Unit 10: Options

An investor buys an ABC May 45 put at 4.25 when the stock is trading at $43. The put is in the money when the stock is A) below 45. B) below 40.75. C) above 47.25. D) below 38.75.

A) Explanation A put is in the money when the underlying stock trades below the exercise price of the put. The put is in the money by two points. LO 10.c

Performance of the terms of a standardized listed option contract are guaranteed by A) the Options Clearing Corporation. B) the Chicago Board Options Exchange. C) FINRA. D) the Securities and Exchange Commission.

A) Explanation The Options Clearing Corporation issues, guarantees, and handles the exercise and assignment of listed options. LO 10.b

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 III C) II and IV D) I and III

A) Explanation 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. LO 10.e

A customer buys 10 ABC Jul 25 calls at 4.50. What is the total premium paid for the position? A) $4,500 B) $20,500 C) $450 D) $29,500

A) Explanation A premium of 4.50 multiplied by 100 shares per contract, multiplied by 10 contracts equals $4,500. LO 10.a

What is the following position? Buy 1 QRS May 40 call Sell 1 QRS May 50 call A) Price spread B) Diagonal spread C) Time spread D) Combination

A) Explanation A price spread is composed of a long and short option of the same type with the same expiration but different strike prices. A price spread is also termed a vertical spread. LO 10.e

Which of the following positions would create the most risk for an investor? A) Sell short 100 shares of SSS and sell 1 SSS put B) Sell short 100 shares of SSS and buy 1 SSS call C) Buy 100 shares of SSS and buy 1 SSS put D) Buy 100 shares of SSS and sell 1 SSS call

A) Explanation A short sale of SSS stock has unlimited loss potential. Selling a put obligates the customer to buy the stock at the strike price in return for premium. A short sale, coupled with a sale of a put, is equivalent to selling an uncovered call and creates the most risk. LO 10.h

If a customer wishes to buy 1 XYZ option and sell another XYZ option, but he is not willing to spend more than $300, which of the following orders should be entered? A) A spread order B) A straddle order C) Two stop orders D) Two limit orders

A) Explanation A spread involves the simultaneous purchase and sale of different option contracts of the same type. A spread incurs a gain or loss depending on what happens to the difference in the premiums between the two contracts. Because this investor wants to limit his risk to $300, he would buy the spread at a net debit of $300 or less. (This is one order, not two.) LO 10.e

A call spread is the combination of A) a long call and a short call. B) a long call and long put. C) a long put and a short put. D) a short call and short put.

A) Explanation A spread option is always a long and short position in the same type of option (two puts or two calls) on the same underlying asset. A long call combined with a short call is a call spread. A long put and a short put constitutes a put spread. A long call and a long put is a long straddle. A short call and short put is a short straddle. LO 10.e

Under FINRA rules, customers who are approved to trade options must receive a copy of the OCC Options Disclosure Document A) at the time of or before account approval. B) at the time of or before the mailing of the next monthly statement. C) at the time of or before the mailing of the confirmation representing the first options trade. D) within 15 days of account approval.

A) Explanation All customers who are approved by the ROP to trade options must receive a copy of the OCC Options Disclosure Document at or before the time the account is approved to trade options. It is the options account agreement that must be returned by the customer within 15 days. LO 10.j

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

A) Explanation 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. LO 10.g

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

A) Explanation 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. LO 10.f

For a customer who has purchased stock and wants to write a call option, the option ticket would be marked A) opening sale. B) closing purchase. C) closing sale. D) opening purchase.

A) Explanation An opening transaction is used when establishing a new option position. It is an opening purchase if your client is buying the option. It is an opening sale if your client is writing the option. Closing is the term used when the client eliminates an existing option position through a trade of the contract. LO 10.a

Which of the following positions will be profitable if the market price of the underlying asset is equal to the exercise price at expiration date? A) A short put B) A long call C) Short stock D) A long put

A) Explanation At expiration, if the strike price and the underlying asset price are the same, the option has no value and will expire unexercised. Option writers (short positions) benefit when this happens because they earn the entire premium. Those with long option positions need price movement to profit. While a short option position profits without movement, a short stock position only profits when the market price goes down. LO 10.d

If at expiration for XYZ options, XYZ stock closes at 40.15, which of the following open option positions will automatically be exercised by the Options Clearing Corporation (OCC)? A) A customer long 1 XYZ 40 call B) A member firm long 1 XYZ 40 put C) A member firm long 1 XYZ 45 call D) A customer long 1 XYZ 40 put

A) Explanation At expiration, the OCC will automatically exercise open option positions if those positions are in the money by 0.01 or more. In this case, the customer's long 40 call position is in the money by 0.15. The member firm 45 call and the 40 puts are out of the money. LO 10.j

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

A) Explanation 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. LO 10.e

A registered representative makes the following comment to her client: "Writing options is a good way to increase your income on this stock." Which of the following statements should be included with this comment? A) You may lose future profits, and risk of loss is still possible. B) You will gain the option premium with no chance of loss. C) Your stock covers the option, so you cannot lose. D) There is no other possible hedge on a long stock position.

A) Explanation Because the registered representative is recommending covered call writing, she should also explain the risks involved. LO 10.d

In a strong bull market, which of the following positions utilizing leverage has the potential for the highest percentage gain? A) Holding calls B) Holding stocks C) Writing puts D) Selling short

A) Explanation Both a long call and a long stock position are profitable in a rising market. However, because options use leverage, the profit relative to the money invested is larger with option positions. A put writer also profits in a rising market, but only by the amount of the premium. A short seller loses money if the stock rises. LO 10.d

An investor buys 2 LMN 40 calls and pays a premium of 4 each, and also buys 2 LMN 40 puts and pays a premium of 2.50 each. At the time of purchase, LMN is trading at $40.75. On the expiration date, LMN is trading at $32.50. If the investor closes her position for its intrinsic value, excluding commissions, the investor realizes A) a $200 profit. B) a $100 loss. C) a $100 profit. D) a $200 loss.

A) Explanation Closing out a position is the opposite of the opening transaction. In this situation, the investor opened by buying two calls for a total of $800, and closed them out by selling for their intrinsic value. (Calls have intrinsic value when the market value is above the strike price; in this situation, there is no intrinsic value.) The investor also bought two puts for a total of $500 and closed them out by selling for their intrinsic value of $1,500. (Puts have intrinsic value when the market value is below the strike price; in this situation, the intrinsic value is $7.50 per contract, or 40 − 32.50 = 7.5 × 2 = 15 × 100 shares = $1,500.) The resulting profit on the position is $200 ($1,500 − $1,300), the total of the premiums paid for all of the options. LO 10.f

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

A) Explanation 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. LO 10.d

Individuals with diversified stock holdings in their portfolios write covered calls to A) increase their rate of return on the stocks held in their portfolio. B) increase the number of shares they own. C) lock in profits. D) benefit from share price increases.

A) Explanation Covered call writing is frequently used by persons who own the underlying stock to increase rate of return. If the options expire unexercised, the writer keeps the premium, which provides additional portfolio income. LO 10.d

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

A) Explanation 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. LO 10.d

The rules on opening an options account contain a number of differences from the normal cash account at a broker-dealer. One of those differences is, if applicable, A) the requirement to obtain the signature of the registered representative handling the account. B) obtaining the name of the customer's employer (if employed). C) the need to determine if the customer is of legal age. D) the requirement to obtain the signature of the principal approving the account.

A) Explanation For a normal account, FINRA requires the signature of the principal approving the account, but not that of the registered representative who will be handling that account. For options, that additional signature is necessary. The other choices are required on any new account form, options or not. LO 10.j

Japan discovers oil in the Pacific while earthquakes in England cause havoc. A customer who reads this article would be most likely to take which of the following actions? A) Buy yen calls or buy pound puts B) Buy pound puts or buy yen puts C) Buy pound calls or buy yen calls D) Buy yen puts or buy pound puts

A) Explanation Here, the yen will go up, and the pound will fall. Thus, a customer would be most likely to buy yen calls and pound puts. LO 10.g

A customer recently approved to trade options writes an OEX put for the account's initial transaction. If the customer fails to return the signed option agreement within 15 days of account approval, which of the following transactions is the customer permitted to make? A) Closing purchase B) Opening purchase C) Closing sale D) Opening sale

A) Explanation If a customer fails to return the signed option agreement within 15 days of account approval, the customer is permitted closing transactions only. Because the customer opened a position by selling, the only transaction permitted would be a closing purchase. LO 10.j

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

A) Explanation 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. LO 10.c

A customer wrote 10 KLM Jun 80 calls for a premium of 4.75 at a time when the market value of KLM was 81.75. What is his gain or loss if he now closes out his positions at 2.12? A) A $2,630 gain B) A $4,750 loss C) A $4,750 gain D) A $2,630 loss

A) Explanation If the customer sold at 4.75 and purchased at 2.12, he nets 2.63, which is multiplied by 100 to yield a $263 gain per contract: 10 × $263 = $2,630 total gain. LO 10.h

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 not entitled to the dividend. B) He is entitled to the dividend only if he sells the underlying stock. C) He is entitled to the dividend. D) He must pay the dividend to the writer.

A) Explanation 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. LO 10.b

An investor is short stock at $70. If the stock's market price is $40, and the investor anticipates the price will continue to decline, to hedge against a rise in the price, the investor should A) buy a call. B) buy a straddle. C) sell a call. D) buy a put.

A) Explanation If the investor buys a call on the stock, he has the right to buy it back (cover his short) at a fixed price. The best way to hedge an unrealized gain on a short stock position is to buy a call. LO 10.d

Which of the following option strategies, besides going long a call, can be used to purchase stock below its current market value? A) Short put B) Long put C) Short call D) Short straddle

A) Explanation If the put is exercised by the owner, the writer of the put will be obligated to purchase the stock. The cost of the stock is reduced by the amount of premium taken in when the put was written, allowing the investor to purchase the stock at a net cost lower than the stock's current market value. LO 10.d

An investor owns 100 shares of IBM. Which of the following would make a long hedge? A) Buying a put on IBM B) Writing a call C) Buying a call on IBM D) Writing a put

A) Explanation If you own the stock, you want the market value to rise. To hedge the position against a decrease in value, you would buy a put option. LO 10.d

A taxable gain or loss on a long call option transaction would be recognized when I) the option is purchased. II) the option expires. III) the option is sold. IV) the option is exercised. A) II and III B) III and IV C) I and IV D) I and II

A) Explanation In addition to being exercised, call options can either be sold or allowed to expire. If either of these situations occurs, the owner of the call would determine hers gain or loss (for tax purposes) at the time of expiration or sale. This would be determined by comparing what she paid for the call versus the price at which she sold the call. If it expires, the entire amount of the premium originally paid is considered a loss. Gains or losses are not determined at the time that calls are exercised. Once exercised, the underlying security must then be sold at the current market value. Then the owner of the call would calculate her profit or loss, taking into account the premium paid, what she paid for the stock, and what she subsequently sold the stock for. LO 10.i

If 1 OEX 375 call is purchased at 3.25 and exercised when the S&P 100 closes at 381, the writer delivers which of the following to the holder? A) $600 cash B) $325 cash C) $381 in securities D) $600 in stocks

A) Explanation Index options settle in cash. Physical delivery does not occur. The call buyer receives cash equal to the difference between the strike price and the index closing value on the day the option is exercised. LO 10.g

All of the following subject an investor to unlimited risk except A) short 100 ABC, buy 1 ABC call. B) short 100 ABC, write 1 ABC put. C) short 100 shares ABC stock. D) 1 ABC uncovered (short) call.

A) Explanation Investors use long calls to protect short stock positions. If the market value of the stock needed to cover the short position begins to rise, the investor can exercise the long call position to buy the stock. Short stock positions, short uncovered calls, and short stock combined with short puts all subject investors to unlimited risk. LO 10.d

A client approved to trade options has taken the opinion that a company's stock might be extremely volatile in the wake of upcoming earnings reports and new product reviews currently being mixed. The client does not own the stock but asks what might be a cost-efficient way to gain if that volatility occurs. You recommend A) purchasing straddles. B) selling all spreads. C) both purchasing and shorting the stock simultaneously. D) either purchasing or shorting the stock.

A) Explanation Long (purchasing) straddles are an appropriate strategy when volatility is expected, with potential gain occurring for moves in either direction. Costs are limited to the premiums paid. LO 10.f

A customer who buys 1 CDE Oct 60 call at 4 and sells 1 CDE Dec 60 call at 6 has created A) a calendar spread. B) a price spread. C) a combination. D) a long straddle.

