35 call to be in the money and the investor can sell the call at a profit. When it comes to hedging a short stock position, buying a call is always the best strategy.

A commodities speculator purchases a 1,000 bushel wheat futures contract at 50 cents per bushel. At expiration, the settlement price is 45 cents per bushel. This individual A) has a $50 gain B) must make delivery of the wheat C) ​effectively hedged the long wheat position D) has a $50 loss

Answer: D The simple math is, the individual bought at 50 cents and sold at 45 cents, losing 5 cents per bushel. Multiply 5 cents ($.05) times 1,000 bushels and the loss is $50.​ ​It is the seller who is obligated to deliver; the buyer of the contract must accept delivery (unless there was an offsetting transaction prior to expiration). This individual was long the futures contract, not long (the owner of) the wheat.

Which of the following is not considered to be a derivative? A) Warrant. B) Unit investment trust. C) Call option. D) Futures contract.

Answer: B All of the other choices "derive" their value from some underlying asset. A UIT is an investment company and its value is based on its own assets.

A farmer entered into a forward contract to sell his produce at $2.25 per bushel. At the expiration date of the contract, the price was $2.00 per bushel. The farmer would receive A) $2.00 B) a price negotiated between the buyer and seller C) $2.125 per contract D) $2.25

Answer: D The reason the farmer entered into this contract was to hedge against a drop in price. Because the strike price was higher than the market price at expiration, the farmer made a good deal, while the buyer of the contract lost.

An option that may be exercised prior to its expiration date is said to be: A) European style. B) Premature style. C) Flexible style. D) American style.

Answer: D There are two forms of option exercise - American and European. American style can be operationally exercised any day that the market is open before the expiration date. With European style, the only time you can operationally exercise your contract is the last trading day before expiration. Remember, even though there is only one day in which you can exercise your contract, you can always close out your option position in the secondary market any day prior to expiration.

An investor who is long XYZ stock would consider going long an XYZ call to: A) hedge the long position. B) obtain income from the premium. C) protect against an increase in the market price of XYZ stock. D) protect against a decrease in the market price of XYZ stock.

Answer: C Going long a call means that you have bought it. Only sellers of options generate income. If you wish to hedge your long stock position, you buy a put, not a call. That leaves us with two choices that are polar opposites. Good test taking skills teach us that, in almost all cases, when we see that, one of those must be the right answer. Buying a call is bullish. Forget the first part (you are long the stock). You would buy a call so that, if the price of the stock went up, you could exercise at the lower strike price of your call option.

Among the benefits of purchasing derivatives would be: I. leverage. II. increased income. III. unlimited potential gain. IV. protection against loss. A) I, II, III and IV. B) I, III and IV. C) III and IV. D) I and II.

Answer: B Any derivative offers the benefit of a small dollar outlay controlling a large investment (leverage). In the case of call options or some other long derivative positions, the gain potential is theoretically unlimited. The purchase of options and certain other derivatives can offer protection against loss. But, in order to generate income, you must sell the derivative, not buy.

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

Answer: B 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.

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

Answer: D 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.

Purchasers of options can have a number of different objectives. One of your clients who is a soft drink fan already has a long position in KO. What would be a possible reason for this client to go long a KO call option? A) This would generate additional income. B) To fix the cost of acquiring additional stock to the portfolio. C) To complete the other side of a spread. D) Owning a long call on stock you already own offers a hedge against a market decline.

Answer: B Those who are bullish on a stock, but don't have sufficient funds at this time to purchase the stock, can "lock-in" their future cost by going long a call. Income is generated only through selling options. Since a long call is on the same side of the market as long stock, there is no hedge. A spread involves a long and short option.

Due to an escalating trade war, the portfolio manager of an equity mutual fund anticipates a negative impact on his fund's assets. To protect his investment portfolio, the fund manager would: A) sell S&P 500 index puts. B) buy S&P 500 index puts. C) buy S&P 500 index calls. D) sell S&P 500 index calls.

Answer: B A portfolio manager who expects a decline in the market as a result of a trade war (or any factor that might hurt stock prices) would buy puts on a broad market index such as the S&P 500 to protect his position. Selling calls limits upside potential, and only protects the portfolio to the extent of the income received from the sale of the calls.

Which of the following is a multi-option strategy? A) Straddle B) Long call C) Short call D) Protective put

Answer: A A straddle consists of a put and call on the same stock with the same strike price and the same expiration date. Therefore, with two option positions, it is a multi-option strategy.