A) Explanation Long a call and short a call is known as a call spread. If the strike prices are the same, and the expiration months are different (Oct and Dec), it is a calendar spread. Calendar spreads are sometimes called time spreads or horizontal spreads. LO 10.e

An investor purchases 100 shares of JKL common stock at a price of $42 per share on April 22, 2018. On June 27, 2019, JKL's market price is $51 and the investor liquidates the position. Which of the following transactions made on October 17, 2018, would have an effect on the investor's tax treatment of this gain? A) Buying a Feb 45 JKL put B) Selling a Feb 45 JKL call C) Buying a Feb 45 JKL call D) Selling a Feb 45 JKL put

A) Explanation Long-term capital gains tax rates are available when one has a holding period of more than 12 months. Although this investor held the JKL stock for more than 14 months, the purchase of the put caused the holding period to be tolled (the IRS term for suspended). It means that the holding period from April 22 to October 17 (almost 6 months) is put on hold until the put is disposed of or expires. When that happens in February, the "clock" picks up where it left off and runs another 4+ months until June 27. The total time period is approximately 10 months, less than the 12 months required for long-term treatment. None of the other positions affects the holding period of a long stock position. LO 10.i

Which of the following are fair and equitable methods for the assignment of options contracts by a brokerage firm to a customer? A) First-in, first-out or random selection B) Last-in, first-out or to the customer with the largest open position in that option C) Last-in, first-out or random selection D) First-in, first-out or to the customer with the largest open position in that option

A) Explanation Options Clearing Corporation (OCC) rules allow broker-dealers to assign customers using first-in, first-out or random selection methods. In addition, the OCC also states that any other fair method is allowed. LO 10.b

A customer has entered an option order with your broker-dealer. At which of the following locations could such an order be executed? I) NYSE II) CBOE III) Nasdaq PHLX None of these A) I, II, and III B) I and II C) IV only D) II and III

A) Explanation Options orders can be executed on the NYSE, the CBOE, and the Nasdaq PHLX, which offers a hybrid of electronic and on-floor execution availability. LO 10.j

A customer sells an FLB Mar 35 call. To establish a straddle, she would A) sell an FLB Mar 35 put. B) sell an FLB Mar 40 call. C) buy an FLB Mar 35 put. D) buy an FLB Mar 40 call.

A) Explanation Straddles involve options of different types, but both options must be of the same series. An option series has the same strike price, expiration date, and underlying security. LO 10.f

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

A) Explanation 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. LO 10.b

As the price of the volatility market index (VIX) rises, investors should expect A) call and put option premiums to rise. B) a decrease in call premiums only. C) call and put option premiums to fall. D) a decrease in put premiums only.

A) Explanation The VIX is a measure of investor expectations regarding market volatility. If the VIX is rising, this reflects an expectation of an increase in market volatility. More market volatility will generally cause all options premiums—both puts and calls—to increase to some extent. LO 10.g

If a customer is long 1 ABC Oct 50 call at 11 and short 2 ABC Oct 60 calls at 5, the maximum loss potential is A) unlimited. B) $1,000. C) $100. D) $1,100.

A) Explanation The customer is short two calls and long one call, leaving one of the short calls uncovered. The loss potential for a naked call writer is unlimited on the upside. If exercised, the writer must buy the stock at the current market price so it will be delivered at the strike price. LO 10.d

In a single day, a customer purchases 15 ACM Sep 50 puts at 6 and 15 ACM Sep 50 calls at 1. The customer would profit from the positions if ACM traded A) either below $43 or above $57. B) between $38 and $52. C) either below $38 or above $52. D) between $43 and $57.

A) Explanation The customer paid $6 for the Sep 50 puts and $1 for the Sep 50 calls. A long straddle is profitable on the call side if the price rises above the strike price plus the combined premiums paid ($57). On the put side, it is profitable if the price falls below the strike price minus the combined premiums paid ($43). LO 10.h

A customer opens the following options position: Long 1 KALE Oct 70 put @4¼; short 1 KALE Oct 80 put @10. What is the customer's maximum gain, maximum loss, and breakeven point? A) Maximum gain is $575; maximum loss is $425; breakeven point is $74.25. B) Maximum gain is $425; maximum loss is $575; breakeven point is $75.75. C) Maximum gain is $425; maximum loss is $575; breakeven point is $74.25. D) Maximum gain is $575; maximum loss is $425; breakeven point is $75.75.

A) Explanation The first step is to identify the position. This is a credit put spread. It is a credit spread because the option sold brought in a higher premium than the one purchased. The credit of $575 is the most the investor can make. This is a bullish spread (the customer bought the low strike price and sold the high strike price). If the customer is correct and the stock rises above $80, the options will expire unexercised and the customer will keep that net credit of $575. If the customer is wrong and the price of the KALE stock falls below $70, the short put at 80 will be exercised, causing the customer to purchase the stock at $80. Then, the customer will exercise the long 70 put and sell that stock at $70. This results in a loss of $1,000 reduced by the $575 net credit, or $425 maximum loss. It is always easier to recognize that the maximum loss is the difference in strike prices minus the maximum profit. In this question, the spread is 10 points and the maximum profit is the credit of 5¾ points. That makes the maximum loss the remaining 4¼ points. Breakeven follows the put-down rule. Subtract the net premium from the higher strike price ($80 - 5.75 = $74.25). LO 10.h

An investor opens the following positions: Sell short 100 shares of BAF @61; short 1 BAF Sep 60 put @3¼. What is the customer's maximum gain, maximum loss, and breakeven point? A) Maximum gain is $425; maximum loss is unlimited; breakeven point is $64.25. B) Maximum gain is $5,775; maximum loss is $425; breakeven point is $64.25. C) Maximum gain is $325; maximum loss is unlimited; breakeven point is $57.75. D) Maximum gain is $425; maximum loss is $5,775; breakeven point is $57.75.

A) Explanation The first step is to identify the position. This is a short sale of stock and a sale of a put option. The sale of the put provides some income and offers protection only to the extent of the premium. Short sellers want the stock's price to decline. They lose when it rises. The investor has received $6,425 ($6,100 from the sale of the stock and $325 from the sale of the option). That makes the breakeven point $64.25 per share. Once the price of the BAF stock goes above that, the investor loses money. Because there is no limit as to how high the stock's price can go, the maximum loss is unlimited. If, on the other hand, the stock's price declines into the 50s or lower, the owner of the 60 put will exercise and our investor will pay $6,000 to purchase the stock. That stock will be used to cover the short sale. That means the investor sold the stock (short) at $61 and bought it back at $60 for a gain of $100. At that point, the investor's profit is the $300 from the premium on the sale of the put plus the $100 gain (the difference between 61 and 60). That is why the maximum gain is $425. 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. LO 10.h

An options trader establishes the following positions: Long 10 ALF Apr 40 calls at 6 Short 10 ALF Apr 50 calls at 2 What is the client's maximum gain and loss per share? A) Gain 6, loss 4 B) Gain 4, loss 2 C) Gain unlimited, loss 6 D) Gain 2, loss 6

A) Explanation The gain is 6 (between 44 and 50). If the stock declines, both options will expire for a loss of 4 (6 − 2). LO 10.e

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

A) Explanation 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. LO 10.g

An investor purchases a GFC Jan 40 call @ 4 and sells a GFC April 30 call @ 9. This is an example of A) a diagonal spread. B) a variable hedge. C) a horizontal spread. D) a vertical spread.

A) Explanation The investor has created a diagonal spread. An investor that buys and sells the same type of option has created a spread. If the strike prices and/or the expiration months of the options are different, it is a diagonal spread. LO 10.e

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

A) Explanation The investor opened with a sale, so the position must close with a purchase. LO 10.a

A stock is trading consistently between $20 and $24. The investor with a long position is neutral on the stock. The goal is to generate income. Which of the following recommendations is most appropriate? A) Sell a call B) Buy a call C) Sell a put D) Buy a put

A) Explanation The investor should sell a call on the stock and collect the premium (income). The investor is long the stock, so it would be better if the price goes up rather than down. Therefore, the sale of a call is better than the sale of a put, and those are the only real choices when the investor wants income through options. LO 10.d

A technology fund manager concerned about a downturn in the value of his portfolio would hedge by A) buying narrow-based index puts. B) selling broad-based index calls. C) buying broad-based index puts. D) selling narrow-based index calls.

A) Explanation The portfolio consists of sector-specific securities, so broad-based index puts such as the OEX would not be appropriate. Instead, the manager should buy narrow-based index puts (for example, indices on technology and electronics). LO 10.g

An investor purchased 100 shares of ABC common stock at $60 per share on March 2, 2019. With the stock selling at $80 per share on January 2, 2020, the investor purchased an ABC Apr 75 put for a premium of 2. On June 2, 2020, the investor sold the stock for $85 per share. As a result, the tax consequences are A) $2,300 short-term capital gain. B) $2,500 short-term capital gain. C) $2,300 long-term capital gain. D) $2,500 long-term capital gain.

A) Explanation The purchase of the put on stock that had a holding period of less than long term (March to January is only 10 months) erases the holding period. The holding period begins again once the put expires. In this case, we have a holding period from expiration in April until June 2. That is clearly a short-term holding period. As far as the math, the cost is $62 per share ($60 cost of the stock plus $2 for the put). The sale price was $85, the gain is $23 per share, $2,300. Alternatively, the sale price of $85 created a $2,500 gain (85-60) and the put was a $200 loss. That is a net of + $2,300. Either way is fine. LO 10.i

The put-call ratio can be used to A) gauge investor sentiment as being either bullish or bearish. B) determine a stocks beta. C) calculate how many options contracts are needed to hedge a stock position. D) determine which institutional trading desks are trading options.

A) Explanation The put-call ratio reflects the current open interest in the trading of put options to call options for a single stock, the broad market, or any market sector. The ratio can be used as a gauge of investor sentiment (bullish or bearish). The higher the ratio is, the more bearish an indicator it is. LO 10.d

A customer goes long 1 ABC June 40 call at 4 when buying the option in their account on Tuesday, April 4. When is the settlement date and what is the amount due? A) Wednesday, April 5; $400 B) Thursday, April 6; $40 C) Tuesday, April 4; $4,000 D) Wednesday, April 5; $4,000

A) Explanation The settlement date for an option trade is T+1 business day, meaning this trade will settle on Wednesday, April 5. On that day, the buyer of the option must have the funds to pay the premium in the options account. The premium per share is $4. Premium times contract size (100 shares) is the amount the buyer will pay, and the amount the seller will receive ($4 times 100 = $400). If the buyer of the call exercised the option, they would buy 100 shares of ABC stock for the exercise price (strike price) of $40 and so would buy the stock for $4,000. Regular way settlement on the stock trade when exercised would be T+2 business days. LO 10.a

When a registered representative opens an options account for a new client, in which order must the following actions take place? I) Obtain approval from the branch manager II) Obtain essential facts from the customer III) Obtain a signed options agreement IV) Enter the initial order A) II, I, IV, III B) I, II, IV, III C) I, II, III, IV D) II, I, III, IV

A) Explanation The steps in opening a new options account occur in the following order: obtain essential facts about the customer, have the manager approve the account, enter the initial order, and have the customer sign the options agreement within 15 days. What about delivery of the options disclosure document (ODD)? That isn't included in the choices here. It must be delivered at or prior to the time the account is approved for options trading. That would mean before or simultaneously with choice I. LO 10.j

The writer of a combination expects the market to be A) stable. B) volatile. C) bullish. D) bearish.

A) Explanation The writer, or seller, of a combination expects the market to be stable. The buyer of a combination expects the market to be volatile. Combinations and straddles are never bullish or bearish, as there are always both calls and puts involved in the strategy, which are both bullish and bearish. Remember, the definition of a combination is a put and a call on the same underlying security with the strike prices and/or the expiration months being different. LO 10.f

If a customer buys 100 shares of MTN at 60, buys an MTN 60 call at 3, and buys an MTN 60 put at 3, the investor's maximum gain would be A) unlimited. B) $5,400. C) $6,000. D) $600.

A) Explanation There is no limit to how high a stock's price can rise. Because this investor owns both the stock and an option to buy, the potential for gain is theoretically unlimited. LO 10.d

A customer is long 100 XYZ currently trading at $40 per share. To generate income, the customer writes 2 XYZ Aug 40 calls at 4 for a maximum loss potential of A) unlimited. B) $3,600. C) $4,000. D) $3,200.

A) Explanation This is an example of ratio writing where a customer writes more calls than he has stock to cover. Because only one of the calls is covered, the other is uncovered, and loss potential is unlimited. LO 10.d

Which of the following would be considered a bearish strategy? A) Writing a call B) A debit call spread C) A credit put spread D) Writing a put

A) Explanation Those who write call options benefit when the price of the underlying asset declines (bearish). It is just the opposite for those who write a put. Spreads are bearish when the low strike price is sold and the high strike price is bought. That results in a debit when it is a put spread and a credit when it is a call spread. Credit put spreads and debit call spreads are bullish because it is the low strike that is purchased and the high strike that is sold. LO 10.e

Which of the following would be considered a bullish strategy? A) Writing a put B) A credit call spread C) A debit put spread D) Writing a call

A) Explanation Those who write put options benefit when the price of the underlying asset increases (bullish). It is just the opposite for those who write a call. Spreads are bearish when the low strike price is sold and the high strike price is bought. That results in a debit when it is a put spread and a credit when it is a call spread. Credit put spreads and debit call spreads are bullish because it is the low strike that is purchased and the high strike that is sold. LO 10.e

An ABC 40 call is quoted at 4.25 - 4.50, and an ABC 45 call is quoted at 1.50 - 2.00. What is the cost of establishing a debit spread? A) $300 B) $225 C) $250 D) $275

A) Explanation To establish a debit spread, an investor buys a 40 call at the ask price of 4.50 and sells a 45 call at the bid price of 1.50. The net premium paid is (4.50 minus 1.50) times 100 shares, which equals $300. LO 10.e

An ABC 40 call is quoted at 4.25 - 4.50, and an ABC 45 call is quoted at 1.50 - 2.00. What is the cost of establishing a debit spread? A) $300 B) $250 C) $275 D) $225

A) Explanation To establish a debit spread, an investor buys a 40 call at the ask price of 4.50 and sells a 45 call at the bid price of 1.50. The net premium paid is (4.50 minus 1.50) times 100 shares, which equals $300. LO 10.e

In a volatile market, which of the following option strategies carries the most risk? A) Short straddle B) Debit spread C) Long straddle D) Credit spread

A) Explanation To establish a short straddle, the investor sells a call and a put; the short call carries unlimited loss potential. LO 10.f

A customer buys XYZ Oct 75 put at 7 when XYZ is trading at 72. The stock falls to 69, and the customer exercises the put. For tax purposes, sales proceeds are A) $6,800. B) $7,500. C) $6,200. D) $6,500.

A) Explanation When a put is exercised, the holder is selling stock at the strike price (75). However, the tax rules require that, if exercised, the cost basis of stock purchased or sales proceeds of stock sold is adjusted to the breakeven point of the option. For puts, breakeven is strike price minus premium (75 − 7 = 68). LO 10.i

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) must pay $14,000. B) receives $14,000. C) receives $700. D) must pay $700.

A) Explanation 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. LO 10.a

One of the advantages of writing a call option covered by shares of the underlying stock is A) immediate income is generated. B) the investor has protected most of the downside risk. C) the investor retains all of the upside potential. D) the underlying stock can be purchased on margin.

A) Explanation When an investor writes a call option and owns the underlying shares, the premium is credited to the account on the next business day (T+1). For this benefit, the investor has given up most of the upside potential because once the stock rises above the exercise price, it will likely be called away. That places a limit on the upside potential. There is downside protection, but it is limited to the extent of the premium received. The underlying stock can be purchased on margin, regardless of writing the call. LO 10.d

A customer holds the following positions: Short 100 XYZ shares at 40 Short 1 XYZ Oct 40 put at 5 With XYZ trading at 35, the customer is assigned an exercise notice on the put, and he uses the stock purchased to cover the short stock position. This results in A) a $500 gain. B) a $500 loss. C) a $1,000 loss. D) a $1,000 gain.

A) Explanation When exercised, the customer is forced to buy stock at 40 that is used to cover the short position for no gain or loss. Because the premium of $500 was received, the investor has a gain of $500 on this position. LO 10.h

A customer believes ABC's stock price will rise, but she does not currently have the money to buy 100 shares. How could the customer use options to profit from a rise in the stock's price? I) Buy calls II) Write calls III) Buy puts IV) Write puts A) I and IV B) I and III C) II and IV D) II and III

A) Explanation When the price of a stock that underlies a call option increases in price, the owner (holder) of that option stands to profit. An investor who has sold a put option on that stock will also benefit because the option will expire unexercised and the writer will get to keep the premium. LO 10.h

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) Explanation 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. LO 10.d

A member firm is assigned an exercise notice by the Options Clearing Corporation (OCC). The member firm may assign the exercise notice to its customers by any of the following methods except A) to the customer having the largest short position. B) in any way that is fair and equitable. C) on a random-selection basis. D) to the customer having the oldest short position.

A) Explanation While the OCC can assign exercise notices using only the random selection basis, a member firm may use any method that is fair and equitable. The two most common methods are first-in, first-out and random selection. It would not be considered fair to assign customers based on the size of their short position. LO 10.b

Due to a distribution of stock, the contract size in the JGH Oct 50 call options is 108. A customer purchasing one of these contracts for a premium of 2½ would expect to pay A) $270. B) $330. C) $258. D) $250.

A) Explanation With a contract size of 108 shares (likely from an 8% stock dividend) and a premium of $2.50 per share, the total cost is $270. Regardless of the reason for the contract size being other than 100 shares, the price paid for an option is always the premium multiplied by the number of shares in the contract. In this question, that would be a premium of $2.50 per share (2½) times 108 = $270.00. LO 10.j

Your clients, an elderly retired couple on a small fixed monthly income, want to write uncovered (naked) calls in their joint account to generate income. For this account, this option strategy would most likely be deemed A) not suitable, because it is a speculative strategy with unlimited loss potential. B) suitable, because it is a standard strategy recommended to all retired customers to add income to their accounts. C) suitable, because it has minimal risk characteristics. D) not suitable, because this strategy cannot be used in a joint account.

A) Explanation Writing naked calls has an unlimited loss potential and is considered a speculative option strategy. While it can be employed in any investment account (single or joint) to generate income, its speculative nature and unlimited loss potential would make it unsuitable for retired persons currently on a small fixed monthly income. LO 10.d

If a March 80 Canadian dollar call option is trading at 6, and the Canadian dollar is at $0.85, which of the following statements is true? A) The contract is at parity. B) The contract has intrinsic value. C) The contract is out of the money. D) The contract has no time value.

B) Explanation A call is in the money whenever the market value of the underlying instrument is above the strike price. The Canadian dollar is currently at $0.85 (85 cents), which is above the strike price of $0.80 (80 cents), so this call is in the money, and therefore, has intrinsic value of 0.05 (5 cents). This contract is trading 0.01 greater than the intrinsic value of 0.05. Therefore, it also has a time value of 0.01 (1 cent). LO 10.c

Which of the following would establish a covered put? A) Long stock at 40, long put at 45 B) Short stock at 40, short put at 35 C) Long stock at 40, short put at 35 D) Short stock at 40, long put at 45

B) Explanation A covered put is created when a short stock is combined with a short put. Covered puts are established when the investor is neutral or slightly bearish; therefore, the strike price of the put is less than the cost of the stock sold short. The reason the put writer is covered (protected) is that if the stock's price should decline below 35 and the holder of the option exercises, the stock purchased by the writer is used to cover (replace) the borrowed stock for the short sale at 40. LO 10.d

Which of the following options strategies could be used by an investor who is bearish on a stock? I) Debit call spread II) Debit put spread III) Long call IV) Long combination straddle A) II and III B) II and IV C) I and III D) I and IV

B) Explanation A debit put spread is a bearish strategy that could realize a profit (the difference between the strike prices minus the premium paid for the spread) if the stock price fell. A long combination, which consists of both a long call and a long put, is both bullish and bearish and could also yield a profit if the stock price fell as a result of the long put. However, both a debit call spread and a long call are bullish strategies and would not be used if one is bearish on the stock. LO 10.e

Which of the following positions meets the IRS definition of a married put? A) Buy one ABC 50 put and sell one ABC 55 put B) Buy 100 shares of ABC at $50 per share and simultaneously buy one ABC 50 put C) Buy 100 shares of ABC at $50 per share and simultaneously sell one ABC 50 put D) Buy one ABC 50 call and buy one ABC 50 put

B) Explanation A married put is a specific type of protective put. Anytime a put option is purchased while the investor is long the underlying stock, it is considered a protective put because it is a hedge against a move to the downside. When the put and stock are bought at the same time, the strategy is known as a married put and has a special tax benefit. Normally, purchasing a put option on stock held less than the long-term holding period causes the existing holding period on the stock to be erased. In the case of the married put, the holding period of the stock is not affected. LO 10.i

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

B) Explanation A put gives the investor the right to sell stock at a set price (the strike price) for a period of time, and it 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. LO 10.d

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

B) Explanation A put seller (writer) will benefit as long as the market price of the underlying security does not drop substantially. His position is bullish. LO 10.d

A customer who is long 1 XYZ Sep 50 call could create a spread by combining it with which of the following positions? A) Long 1 XYZ Sep 60 call B) Short 1 XYZ Sep 60 call C) Long 1 XYZ Sep 50 put D) Short 1 XYZ Sep 50 put

B) Explanation A spread involves two simultaneous positions in related options of the same type—one long and the other short of the same underlying security. LO 10.f

Automatic exercise will occur for equity options at expiration that are in the money by at least A) one-quarter of a point. B) $0.01. C) one-eighth of a point. D) $0.05.

B) Explanation Automatic exercise will occur for equity options at expiration that are in the money by at least 0.01, unless specific instructions are given by the customer not to do so. LO 10.j

If an investor buys 300 shares of FLB, and one month, later buys 1 FLB Jul 50 put, how does this affect the holding period on his stock? A) It ends the holding period on the put. B) It erases the holding period on 100 shares. C) It has no impact on the holding period for any of the shares owned by the investor. D) It erases the holding period on 300 shares.

B) Explanation Because the stock has not been held more than 12 months, the put purchase erases the holding period for any shares the put subsequently allows the holder to sell. Because the holder owns one put, this erases the holding period on 100 shares owned. The other 200 shares are unaffected. LO 10.i

Which of the following affects the holding period of XYZ stock, a position that has been held for six months? I) Buying an in-the-money put II) Buy an out-of-the-money put III) Writing an in-the-money call IV) riting an out-of-the-money call A) II and III B) I and II C) III and IV D) I and IV

B) Explanation Buying a put (in or out of the money) on a stock held short term (one year or less) erases the holding period until the put is disposed of. At that time, the holding period starts over. LO 10.i

The covered call writing strategy would be most suitable for which of the following investors? A) 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 C) An 28-year-old who is saving to buy a house before turning 30 D) A married couple that is saving for a grandchild's higher education

B) Explanation 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. LO 10.d

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

B) Explanation 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. LO 10.d

An investor owns six RIF Apr 150 puts. How many shares of the RIF will change hands if all the options are exercised? A) 100 B) 600 C) 900 D) 150

B) Explanation Each of the six contracts allows the owner to sell (put) 100 shares of the RIF stock at $150 per share. If all six contracts are exercised, that will be 6 × 100 = 600 shares. LO 10.a

The holder of a yield-based call option would be more likely to profit if I) rates rise. II) rates fall. III) debt prices rise. IV) debt prices fall. A) I and III B) I and IV C) II and IV D) II and III

B) Explanation Holders of yield-based call options profit if rates rise. Prices of debt securities fall if rates rise. LO 10.g

If your client was recently approved to trade options and writes 1 XYZ Oct 60 put but fails to return the signed option agreement within 15 days of account approval, which of the following orders could you accept? A) Buy 1 XYZ Jan 55 put B) Buy 1 XYZ Oct 60 put C) Buy 1 XYZ Oct 55 put D) Buy 1 XYZ Jan 60 put

B) Explanation If a customer fails to return a signed options agreement within 15 days of account approval, your firm can permit closing transactions only. While the customer may offset her existing position, she may not offset a short position in an Oct 60 put by buying an XYZ put with a different expiration month and/or a different strike price. LO 10.j

A speculative investor believes the market in Japanese yen will remain stable for several months. Which of the following positions might allow the investor to take advantage of a lack of movement in the exchange rate between the yen and the U.S. dollar? A) Long straddle B) Short straddle C) Call debit spread D) Put debit spread

B) Explanation If the spot price does not move, at least one option—perhaps both—will expire unexercised. The other positions will not yield profit without price movement. Note that a short straddle carries unlimited loss potential. LO 10.f

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

B) Explanation 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. LO 10.f

Using yield-based options, which of the following hedging strategies offers a bond portfolio manager the greatest protection against rising long-term interest rates? A) Sell 30-year T-bond yield-based puts B) Buy 30-year T-bond yield-based calls C) Buy 30-year T-bond yield-based puts D) Sell 30-year T-bond yield-based calls

B) Explanation In this example, the options would increase in value, as the actual yield on the 30-year Treasury bonds rose above the yield value represented by the strike price of the option. LO 10.g

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

B) Explanation 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. LO 10.d

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

B) Explanation Investors who short stock have sold borrowed shares and profit when the market price declines. LO 10.d

A client bought 100 XYZ at $65 per share and sold an XYZ 65 call at 8. Closing the short call at 10 and selling XYZ at 68 would result in A) a $100 loss. B) a $100 profit. C) a $500 loss. D) a $500 profit.