Which of the following statements is most accurate when describing equity straddle options? I. The option buyer is looking for market volatility. II. The option buyer is looking for market stability. III. The option seller is looking for market volatility. IV. The option seller is looking for market stability. A) I and IV. B) I and III. C) II and III. D) II and IV.

Answer: A A straddle is the combination of a put and a call on the same stock with the same strike prices and expiration dates. The solution to the question is the same for any option position in that option buyers need price movement and option sellers make money from stability. In the case of a straddle, a buyer is expecting sharp movement but does not know the direction of the move. The seller of the straddle will benefit if there is no significant price movement.

Which of the following best defines a derivative? A) an investment whose value is based upon another asset B) a hedge C) an option D) an investment created from off-book assets

Answer: A Derivatives derive their value based on some other asset. Options are one form of derivative securty and may be used to hedge a position, but neither term specifically defines a derivative.

The term, "derivative", would not apply to which of the following? A) REITs. B) forwards. C) futures. D) LEAPS.

Answer: A REITs are not based on the value of something other than their own assets. LEAPS are options and futures and forwards are contracts whose value is based on some underlying asset.

If an investor purchases 500 shares of an aggressive growth stock, which strategy would limit his downside risk? A) Buying 5 calls on the stock. B) Writing 5 puts on the stock. C) Writing 5 straddles. D) Buying 5 puts on the stock.

Answer: D A put gives the investor the right to sell stock at a set price (the strike price) for a period of time, and protects against losses below the strike price. Buying calls can protect a short stock position. If the customer is long stock, the purchase of calls on that security increases leverage and risk. Writing a put creates the obligation to buy more stock at the strike price, which increases downside risk.

A client calls to say he has just read about a European option and doesn't know what it is. You would explain that it is a derivative because: A) its value is based on some underlying asset. B) it can only be exercised on the expiration date. C) intrinsic value does not affect the premium. D) the currency used is generally something other than the U.S. dollar.

Answer: A Although the unique characteristic of a European option is that it can only be exercised on its expiration date, that doesn't answer this question. It is a derivative like any other option because its value is based on the underlying asset.

For which of the following is there no active secondary market? A) Options. B) ETFs. C) Forward contracts. D) Futures contracts.

Answer: C One of the disadvantages when investing in forward contracts is that there is no active secondary market. Because each contract is between one buyer and one seller and there is no standardization, no exchange trading is possible.

Which of the following strategies would most effectively protect an investor with a short stock position? A) Sell a put. B) Sell a call. C) Buy a call. D) Buy a put.

Answer: C Purchasing a call on the security protects the customer from a loss in excess of the strike price plus the cost of the call should the security rise in price.

Nonsecurities derivatives would include I. Forward contracts II. Futures contracts III. Hedge funds IV. REITs A) I, II, and IV B) I and II C) I and IV D) I, II, and III

Answer: B Forward contracts and futures contracts are known as nonsecurities derivatives because they derive their value from something that is not a security. REITs and hedge funds are securities, not derivatives.

The term "derivative" would apply to all of the following EXCEPT A) options B) hedge funds C) forwards D) futures

Answer: B Hedge funds are pooled investments, a form of investment company, and are not derivatives as are the other three choices. This is one example of a question where you get the correct answer by knowing the other three choices are not the exception.

A corporation sponsors a defined benefit pension plan. The assets of the plan are invested in a diversified portfolio of large-cap stocks. Which of the following options positions would be most appropriate if the corporation wished to protect their ability to meet their obligations to employees? A) Buy S&P 500 index puts. B) Buy S&P 500 index calls. C) Sell S&P 500 index calls. D) Sell S&P 500 index puts.

Answer: A In a defined benefit plan, the corporation is assuming the investment risk. Regardless of the security, the best way to protect a long position is to buy a put, either on that security or an index with a close correlation. In this case, with a portfolio of large-cap stocks, the S&P 500 index would seem to be the appropriate option to use.

An investor who buys a stock and wishes to limit the potential downside risk should: A) buy a put. B) buy a call. C) enter a sell limit order. D) enter a buy stop order.

Answer: A The purchase of a put limits the downside risk to the difference between the stock price and the put's strike price.

An investor wishes to be able to obtain the right, but not the obligation, to purchase 100 shares of KAPCO common stock at $50 per share for the next 6 months. KAPCO is currently selling for $52 per share. This investor's wishes could be met by the A) purchase of a forward contract B) purchase of a call option C) purchase of a pre-emptive right D) sale of a put option

Answer: B A call option gives the holder the right, but not the obligation, to buy an asset at a specific price during a specific period. Although it would be possible to purchase a stock right in the open market, it is unlikely to ever find one with an expiration date more than 45 days from issuance. Selling a put creates an obligation on the seller to buy the stock if the option is exercised and there are no forward contracts on stock.