B) Explanation Let's use the T-chart to show the flow of the money. The client bought 100 shares of the stock at $65 per share, so $6,500 went out (a debit). At the same time, the call was sold for a premium of 8, which brought in $800 (a credit). The short call was closed out (bought back something you sold) at 10, so we put $1,000 in the out (DR) column, and the stock was sold for $6,800, which goes in the in (CR) column. That means, $6,500 plus $1,000 went out, and $6,800 plus $800 came in. That is a total of $7,500 out and $7,600 in, for a net gain of $100. LO 10.h

Which of the following are on the same side of the market? A) Short 1 XYZ call and short 1 XYZ put B) Short 1 XYZ call and long 1 XYZ put C) Long 1 XYZ call and short 1 XYZ call D) Long 1 XYZ call and long 1 XYZ put

B) Explanation Long calls and short puts are on the same side (bullish), and long puts and short calls are on the same side (bearish). The number of contracts on the same side of the market are used to calculate whether or not position limits have been violated. LO 10.j

A customer establishes the following positions: Buy 100 ABC for 63 Write 1 ABC Jan 70 call for 1 What is the customer's maximum gain? A) Unlimited B) 800 C) 600 D) 700

B) Explanation Maximum gain on the covered call position occurs when the stock's market value rises. The short call is exercised when the stock is above 70, so the stock bought for 63 will be sold for 70—a profit of $7 per share. In addition, the customer receives the premium of $1, so the total profit is $800 ($700 + $100). LO 10.h

What option strategy might be used by an investor with a short position in a stock who wishes to generate some income? A) Write a call on the stock B) Write a put on the stock C) Go long a put on the stock D) Go long a call on the stock

B) Explanation Normally, investors who are short a stock, buy calls on that stock to protect the upside from unlimited potential loss. This question does not deal with that situation. Although the investor is short stock, the objective here is generating income. Selling (writing) an option is the only way to do that. Of the two choices, writing the put is the more logical. Short sellers of stock have an obligation to buy the stock to cover the short position. Writing the put generates income while also obligating the writer to buy the stock at the strike price if the holder of the option exercises. The stock put to the writer can be used to cover the short stock position, and everything is closed out. If you chose "write a call," a call writer is obligated to sell stock at the exercise price, stock the investor does not own. This investor is already obligated to buy back the stock sold short; why create an obligation to go into the market to buy more. In fact, writing a call would expose this investor to unlimited potential loss on both the short stock position and the uncovered call. LO 10.h

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) Buy calls B) Sell covered calls C) Sell covered puts D) Buy puts

B) Explanation Selling calls will generate income and protect the downside to the extent of the premiums received. LO 10.d

If a customer buys 100 XYZ at $52.50 and buys 1 XYZ Aug 50 put at 1.50, what is the customer's maximum possible loss? A) $5,400 B) $400 C) $5,250 D) Unlimited

B) Explanation Stockholders often buy puts to protect long positions. In this case, if the stock falls below 50, the investor will exercise the right to sell it at 50. The loss on the stock is limited to 2.50, which, combined with the premium paid of 1.50, results in a $400 loss. LO 10.h

If the Swiss franc is trading at 0.69, and a customer buys 1 Sep SF 70 put and writes 1 Sep SF 65 put, this position is A) a diagonal spread. B) a bear spread. C) a bull spread. D) a calendar spread.

B) Explanation The 70 put is dominant because it will have a higher premium than the 65 put. Buying puts is bearish; this is a debit put spread. LO 10.g

A customer is long an ABC Apr 40 call and is short an ABC Jul 40 call. Which of the following best describe his position? I) Bullish II) Bearish III) Calendar spread IV) Vertical spread A) I and III B) II and III C) II and IV D) I and IV

B) Explanation The July call will have a higher premium than the April call because it has more time value. Because the customer is selling the call with the higher premium, he is counting on the July call to go unexercised, which would allow him to keep the premium as a profit. That means the market value of the underlying security must either stay the same or decline. Therefore, this customer's position is bearish. Because the options expire in different months, the trade is a calendar spread. LO 10.e

Which of the following is applicable to the Nasdaq PHLX? I) Regional exchange operated by Nasdaq II) Offers trading in equity securities and options contracts III) Completely electronic exchange with no physical trading floor IV) Regional exchange operated by FINRA for the execution of over-the-counter stocks only A) I and IV B) I and II C) I and III D) II and III

B) Explanation The Nasdaq PHLX is a regional exchange operated by Nasdaq where equity securities and options contracts are traded both electronically and on the floor. LO 10.j

It would be fair and equitable for a brokerage firm to assign an option exercise notice to a customer A) with the largest open position in that option. B) who first wrote that option. C) with the smallest open position in that option. D) who last wrote that option.

B) Explanation The assignment of options contracts can be done on a first-in, first-out (FIFO) basis or by any other method that the Options Clearing Corporation considers fair (i.e., random). Determining assignment by the size of contract or on a last-in, first-out basis is not considered fair. LO 10.b

Your client writes 2 ABC Nov 220 calls at 5 and buys 200 shares of ABC common stock at $220 in his margin account. What is the breakeven point for the client's position? A) $225 B) $215 C) $210 D) $230

B) Explanation The breakeven point for covered call writing is the cost of stock purchased less the premium (220 − 5). Breakeven is the same if it is one covered call, or 1,000. LO 10.d

If a customer buys 300 ABC at 53 and writes 3 ABC Jun 55 calls at 4, and the contracts expire unexercised, the customer's cost basis in ABC stock at expiration is A) $51. B) $53. C) $49. D) $57.

B) Explanation The cost basis in the stock remains at the original purchase price. The premium received must be declared by the investor as a capital gain for tax purposes. Premiums on options will only affect the stock's cost basis or sales proceeds if the option is exercised, or if (on the same day) a customer buys stock and buys a put. LO 10.i

A customer purchases 2 QRS Jul 30 calls at 2 and 2 QRS Jul 30 puts at 2.50. She will break even when the price of the underlying stock is I) $25.50. II) $27.50. III) $32.00. IV) $34.50. A) I and II B) I and IV C) II and III D) III and IV

B) Explanation The customer has purchased calls and puts with the same strike price and expiration date, so the position is a long straddle. Straddles have two breakeven points: the strike price plus the sum of the two premiums, and the strike price minus the sum of the two premiums. The customer profits in a long straddle when the stock price is outside the breakeven points (i.e., higher than 34.50 or lower than 25.50). LO 10.h

Covered put writing is a strategy where an investor A) sells a put and sells a call on the same stock. B) sells a put on a stock he has sold short. C) sells a put on a stock that he owns. D) sells a put and buys a call on the same stock.

B) Explanation The customer sells the put to generate income. The short stock position provides the necessary cash should his short put be exercised, forcing him to buy the stock. LO 10.d

An investor opens the following options position: Long 1 ABC Aug 50 call @ 5½; short 1 ABC Aug 55 call @ 3½. What is the investor's maximum gain, maximum loss, and breakeven point? A) Maximum gain is $300; maximum loss is $200; breakeven is $53. B) Maximum gain is $300; maximum loss is $200; breakeven is $52. C) Maximum gain is $200; maximum loss is $300; breakeven is $52. D) Maximum gain is $200; maximum loss is $300; breakeven is $53.

B) Explanation The first step is to identify the position. This is a debit call spread. It is a debit spread because the option purchased costs more than the one sold. The investor purchased the 50 call for a premium of 5½ and sold the 55 call for a premium of 3½. That difference (5½ minus 3½), a debit of $200, is the most the investor can lose. This is a bullish spread (the investor bought the low strike price and sold the high strike price). If the investor is correct and the stock rises, the short call will be exercised. That means the writer will have to sell the stock at $55 per share. However, the investor will exercise the 50 call and deliver the stock purchased for $5,000 and receive proceeds of $5,500. The $500 profit is reduced by the $200 it cost to put on the spread (the debit). That means a net gain of $300. The fastest way to do a question like this is to subtract the debit from the strike price difference (5 points here) and you have your maximum gain. In this case, it is $5 minus $2 = $3. Breakeven follows the call-up rule; add the net premium (the debit of $2) to the lower strike price ($50) to arrive at $52. LO 10.h

A customer writes two ABC Jul 15 puts at 2 when ABC is 14. If the contracts are closed at a premium of 4 when ABC is 13, the customer has A) a $200 loss. B) a $400 loss. C) a $200 gain. D) a $400 gain.

B) Explanation The investor receives $400 in premiums (2 × $200) and pays $800 to close out the options (2 × $400), resulting in a net loss of $400 ($800 − $400). LO 10.h

Your customer is interested in buying call options on CDL common stock. The client asks you, "Who issues CDL options?" The proper response is A) the exchange where the option is traded. B) the Options Clearing Corporation. C) CDL Corporation. D) the seller of the option.

B) Explanation The issuer and guarantor of the options covered on the exam is the Options Clearing Corporation (OCC). Unlike other derivatives, such as rights and warrants, a corporation does not issue options on its own stock. Please do not confuse this with employee stock options, which is a different topic. As the guarantor, the OCC guarantees that the writer (seller) of the option will perform. That is, if exercised on a call, the stock will be delivered at the strike price, and if exercised on a put, the seller will pay the strike price. LO 10.b

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

B) Explanation 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. LO 10.a

An investor is long 10 XYZ 60 calls. After XYZ goes "ex" a 50% stock dividend, the adjusted position will be A) 10 XYZ Oct 60 calls, contract size 150 shares. B) 10 XYZ Oct 40 calls, contract size 150 shares. C) 15 XYZ Oct 40 calls, contract size 100 shares. D) 15 XYZ Oct 60 calls, contract size 100 shares.

B) Explanation The number of contracts is not adjusted; the number of shares is. A 50% stock dividend increases the shares per contract to 150. The aggregate exercise price per contract remains the same. It was $6,000 (100 shares × $60 per share). Now, with a contract size of 150 shares and an aggregate exercise price of $6,000, the strike price is reduced to $40 per share ($6,000 divided by 150 shares). LO 10.j

If TCB is trading at 43 and the TCB Apr 40 call is trading at 4, what are the intrinsic value and the time value of the call premium? A) Intrinsic value: 3; time value: 4 B) Intrinsic value: 3; time value: 1 C) Intrinsic value: 1; time value: 3 D) Intrinsic value: 4; time value: 0

B) Explanation The option is in-the-money by 3 points because the strike price is 40 and the market price is 43. This sets a minimum premium of $3 per share. Because the actual premium is 4, the balance of 1 represents time value. The premium, minus the intrinsic value, equals the time value. This is true whether the option is a put or a call. LO 10.c

A customer buys 100 shares of ABC at 56.50 and writes 1 ABC Aug 60 call at 2. If the call is exercised, the consequences are I) a cost basis of $56.50 per share. II) a cost basis of $58.50 per share. III) sales proceeds of $60 per share. IV) sales proceeds of $62 per share. A) I and III B) I and IV C) II and IV D) II and III

B) Explanation The premium of the option affects the basis of the stock (bought or sold) as a result of exercise, adding the premium per share ($2) to the price per share ($60), for total sales proceeds of $62. The original cost basis is not affected by the exercise, so it remains $56.50. LO 10.i

On which of the following positions does the potential loss equal the premium? A) Covered calls B) Long puts C) Uncovered puts D) Covered puts

B) Explanation The premium paid to acquire the option represents the most an investor stands to lose on a long option position. Covered and uncovered are terms that relate to short option positions. LO 10.c

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) for the underlying XYZ stock, more calls than puts are being traded. B) for the underlying XYZ stock, more puts than calls are being traded. C) for the underlying XYZ stock, straddles are being purchased. D) investors are becoming more and more bullish on XYZ stock.

B) Explanation 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. LO 10.d

A registered representative executes the following trades for an options account: Buy 1 FLB Apr 40 call at 9 Sell 1 FLB Apr 45 call at 4 Are these suitable trades? A) It depends on the customer's investment objectives. B) No, because the customer cannot make a profit on these trades. C) It is impossible to tell. D) Yes, because the trades will result in a small profit.

B) Explanation These trades are not suitable because the customer will not make a profit. In any price spread, the net debit represents maximum loss; in this case, the net debit is five points, or $500. Maximum loss added to maximum gain will always equal the difference between the strike prices. In this example, the difference between the strike price is five points; therefore, the maximum gain is zero. LO 10.e

John purchased a DMF May 90 call and simultaneously sold a DMF Jun 80 call. Which of the following best describes John's position? A) A bull spread B) A bear spread C) A long spread D) A short spread

B) Explanation This investor has established a net credit diagonal call spread. He bought the lower premium call (higher strike and earliest expiry) and sold the higher premium call (lower strike and longest expiry). He hopes the spread will narrow to zero (if the market falls below 80 and both calls expire worthless) so he can keep all of the premiums. He is a bear, and so is the spread. LO 10.e

An investor purchases 1,000 shares of PLEX common stock at a price of $153 per share. Shortly afterward, with PLEX selling for 149 per share, a purchase of 10 PLEX 150 puts at 4 takes place. What is the investor's breakeven point? A) $149 per share B) $157 per share C) $153 per share D) $113 per share

B) Explanation This investor is looking for the price to go up. The purchase price was $153 and the cost of the "insurance" (the put option) was 4. That means that the investor will not start making money until the stock rises above the cost of the stock plus the cost of the put ($153 plus $4 = $157). In a question like this, the current market price of the stock and the exercise price of the option are irrelevant. Breakeven on long stock and long put is the cost of the stock plus the cost of the put. As is always the case when computing breakeven, the number of shares and number of option contracts is meaningless−breakeven is the same price for one or one thousand. LO 10.h

Long an ABC Apr 60 call and short an ABC Apr 70 call is A) a calendar spread. B) a net debit spread. C) a net credit spread. D) a straddle.

B) Explanation This is a vertical spread, not a calendar spread. To determine whether it is a net credit or debit, look at the strike prices. For call options with the same expiry month, the lower strike price will always have a higher value. In this case, the investor is long the higher valued option, which gives a net outflow of cash to enter the entire position. (More money was spent on the lower strike price call than received for the higher strike price call.) Therefore, the investor has a net debit for her account. LO 10.e

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

B) Explanation 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). LO 10.h

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

B) Explanation 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. LO 10.a

An investor long 100 shares of stock writes a call against the long stock position. If the call is exercised, and the investor must deliver the stock, which of the following tax consequences will occur? A) Cost basis is adjusted for the stock. B) The investor's sales proceeds are the strike price plus the premium. C) Both cost basis and sales proceeds must be adjusted. D) There are no adjustments for cost basis or sales proceeds for tax purposes.

B) Explanation When the call is exercised, the owner of the stock will be obligated to sell the shares owned at the strike price. The sales proceeds for the stock will be adjusted upward by the amount of the premium received when the call was sold. LO 10.i

All of the following actions must be completed before a customer entering her first option trade except A) delivery of an Options Clearing Corporation disclosure booklet. B) completion of the new account form. C) completion of the options agreement. D) approval by a sales supervisor.

C) Explanation Customers do not have to complete (sign) the options agreement before entering an order, although under exchange rules, the agreement must be signed and returned by the customer within 15 days of account approval. LO 10.j

If an investor establishes a call spread, and buys the lower exercise price and sells the higher exercise price at a net debit, he anticipates that A) the exercise prices will change. B) the price of the underlying stock will not change. C) the spread will widen. D) the spread will narrow.

C) Explanation Debit spreads are profitable when both sides are exercised or the spread widens between the premiums. Credit spreads are profitable when both sides expire or the spread narrows between the premiums. LO 10.e

A customer, long 100 shares of ABC at 73, writes 1 ABC Apr 75 call at 2 to generate additional income. ABC stock subsequently moves higher, at which time, the customer is exercised. For tax purposes, which of the following statements are true? I) Cost basis is $73 per share II) Cost basis is $71 per share III) Sales proceeds are $75 per share IV) Sales proceeds are $77 per share A) II and III B) II and IV C) I and IV D) I and III

C) A customer, long 100 shares of ABC at 73, writes 1 ABC Apr 75 call at 2 to generate additional income. ABC stock subsequently moves higher, at which time, the customer is exercised. For tax purposes, which of the following statements are true? Cost basis is $73 per share Cost basis is $71 per share Sales proceeds are $75 per share Sales proceeds are $77 per share A) II and III B) II and IV C) I and IV D) I and III Explanation If a covered call writer is exercised, cost basis (for tax purposes) is the cost of stock purchased. Sales proceeds are adjusted (strike price plus premium) to reflect the premium received. LO 10.i

An investor buys two ABC Nov 50 calls, three ABC Dec 45 calls, and one ABC Jan 50 call. The best way to describe the portfolio is that it consists of A) two options of one class, three of another class, and one of a third class. B) six options of the same series. C) six options of the same class. D) six options of the same type.

C) Explanation A class of options is when they are all of the same type (in this case, calls) and all on the same underlying security (in this case, ABC). Yes, they are all of the same type, but, in a question like this, FINRA is asking for the most specific answer. Same class is more specific than same type. The same series would be if they all had the same expiration date and exercise price. LO 10.a

In the trading of options, there are a number of different multiple option strategies. An investor has the following position: Buy one RIF Apr 120 call Buy one RIF Jul 130 put Which strategy is the investor using? A) Long straddle B) Diagonal spread C) Long combination D) Time spread

C) Explanation A combination is composed of a long call and long put, or a short call and a short put, each having different strike prices and/or expiration months on the same underlying security. A straddle is when the expiration dates and exercise prices are the same. A spread consists of a long and short position in the same options class (two puts or two calls). In a diagonal spread, the exercise price and the expiration dates are different. In a time spread, everything is the same except the expiration dates. LO 10.f

An investor owns $100,000 of convertible bonds with a conversion price of $50. By depositing these bonds into her account, how many covered calls could she write? A) 2,000 B) 50 C) 20 D) None

C) Explanation A covered call means that the seller of the options has 100 shares of stock to cover each call. These bonds are convertible into 20 shares for each $1,000, making a total of 2,000 shares. At 100 shares per contract, that's enough stock to cover 20 calls. LO 10.h

An investor establishes the following positions: Long 1 XYZ Apr 45 call at 3.50 Long 1 XYZ Apr 45 put at 2.75 The investor's strategy will realize a gain if XYZ trades above A) $47.75. B) $45.00 C) $51.25. D) $48.50.

C) Explanation A long straddle is profitable if the stock price moves sharply in either direction. In this example, the investor paid a premium of 6.25 to establish the straddle. To realize a gain, the stock must either fall below the strike price minus the combined premium (45 − 6.25 = 38.75) or rise above the strike price plus the combined premium (45 + 6.25 = 51.25). LO 10.f

An investor writing an XYZ Oct 50 put could cover that put with A) an XYY Oct 60 put. B) an XYZ Oct 45 put. C) an XYZ Oct 55 put. D) an XYZ Jul 55 put.

C) Explanation A short put can be covered with a long put. The long put must have an exercise price the same or higher than the short put and an expiration date at least as long as the short put. The only choice meeting both criteria is the October 55 put. Two other ways to cover a short put is with short stock and cash. An XYY put will not cover an XYZ put. **This question deals with material not covered in your LEM, but it relates to recent rule changes and/or student feedback. LO 10.d

A customer writes 1 XYZ Sep 45 put at 6 and 1 XYZ Sep 35 call at 6 when XYZ is at 40. Before expiration, if XYZ is at 43, and the customer closes her positions at intrinsic value, the customer has A) a $600 gain. B) a $600 loss. C) a $200 gain. D) a $200 loss.

C) Explanation The customer collects $1,200 in premiums for writing the options (6 + 6), but later pays $200 (45 − 43) to close out the put and $800 to close out the call (43 − 35). In this case, $1,200 received minus $1,000 paid leaves a gain of $200. LO 10.c

What are the breakeven points on the following position? Write 2 DWQ Apr 30 calls at 2.25 Write 2 DWQ Apr 30 puts at 2.10 I) 25.65 II) 27.85 III) 32.25 IV) 34.35 A) II and IV B) II and III C) I and IV D) I and III

C) Explanation A straddle, whether long or short, has two breakeven points: the strike price plus and minus the sum of the premiums paid or received. In this case, the sum of the premiums received for the two short options is 4.35, and the strike price is 30. If the stock price is greater than 34.35 or less than 25.65, the investor will lose money. With short straddles, the customer profits if the stock price stays inside the breakeven points. Maximum gain is the premium received, and maximum loss is unlimited because of the uncovered calls. LO 10.f

A customer would buy index calls if she is A) bearish on a particular blue-chip stock. B) bullish on a particular over-the-counter stock. C) bullish on the broad market. D) bearish on the Fortune 500 stocks.

C) Explanation An index option is based on the value of the broad market, not the value of an individual security. A person who believes the overall market is rising could take a bullish position and buy calls on the index's value. LO 10.g

Regarding rules addressing acting in concert, each of the following must observe position and exercise limits except A) two or more individuals who have an agreement to act together. B) an individual with accounts at several brokerage firms. C) a registered representative (RR) accepting unsolicited orders to exercise options. D) an investment adviser placing exercise orders for his discretionary accounts.

C) Explanation An individual investor or a group of investors acting in concert must observe position and exercise limits. These limits apply to an individual adviser acting for a group of discretionary accounts and to an individual who has accounts with several firms. Acting in concert does not apply to an RR simply accepting exercise order instructions from customers. LO 10.j

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 out of the money. C) The time value is zero. D) The option is at the money.

C) Explanation 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). LO 10.c

A registered representative would recommend a customer establish a short straddle on T-bonds when interest rates are expected to A) be volatile. B) decline. C) remain unchanged. D) rise.

C) Explanation Any straddle writer is always looking for a stable market. Volatility is the biggest enemy of the writer. Because this question is referring to debt options, their price movements are based upon changes in interest rates. No fluctuations in interest rates means no price changes. LO 10.g

A gain on the sale of a long equity put option is A) a short- or long-term capital gain. B) always a long-term capital gain. C) always a short-term capital gain. D) ordinary income.

C) Explanation Any trading in options produces only short-term gains or losses; therefore, any gain on the sale of a long put option must always be a short-term capital gain. (If a question wishes you to consider LEAPS, the question will refer to them.) LO 10.i

On exercise of the option, the holder of a put will realize a profit if the price of the underlying stock A) falls below the exercise price. B) exceeds the exercise price plus the premium paid. C) falls below the exercise price minus the premium paid. D) exceeds the exercise price.

C) Explanation Breakeven for the buyer of a put is the strike price of the option minus the premium paid for the option. LO 10.a

On December 13, an investor buys six ABC Feb 60 calls at 2.25 each, when ABC is trading at 59.50 per share. If the calls expire unexercised, how much money will the investor lose? A) $810 B) $6,000 C) $1,350 D) $225

C) Explanation Buyers of options lose premiums if the options expire unexercised. The most this investor can lose is the number of contracts (6) multiplied by the amount of the premium (2.25). This investor's maximum loss is $1,350. LO 10.h

An investor has researched XYZ Corporation and is convinced the company's stock will soon decline in value. If the investor wishes to act on that conviction, which investment strategy will allow the investor to take advantage of the anticipated decline in share value with the smallest cash investment? A) Purchase a call option B) Sell the company's stock short C) Purchase a put option D) Purchase a call spread

C) Explanation Buying a put is a basic option strategy used when one is bearish on a stock. If the stock declines as anticipated, the investor could exercise the put, which allows the stock to be sold at the strike price and then repurchase it at its lower current market price for a profit. The premium paid to buy the put costs less than the margin required if one were to sell the stock short. Purchasing a call or a call spread are bullish options strategies. LO 10.d

If a customer believes the price of ABC is going to fall, which of the following option strategies would be appropriate? I) Buy calls on ABC. II) Write calls on ABC. III) Buy puts on ABC. IV) Write puts on ABC. A) II and IV B) I and IV C) II and III D) I and II

C) Explanation Buying puts and writing calls are bearish strategies. LO 10.d

All of the following option contracts are in-the-money when XYZ is 54 except A) long XYZ 50 call. B) long XYZ 60 put. C) short XYZ 50 put. D) short XYZ 45 call.