An investor who is long a put option for 100 shares of ABC common stock A) has the right to buy 100 shares at the lower of the exercise or market price B) has the right to sell 100 shares at the stated exercise price C) has the right to buy 100 shares at the stated exercise price D) has the right to sell 100 shares at the higher of the exercise or market price

Answer: B One who is long a put is an owner of the option. Owning a put option gives the holder the right to sell the underlying asset (in this case 100 shares of ABC stock) at the stated exercise (or strike) price. This would be advantageous if the strike price is above the current market price.

Which of the following statements about options are TRUE? I. An option is in-the-money if, disregarding the premium paid, exercising the option would be profitable. II. If the owner of an option does not exercise the option, the option will eventually expire. III. If an option expires, the holder loses only the premium the holder paid for the option. A) II and III. B) I, II and III. C) I and II. D) I and III.

Answer: B When conditions are such that exercising an option, without regard to any premium paid, would be profitable, the option is said to be in-the-money. An option will eventually expire if the owner does not exercise it. In that case, the owner's losses are limited to the amount paid for the option, known as the premium.

Writing an option provides all of the following EXCEPT: A) hedging. B) maximum protection against loss. C) income. D) limited downside protection when long the underlying asset.

Answer: B Writing an option provides only limited protection for a long or short position. That protection is limited to the amount of the premium received.

Which of the following financial instruments is NOT a derivative? A) A call option. B) LEAPS. C) A share of stock. D) A put option.

Answer: C A derivative is a type of financial instrument that derives its value from another asset or combination of assets. The best known examples of derivatives are options, of which puts, calls, and LEAPS are examples.

Which of the following is a multi-option strategy? A) short call. B) protective put. C) straddle. D) long call.

Answer: C A straddle consists of a put and call on the same stock with the same strike price and the same expiration date. If the investor has purchased both options, it is known as a long straddle; if they've both been sold (written), it is known as a short straddle. Therefore, with two option positions, it is a multi-option strategy.

Which one of the following option positions would generally command the greatest time value? A) puts B) straddles C) LEAPS D) calls

Answer: C LEAPS, the acronym for Long-term Equity Anticipation Securities, have expiration dates that can run more than 3 years compared to the 9 months for standard option contracts. Because time value is a direct function of the length of the option, the longer the time until expiry, the greater the potential time value.

Options positions can either create rights or obligations. In which option position has the investor created the possible obligation to purchase stock? A) Purchasing a call. B) Selling a call. C) Selling a put. D) Purchasing a put.

Answer: C When you sell, (write, go short) an option, you create an obligation. In the case of a put, you are obligated to purchase stock that is "put" to you. In the case of a call, you are obligated to sell stock that is "called" away from you. Option buyers have rights, they can choose what they wish to do - there are no obligations.

The type of security that gives the holder the right, but not the obligation, to sell a certain number of shares of stock for a specified price during a specified period is a: A) call option. B) currency swap. C) stock index future. D) put option.

Answer: D A put option gives the holder the right to sell a certain number of shares of stock for a certain price within a certain period. A call option gives the holder the right to buy shares of stock for a certain price during a certain period.

All of the following positions expose a customer to unlimited risk EXCEPT: A) Short 200 shares of XYZ. B) Short 2 XYZ uncovered calls. C) Short 200 shares of XYZ and short 2 XYZ puts. D) Short 2 XYZ uncovered puts.

Answer: D A put writer will lose money if the stock goes down, but the furthest it can drop is to zero. Therefore, the potential loss is not unlimited. All of the other positions expose the client to unlimited risk because a loss will occur if the stock price rises.

One of your advisory clients indicates that he would like to sell forward contracts in soybeans. It would be wise to warn the client that he will be facing the following risks: I. liquidity. II. creditworthiness of the buyer. III. lack of assurance that the delivery price will remain stable. IV. the location for the delivery may change. A) III and IV. B) I and IV. C) II and III. D) I and II.

Answer: D Because there is no standardization for forward contracts, they are considered to be illiquid. Since there is no entity backing up the contract (as the OCC does with listed options), a seller must always be concerned about the ability of the buyer to pay. Although the market price probably will change, the delivery price is always agreed upon at the time of the contract as is the method, location and time of delivery.

Which of the following is not traded on any exchange? A) Futures contracts B) ETFs C) Closed-end funds D) Forward contracts

Answer: D Forward contracts are non-standardized and, as such, do not trade on any exchange.