C) Explanation Call options are in-the-money whenever the market price is greater than the strike price. Put options are in-the-money whenever the market price is lower than the strike price. Try to remember: call up and put down. LO 10.c

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) Debit call spread B) Uncovered put writing C) Uncovered call writing D) Credit put spread

C) Explanation Call writing is bearish, while credit put spreads, debit call spreads, and uncovered put writing are bullish. LO 10.g

If a customer is long 1 ABC Oct 50 call at 11 and short 2 ABC Oct 60 calls at 5, the maximum loss potential is A) $100. B) $1,000. C) unlimited. D) $1,100.

C) Explanation The customer is short two calls and long one call, leaving one of the short calls uncovered. The loss potential for a naked call writer is unlimited on the upside. If exercised, the writer must buy the stock at the current market price so it will be delivered at the strike price. LO 10.d

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) shorting the same stock. C) buying puts. D) buying calls.

C) Explanation 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. LO 10.d

If an investor sold two BCD Feb 40 calls at 4 on August 4, 2018, and the call expired unexercised, what were the tax consequences? A) $800 ordinary income for tax year 2019 B) $800 ordinary income for tax year 2018 C) $800 short-term capital gain for tax year 2019 D) $400 short-term capital gain for tax year 2019

C) Explanation For tax purposes, any premiums earned are recognized at the expiration date. In this case, the February call options sold in August 2018 for $400 each and expired in February 2019. Uncovered options writers always have short-term gains or losses. LO 10.i

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

C) Explanation If exercised, the assigned call writer must deliver the underlying stock within two business days (regular way settlement for equity transactions). LO 10.b

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

C) Explanation 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. LO 10.g

If a customer writes one uncovered in-the-money put, the maximum loss to the customer is A) the strike price plus the premium multiplied by 100 shares. B) unlimited. C) the strike price minus the premium multiplied by 100 shares. D) 100% of the premium.

C) Explanation If the stock becomes worthless, the investor will be forced to buy the stock at the strike price, but they still keep the premium received when the option was written. Essentially, maximum loss is breakeven multiplied by 100 shares. The fact that the put was in-the-money when the option was written is of no consequence. It is only there to distract you. LO 10.h

The market attitude of a customer who establishes a debit put spread is A) speculative. B) bullish. C) bearish. D) neutral.

C) Explanation In a put spread, a customer is buying one put and selling another with different strike prices and/or expirations. In any spread, one of the options is dominant. In a long put spread, the long put position is dominant because it has the higher premium. Buying puts is bearish. LO 10.e

Compared with selling short, it would not be correct to state that buying a put option A) requires a smaller capital commitment. B) does not require meeting the locate requirement for short sales. C) offers a high potential profit. D) has a lower loss potential.

C) Explanation In both cases, the investor profits when the price of the underlying asset declines. The maximum profit is when the price of the asset reaches zero. That makes the maximum profit on the long put equal to the strike price minus the premium. Because there is no cost in selling short (the margin deposit requires a capital commitment, but is the investor's money), the maximum profit is the entire decline to zero. For exam purposes, we disregard commissions. Buying a put requires a smaller capital commitment than does shorting the stock and has a lower loss potential (the premium only) because selling short involves unlimited risk. When selling stock short on an exchange, the shares to be borrowed must be located before the sale. This is not a requirement when buying a put. LO 10.d

A client bought 100 XYZ at $65 per share and sold an XYZ 65 call at 8. Closing the short call at 10 and selling XYZ at 68 would result in A) a $500 profit. B) a $500 loss. C) a $100 profit. D) a $100 loss.

C) Explanation Let's use the T-chart to show the flow of the money. The client bought 100 shares of the stock at $65 per share, so $6,500 went out (a debit). At the same time, the call was sold for a premium of 8, which brought in $800 (a credit). The short call was closed out (bought back something you sold) at 10, so we put $1,000 in the out (DR) column, and the stock was sold for $6,800, which goes in the in (CR) column. That means, $6,500 plus $1,000 went out, and $6,800 plus $800 came in. That is a total of $7,500 out and $7,600 in, for a net gain of $100. LO 10.h

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

C) Explanation Long stock and long calls have the same market attitude: bullish. Therefore, covering a long stock position cannot be accomplished by buying calls. The remaining choices are all strategies that could warrant call buying: increased leverage, acquisition of stock, and hedging a short stock position. LO 10.a

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 loss of $250. C) a gain of $250. D) a gain of $350.

C) Explanation Looking at each trade separately, the customer buys 100 shares of the RAN at $62.75 and sells the shares at 66.25 for a $350 gain. The customer pays $100 for the put, which expires worthless, resulting in a $100 loss. Overall, the gain is $250. Alternatively, the investor's cost is $62.75 for the stock plus one point for the put. That is a total cost of $63.75 per share. The put is worthless and the sale of the shares brings in $66.25. Once again, there is a gain of $250. LO 10.h

What option strategy might be used by an investor with a short position in a stock who wishes to generate some income? A) Write a call on the stock B) Go long a call on the stock C) Write a put on the stock D) Go long a put on the stock

C) Explanation Normally, investors who are short a stock, buy calls on that stock to protect the upside from unlimited potential loss. This question does not deal with that situation. Although the investor is short stock, the objective here is generating income. Selling (writing) an option is the only way to do that. Of the two choices, writing the put is the more logical. Short sellers of stock have an obligation to buy the stock to cover the short position. Writing the put generates income while also obligating the writer to buy the stock at the strike price if the holder of the option exercises. The stock put to the writer can be used to cover the short stock position, and everything is closed out. If you chose "write a call," a call writer is obligated to sell stock at the exercise price, stock the investor does not own. This investor is already obligated to buy back the stock sold short; why create an obligation to go into the market to buy more. In fact, writing a call would expose this investor to unlimited potential loss on both the short stock position and the uncovered call. LO 10.h

A new customer has been approved for all levels of options trading and has signed the options disclosure document. Even though approved for all levels of options trades, she notes that she will not be employing, and the registered representative (RR) should not recommend, any strategies with unlimited maximum loss potential. Given this criteria, an RR could suitably recommend A) short stock or short stock/short put hedge. B) short or long straddles. C) short or long spreads. D) short or long uncovered calls.

C) Explanation Of the pairings offered, only short and long spreads both have defined loss potentials. Short stock, short calls, short straddles, and a short stock/short put hedge positions all have unlimited loss potentials. LO 10.e

In determining a violation of position limits, short calls are aggregated with A) long calls. B) long puts. C) short puts. D) all of these.

C) Explanation Position limits are measured by the number of contracts on the same side of the market. Long calls and short puts are on the bull side, and short calls and long puts are on the bear side. LO 10.j

Which of the following positions subject an investor to unlimited risk? I) Short naked call II) Short naked put III) Long put IV) Short sale of stock A) II and III B) I and III C) I and IV D) I and II

C) Explanation Short stock and short naked calls subject an investor to unlimited risk because there is no limit on how high a stock's price might rise. Risk is limited for the other positions. LO 10.d

One of the most popular index options is the VIX. The VIX trades on A) the Boston Options Exchange (BOX). B) the New York Stock Exchange-American (AMEX). C) the Chicago Board Options Exchange (CBOE). D) the Nasdaq Options Market (NSDQ).

C) Explanation The VIX, usually referred to as the fear index, trades solely on the CBOE. Just as is the case with stock, it is not unusual to have an option listed on more than one exchange. However, the VIX is a single-market product. LO 10.g

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) Buy a DFI call with an exercise price of 40 B) Write a DFI put with an exercise price of 40 C) Buy a DFI call with an exercise price of 35 D) Write a DFI call with an exercise price of 40

C) Explanation 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. LO 10.d

Your client sells one naked MAV Oct 40 call at 2 when the market price of MAV is $41. What must MAV be selling at for the client to break even? A) 43 B) 38 C) 42 D) 40

C) Explanation The breakeven point for a call is the strike price plus the premium (call up). The breakeven point is the same for both the buyer and the writer. LO 10.h

Your customer is opening a new options account. Which of the following need not occur to open the account? A) The registered representative must document that the client has received a current OCC disclosure document. B) The client must agree that any material change in financial status requires the broker-dealer be notified and the options agreement be amended. C) The OCC must verify the financial information supplied by the client to ultimately approve the account. D) The background and financial information provided by the client must be verified by the client and returned within 15 days of the time the account was approved.

C) Explanation The client must have a current Options Clearing Corporation (OCC) disclosure document. This is verified by the client's signature on the options agreement form, which must be signed and returned within 15 days of account approval. The client must agree to notify the firm of any changes in financial status as soon as possible, and the options agreement must be amended, if necessary. OCC approval for an options account is not required, nor do they verify any information given by the client. LO 10.j

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 bull horizontal spread C) A bull vertical spread D) A bear vertical spread

C) Explanation 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. LO 10.e

A customer buys 200 XYZ at 39 and writes 2 XYZ Feb 40 calls at 3. When the stock rises to 44, the customer is exercised for a gain of A) $200. B) $400. C) $800. D) $1,600.

C) Explanation The customer bought 200 shares at 39 and was forced to sell them at 40 for a $200 gain. In addition, the customer received $600 in premium income, so the overall gain is $800. Alternatively, the breakeven point for covered call writing is cost of shares purchased less premium received (39 − 3 = 36). As the customer is bullish, gain occurs above 36. However, for this customer, the stock can go no higher than 40 because she will be exercised (40 − 36 = 4 points × 200 shares = $800). LO 10.h

A customer purchases 200 shares of XYZ at 17.50 and writes 2 XYZ Jan 20 calls at 1. At expiration, with the stock trading at 19, the options expire worthless. If the customer sells his long stock at the current market price, the gain is A) $350. B) $250. C) $500. D) $700.

C) Explanation The customer buys stock at $17.50 and sells his shares at $19 for a gain of $300. In addition, the customer keeps the $200 in premiums, for an overall gain of $500. LO 10.h

A customer buys 200 XYZ at 32, 2 XYZ JUN35 calls at 3, and 1 XYZ JUN 35 put at 6.50. Two months later, the customer purchases 1 XYZ JUN 35 put at 4. Before expiration, with XYZ trading at 37, he sells his stock and closes his calls at 2.10 and his puts at 0.25 for A) a gain of $450. B) a gain of $180. C) a loss of $180. D) a loss of $450.

C) Explanation The customer opens four positions with debits to his account: 200 shares at $32 per share equals a debit of $6,400; two calls at $300 each equals $600; one put at $650 equals a debit of 650; and finally, an additional put at $400. The stock position is sold for $37 per share for a credit of $7,400. The calls are closed for 2.10 each (a credit of $420), and the puts are closed for a credit of $25 each. LO 10.d

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 loss of $1,500. B) a loss of $7,500. C) a gain of $1,000. D) a gain of $7,500.

C) Explanation 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. LO 10.f

If a customer opens a spread on Canadian dollars (10,000 units) by purchasing 1 Dec 74 call for 2.30 and selling 1 Dec 77 call for 1.50, what is the total cost of this debit spread? A) $700 B) $4,970 C) $80 D) $800

C) Explanation The customer pays a premium of 2.30 ($230) and receives a premium of 1.50 ($150) for a net debit of 0.80, or $80. LO 10.g

A customer opens the following options position: Long 1 ALE Feb 40 put @3¼; short 1 ALE Feb 45 put @6¼. What is the customer's maximum gain, maximum loss, and breakeven point? A) Maximum gain is $200; maximum loss is $300; breakeven point is $43. B) Maximum gain is $200; maximum loss is $300; breakeven point is $42. C) Maximum gain is $300; maximum loss is $200; breakeven point is $42. D) Maximum gain is $300; maximum loss is $200; breakeven point is $43.

C) Explanation The first step is to identify the position. This is a credit put spread. It is a credit spread because the option sold brought in a higher premium than the one purchased. The credit of $300 is the most the investor can make. This is a bullish spread (the customer bought the low strike price and sold the high strike price). If the customer is correct and the stock rises above $45, the options will expire unexercised and the customer will keep that net credit of $300. If the customer is wrong and the price of the ALE stock falls below $40, the short put at 45 will be exercised, causing the customer to purchase the stock at $45. Then, the customer will exercise the long 40 put and sell that stock at $40. This results in a loss of $500 reduced by the $300 net credit, or $200 maximum loss. It is always easier to recognize that the maximum loss is the difference in strike prices minus the maximum profit. In this question, the spread is 5 points and the maximum profit is the credit of 3 points. That makes the maximum loss the remaining 2 points. Breakeven follows the put-down rule. Subtract the net premium from the higher strike price ($45 - 3 = $42). LO 10.h

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 $57.00. B) Maximum gain is $300; maximum loss is $200; breakeven point is $57.00. C) Maximum gain is $300; maximum loss is $200; breakeven point is $58.00. D) Maximum gain is $200; maximum loss is $300; breakeven point is $58.00.

C) Explanation The first step is to identify the position. This is a debit put spread. It is a debit spread because the option purchased cost more than the one sold. The debit of $200 is the most the investor can lose. This is a bear put 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 both options are exercised. For example, if the market price of PKE should fall below 55, the owner of the 55 put will exercise, causing the seller to purchase the stock for $5,500. The seller can then exercise the long 60 put and deliver the stock purchased at 55 for 60. That is a profit of $500 less the cost of the options (the debit of $200), or $300. The quick way to do this is to 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. LO 10.h

An investor opens the following positions: Sell short 100 shares of ROC @90; sell 1 ROC May 90 put @3. What is the customer's maximum gain, maximum loss, and breakeven point? A) Maximum gain is $9,300; maximum loss is unlimited; breakeven point is $93. B) Maximum gain is $300; maximum loss is $8,700; breakeven point is $87. C) Maximum gain is $300; maximum loss is unlimited; breakeven point is $93. D) Maximum gain is $8,700; maximum loss is $300; breakeven point is $87.

C) Explanation The first step is to identify the position. This is a short sale of stock and a sale of a put option. The sale of the put provides some income and offers protection only to the extent of the premium. Short sellers want the stock's price to decline. They lose when it rises. The investor has received $9,300 ($9,000 from the sale of the stock and $300 from the sale of the option). That makes the breakeven point $93 per share. Once the price of the ROC stock goes above that, the investor loses money. Because there is no limit as to how high the stock's price can go, the maximum loss is unlimited. If, on the other hand, the stock's price declines into the 80s or lower, the owner of the 90 put will exercise and our investor will pay $9,000 to purchase the stock. That stock will be used to cover the short sale. That means the investor sold the stock (short) at $90 and bought it back at $90 for no gain. At that point, the investor's only profit is the $300 from the premium on the sale of the put. 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. LO 10.h

If a customer buys 1 XYZ Nov 70 put and sells 1 XYZ Nov 60 put when XYZ is selling for 65, this position is A) a bull spread. B) a combination. C) a bear spread. D) a straddle.

C) Explanation The first step is to identify this position. A spread is the simultaneous purchase of one option and sale of another option of the same class (puts or calls). A call spread is a long call and a short call. A put spread is a long put and a short put. On the exam, it is not unusual for there to be a question about a spread that does not contain the premiums. In this case, we have a put spread, and all we are shown is the strike prices. In the case of a put (the ability to sell stock), the higher the strike price, the more valuable the option. Therefore, we know the 70 put will have a higher premium than the 60 put (wouldn't you rather be able to sell XYZ at 70 instead of 60)? That makes the option purchased (the 70) cost more than the one sold (the 60), resulting in a debit spread. A debit spread is a net buy, while a credit spread is a net sale. Therefore, a debit put spread is like buying a put, which is bearish. LO 10.d

The intrinsic value of a 60 call at 4 when the current market value of the stock price is 62 is A) $0.00. B) $400. C) $200. D) $600.

C) Explanation The intrinsic value for a call is the current market value minus the strike price. It is the amount the contract is in-the-money. In this case it is 62 - 60 = $2 per share. With 100 shares in the contract, the intrinsic value is $200. The premium is $400 and has no impact on the intrinsic value, but it does tell us that the time value is 2 points. The extent to which the premium exceeds the intrinsic value is the time value and that reduces as the option gets closer to expiration (runs out of time). LO 10.c

If an investor who has owned FLB stock for two years buys 1 FLB Oct put, this will A) end the holding period and cause any gain or loss to be short term. B) end the holding period and cause any gain or loss to be long term. C) have no effect on the holding period. D) end the holding period and cause any loss to be long term and any gain to be short term.

C) Explanation The investor already held the stock long term when the put was acquired, so there is no effect on the holding period. LO 10.i

If a customer buys 1 ABC Oct call at 7 on March 10 and sells it for 3 on October 10, the customer has a capital A) gain of $400. B) gain of $700. C) loss of $400. D) loss of $700.

C) Explanation The investor paid $700 to buy the call and received $300 to sell the call, for a net loss of $400. Options are capital items. If a put or call on a stock expires unexercised, the amount a writer receives is a short-term capital gain. The amount a buyer pays is a capital short-term loss. LO 10.i

An investor purchased 100 shares of RAVAD common stock at $40 per share on June 17, 2019. On May 11, 2020, with the RAVAD selling at $60, the investor hedges by purchasing one RAVAD Oct 55 put at 2. The put expires with the RAVAD selling at $65 and the investor liquidates the long stock position at that price. This would result in A) a long-term capital gain of $2,500 and a short-term capital loss of $200. B) a short-term capital gain of $2,700. C) a short-term capital gain of $2,500 and a short-term capital loss of $200. D) a long-term capital gain of $2,300.

C) Explanation The investor purchased a protective put on the long RAVAD position. At the time of the purchase of the put, the holding period of the stock was less than the long-term requirement of more than 12 months. When that happens, the IRS rules that the short-term holding period (June to May is short term) is erased. Your new holding period for the underlying stock begins on the earliest of the date you dispose of the stock, the date you exercise the put, the date you sell the put, or the date the put expires. Because the investor disposed of the stock at the same time the put expired, there is no holding period, so any gains will be short term. As far as the math, the stock was purchased for $4,000 (100 shares @ $40 per share). The stock is sold for $6,500 (100 shares @ $65 per share). That is a gain of $2,500 (short term). When a long put expires, it is a capital loss in the amount of the premium. In our question, the premium was 2 points ($200) and that is a complete loss. Because the put has a five-month holding period (May to October), the loss is short term. In the real world, most accountants would just net the $2,500 short-term gains and the $200 short-term loss and report a $2,300 short-term gain. It is possible that could appear on the exam, but unlikely that you would have both choices. Please let us know if you do see something like this. LO 10.i

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) I and IV D) III and IV

C) Explanation 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. LO 10.g

If your client expected short-term interest rates to fall, you might recommend that the client A) buy a Treasury bond yield-based put. B) write a Treasury bill yield-based call. C) buy a Treasury bill yield-based put. D) buy a Treasury bill yield-based call.

C) Explanation The key to debt options is that the investor is betting on the movement of interest rates, not the price of the security. As with any other investment based on downward movement (put down), the strategy called for here is buying a U.S. Treasury bill put option. Why not the Treasury bond put? Because the question refers to short-term rates and Treasury bonds are a play on long-term ones. LO 10.g

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) Selling straddles B) An option purchasing program C) A covered call writing program D) An uncovered call writing program

C) Explanation 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. LO 10.d

Trading in expiring options series concludes the same day as expiration at A) 11:00 pm ET. B) 5:00 pm ET. C) 4:00 pm ET. D) 12:00 pm ET.

C) Explanation The official close is 4:00 pm ET on the third Friday of the expiration month. Expiring options may be exercised until 5:30 pm ET on the same day. LO 10.a

In early April, a customer buys 1 XYZ Oct 60 call for 9 and sells 1 XYZ Jul 70 call for 4. Before the calls expire, the customer may realize a pretax profit if A) the price of XYZ decreases. B) the price of XYZ stays the same. C) the spread widens to more than $5. D) the spread narrows to less than $5.

C) Explanation This is a debit spread of $5 (net debit). Debit spreads are profitable if the spread widens between the premiums. LO 10.e

What is the breakeven point on the following position? Buy 1 CDE Apr 30 put at 3.10 Write 1 CDE Apr 35 put at 5.85 A) $30.10 B) $32.75 C) $32.25 D) $33.10

C) Explanation This is a put spread established at a credit of 2.75. To find the breakeven point on a put spread, subtract the net premium from the higher strike price (in this case, 35 − 2.75 = 32.25). LO 10.e

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) Sell an AMNZ put C) Sell an AMNZ call D) Buy an AMNZ put

C) Explanation 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). LO 10.a

When opening an options trading account, a broker-dealer is required by FINRA to A) determine if the customer is approved for options trading at any other member firm. B) deliver the OCC Options Disclosure Document to the customer within five business days of the account being opened. C) make sure the options agreement is signed and returned to the firm within 15 days of the account being approved. D) have the customer sign the options account agreement prior to or concurrent with the first trade in the account.

C) Explanation The options agreement must be signed and returned to the firm within 15 days of the account being approved. If it is not, then the only options activity permitted is closing transactions. A Registered Options Principal (Series 4) or Sales Principal (Series 10) signs off on the account approval. There is no requirement to determine the existence of accounts (options or otherwise) at another member firm. LO 10.j

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) Explanation 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. LO 10.h

On November 4, a customer writes an S&P 100 Jan 785 put at 6. The maximum potential gain on this position is A) 100. B) unlimited. C) 600. D) 300.

C) Explanation The potential gain on a short option is the premium received on the transaction. LO 10.h

All of the following terms are associated with the holder of an option except A) owner. B) long. C) seller. D) buyer.

C) Explanation The seller of an option contract, put or call, is not the holder of the option. The holder of an option is also known as the buyer. Buyers have a long position in the option, making them the owner of the option. As buyers, they pay the premium for the option. The seller of the contract is the writer of the option and has a short position. The writer of the option receives the premium the buyer pays. LO 10.a

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 I) buy an XYZ 35 call. II) sell an XYZ 35 call. III) buy an XYZ 35 put. IV) sell an XYZ 35 put. A) II or IV B) I or III C) I or IV D) II or III

C) Explanation 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. Likewise, the short 35 put will be out of the money and will expire, with the investor earning the premium. LO 10.d

Using listed options to reduce the market risk in a stock position by taking an opposing position in the options that represent an equivalent number of shares is known as A) straddling. B) spreading. C) hedging. D) market timing.

C) Explanation This describes hedging, which is a technique used to reduce the market risk or adverse price movement in a stock position using options. Each standardized listed equity option contract represents 100 shares, so the number of contracts needed to hedge an existing stock position is determined by the number of shares the investor is currently long or short. LO 10.d

An investor believes that the U.S. dollar will rise in value against the British pound. To profit with limited risk, which of the following foreign currency option transactions would you recommend? A) Sell British pound puts B) Buy British pound calls C) Buy British pound puts D) Sell British pound calls

C) Explanation This investor should buy puts on the British pound to lock in the highest possible price at which to sell pounds. Any answer must be framed in terms of the British pound because there are no listed options on the U.S. dollar. LO 10.g

If a customer buys 1 XYZ Aug 50 put at 1 and sells 1 XYZ Aug 65 put at 10 when XYZ is at 58, what is the maximum risk? A) $100 B) $900 C) $600 D) $1,500

C) Explanation This is a credit spread. The maximum loss is the difference between the strike prices and the net credit. In this example, the strike price difference is 15 (65 - 50) and the net premium is 9 (10 − 1), or 15 − 9 = 6 × $100 = $600 maximum loss. The maximum gain is the net credit of $900. Credit put spreads are bullish (buy the low strike, sell the high strike). If the stock's price should rise above $65 per share, both options expire worthless (who wants to sell stock at $50 or $65 when the price is above that). If the investor is wrong and the stock price falls below $50, the short put will be exercised and the investor will have to buy the stock at $65 per share. Now that the stock is owned, it can be used to exercise the long put and be sold at $50 per share. That $15 difference between the 50 and 65 strikes is the largest spread possible. Comparing the loss of $1,500 to the initial credit of $900 proves that the maximum risk of loss is $600. LO 10.e

On exercise of the option, the holder of a long call will realize a profit if the price of the underlying stock A) falls below the exercise price minus the premium paid. B) falls below the exercise price. C) exceeds the exercise price plus the premium paid. D) exceeds the exercise price.

C) Explanation To profit on a long call, the market price must exceed the strike price plus the premium paid (the breakeven point) computed using the call up rule. LO 10.h

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 puts B) Write 10 ZOO puts C) Buy 10 ZOO calls D) Write 10 ZOO calls

C) Explanation 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. LO 10.d

Which of the following has unlimited risk if it is the only position in an account? A) Short put B) Long call C) Short call D) Long put

C) Explanation Uncovered short calls carry unlimited risk. LO 10.d

Buying back an option contract that was previously written or selling an option contract that was previously purchased is known as A) indexing. B) exercising. C) closing out a position. D) dollar cost averaging.

C) Explanation When an investor sells a security they are long or buys back a security they are short, he is closing out an existing position. LO 10.a

A covered call could be written to A) purchase future securities. B) lock in a profit. C) improve the return on a portfolio. D) protect a short stock position.

C) Explanation Writing a call will not necessarily lock in the profit. In the form of increased cash flow, it will improve the return on the portfolio. LO 10.d

The writer of an IRX yield-based option, if exercised, must A) receive cash. B) deliver T-bills. C) deliver cash. D) receive T-notes.

C) Explanation Yield-based options settle in cash if the option is exercised. The writer must deliver the in-the-money amount in cash. LO 10.g

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 smallest position in the option B) Assignment to the customer with the largest position in the option C) Assignment to the customer with the oldest position in the option D) Assignment to the customer with the largest position in the underlying security

C) Explanation You cannot discriminate between large and small customers. First-in, first-out is not considered to be discriminatory. LO 10.b

An investor is short stock at $70. If the stock's market price is $40, and the investor anticipates the price will continue to decline, to hedge against a rise in the price, the investor should A) buy a put. B) buy a straddle. C) sell a call. D) buy a call.

D) Explanation If the investor buys a call on the stock, he has the right to buy it back (cover his short) at a fixed price. The best way to hedge an unrealized gain on a short stock position is to buy a call. LO 10.d

As a registered representative, you often have customers who are interested in learning about derivative products such as options and different derivative strategies. Of the following customer profiles, which would writing calls be considered least suitable for? A) Roald and Katy Johnson, both young professionals with a combined annual income of $80,000. Both making small annual IRA contributions and participating in company-sponsored 401(k) plans. Katy will also be eligible for pension plan payments after retirement several years away. Current savings total $25,000, and their joint investment account objective is growth. B) DeMarcus, a small business owner nearing the sale of his business to take an early retirement at age 52. A lump-sum annuity has been in place in anticipation of the early retirement, and the business sale proceeds will be more than adequate for his early anticipated living expenses. Current savings total $55,000, and his investment account objective is growth. C) Chanice, age 41, able to add to her savings each month after living expenses from her monthly income. Currently building retirement account balances in an IRA and company-sponsored 401(k) plan. Recently investing in an income-producing vacation property. Her savings outside of retirement accounts currently total $70,000. Growth is listed on her investment account as her objective. D) Bernard and Judy Jones, both retired, covering monthly expenses with their Social Security and annual mandatory IRA withdrawals. Savings outside of retirement accounts total $25,000. Income is the investment objective listed on the account. Explanation LO 10.j

D) While these profiles offer some guidance, and any of them could be considered incomplete to some extent, the one for whom writing calls would be considered the least suitable is the retired joint account of Bernard and Judy Jones. Factors to note would be the nominal total savings and that both are in retirement, needing Social Security and mandatory IRA withdrawals to meet current living expenses. Consider that while writing calls brings income into an account, it is a strategy that is high in risk with an unlimited maximum loss potential—not suitable for a retired couple in their position.

If an investor buys a LEAPS contract on issuance and allows it to expire unexercised, what is the investor's tax consequence at expiration? A) Long-term capital gain B) Short-term capital loss C) Short-term capital gain D) Long-term capital loss

D) Explanation A LEAPS contract has an expiration of more than one year. Upon expiration, the buyer incurs a long-term capital loss equal to the amount of the premium paid. LO 10.i

Which term describes the following position? Write 1 DOH Jan 30 call Write 1 DOH Jan 40 put A) Short straddle B) Diagonal spread C) Price spread D) Short combination

D) Explanation A combination is composed of a long call and long put, or a short call and a short put, each having different strike prices and/or expiration months on the same underlying security. LO 10.f

Which of the following is a bull spread? A) Long Aug 30 call, short Aug 25 call B) Long May 40 put, short May 35 put C) Short Aug 40 call, short Aug 40 put D) Long Jul 30 put, short Jul 35 put

D) Explanation A debit call spread is bullish and a credit put spread is bullish. Long Jul 30 put, short Jul 35 put is the only bullish position in the answer choices. Short Aug 40 call, short Aug 40 put is a short straddle, not a spread, and the remaining two positions are bearish: long Aug 30 call, short Aug 25 call and long May 40 put, short May 35 put. Remember, buying the low strike and selling the high strike is always a bull spread, regardless of the spread being puts or calls. LO 10.e

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

D) Explanation 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. LO 10.b

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 sell stock. D) the right to buy stock.

D) Explanation A long call gives the holder the right to buy stock. LO 10.a

On a single day, a customer purchases 15 TPL Sep 50 puts at 6 and 15 TPL Sep 50 calls at 1. If the price of TPL is $45 per share and the customer has no other security positions, what is this position called? A) Combination B) Covered C) Spread D) Straddle

D) Explanation A long straddle is the purchase of a call and a put on the same stock with the same strike price and expiration. A straddle differs from a combination in that the strike prices and/or the expiration dates on a combination are different. A spread is a long put and a short put or a long call and a short call, rather than a put and a call. LO 10.f

All of the following option positions have limited potential loss except A) long puts. B) long calls. C) short uncovered puts. D) short uncovered calls.

D) Explanation A short uncovered call has unlimited potential loss because, theoretically, a stock's price can rise indefinitely. The potential loss on a short uncovered put can be large but is limited to the put's strike price minus the premium received per share. The potential loss on a long call or a long put is limited to the premium paid. LO 10.d

You and your spouse like to invest in option contracts. You each have separate individual accounts with different brokers for executing your trades. The current level of contract position limits for ABC stock is 75,000 contracts. Which of the following would be a violation of the contract limit? A) You are long 36,650 ABC calls, and your spouse is long 38,350 ABC puts. B) You are short 38,650 ABC calls, and your spouse is short 36,345 ABC calls. C) You are long 37,950 ABC calls, and your spouse is short 37,020 ABC calls. D) You are long 37,650 ABC puts, and your spouse is short 37,560 ABC calls.

D) Explanation A violation would occur if you exceed the 75,000-contract position limit for ABC stock with combined positions that are on the same side of the market. A long put and a short call each represent a bearish position, and the combined positions in the correct answer exceed 75,000. Even though you each have individual accounts, it is deemed that you would each have control over the other's account for determination of contract position limit violations. LO 10.j

Which of the following positions exposes a customer to unlimited risk? A) Short 200 shares of XYZ and short 2 XYZ puts B) Short 200 shares of XYZ C) Short 2 XYZ uncovered calls D) All of these

D) Explanation All of the positions expose the client to unlimited risk because a loss will occur if the stock price rises. LO 10.d

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

D) Explanation An investor wants a debit spread to widen (I and II). As the difference between premiums increases, so does potential profit because the investor may sell the option with the higher premium and buy back the option with the lower premium. With credit spreads, investors profit if the spread between the premiums narrows. LO 10.e

An option confirmation must include all of the following except A) the strike price. B) the number of contracts and premium. C) the type of option and commission. D) the positions market attitude (bullish or bearish).

D) Explanation An option transaction's confirmation must completely recap the essential elements of the trade, including the number of contracts traded, the description of the security traded (type of option and strike price), the price of the security traded (premium), and any commission charges. The positions market attitude (bullish or bearish) is not included on the confirmation. LO 10.a

DWQ declares a quarterly cash dividend of $0.20. After the ex-dividend date, what will be the exercise price of a listed DWQ May 25 call option? A) $24.80 B) $25.25 C) $24.75 D) $25.00

D) Explanation Because a listed option is not adjusted for a cash dividend, the exercise price of a DWQ May 25 call option remains the same: $25. LO 10.j

A Japanese manufacturer sells recorders to a U.S. retailing firm. The manufacturer is to receive USD$1 million in 90 days. How can he best protect himself against a decline in the dollar? A) Buy yen puts B) Sell yen calls C) Sell yen puts D) Buy yen calls

D) Explanation Because he is receiving U.S. dollars, his risk is that the U.S. dollar will go down in value against the Japanese yen. If the dollar goes down against the yen, the yen will rise. Therefore, to protect his risk against a rising yen, he should buy yen calls. The yen calls will increase in value if the yen rises. LO 10.g

What is the breakeven point on the following position? Buy 1 QRS Jan 40 call at 2.35 Write 1 QRS Jan 45 call at 0.85 A) $43.25 B) $41.75 C) $43.50 D) $41.50

D) Explanation Because this is a call spread, the breakeven point is calculated by adding the net premium of 1.50 to the lower strike price (40 + 1.50 = 41.50). LO 10.e

One of your customers might buy a call option for all of the following reasons except A) diversifying an investor's holdings. B) deferring a stock buying decision. C) protecting an existing short stock position. D) protecting an existing long stock position.

D) Explanation Buying a call will not protect a long stock position because a long call is a bullish strategy just as is a long position in a stock. Protection comes from buying an option with the opposite strategy, such as a long put. Buying a call is the strongest upside protection for a short stock position. A long call allows an investor to defer buying a stock by locking in the purchase price for up to nine months. Buying calls instead of buying their underlying stocks is also a strong diversification tool because it allows the investor to control many stocks in many different industries with a small outlay of funds. LO 10.d

Which of the following options positions would reduce the risk on a long position in the underlying stock? I) Buy a put II) Buy a call III) Sell a call IV) Sell a put A) II and III B) I and IV C) I and II D) I and III

D) Explanation Buying a put reduces risk on the stock's decline. Selling a call reduces the net cost of the long purchase. Both are hedging the stock position. LO 10.d

An investor who owns XYZ stock is optimistic about the long-term growth potential of the company. However, the stock—currently priced at $58—has made a sharp advance in the past week, and the investor wants to lock in a minimum price in case the share price drops. Which of the following option transactions will help meet the investor's objective? A) Buy $55 call options B) Sell $55 call options C) Sell $55 put options D) Buy $55 put options

D) Explanation Buying the puts creates a long stock, long put hedge position. The exercise price for a put is the price at which the owner of the put can sell the stock when the put is exercised. With this position, if the stock falls, the investor will exercise the put and sell the stock at $55. Thus, a sale price of $55 will be assured in the event that the stock price falls. LO 10.d

All of the following will cover a short call except A) a long call with a lower strike price and later expiration. B) a long position in the underlying stock. C) an escrow receipt for the stock. D) cash equal to the aggregate exercise value.

D) Explanation Cash never covers a short call because the cost to purchase the stock in the market for delivery at the strike price is unknown. If assigned, the customer must sell (deliver) at the strike price. LO 10.d

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) $700. B) $200. C) $2,300. D) $1,800.

D) Explanation 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. LO 10.h

U.S. exchange-listed foreign currency option premiums are quoted in which of the following? A) Units of foreign currency B) Both units of foreign currency and the percentage of value of the foreign currency C) Percentage of value of the foreign currency D) U.S. dollars

D) Explanation Foreign currency option premiums are quoted in U.S. dollars. Because one point equals $100, a premium quote of 1.70 equals $170. LO 10.g

A customer is short a DMF 50 call for which he received a premium of 4. Seven months later, the call was exercised when the current market for DMF was 56. Under the Internal Revenue Code, what were the proceeds of his sale? A) $5,000 B) $4,600 C) $5,600 D) $5,400

D) Explanation He wrote a call and received a premium of 4. He later sold the security at $50, which made his total receipts for the stock $54. Proceeds in this case refers to the total amount he took in (a $400 premium plus $5,000 upon the sale). LO 10.i

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

D) Explanation 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. LO 10.g

An investor opens the following position: Buy 1 COD Jan 40 put at 6.50 Write 1 COD Jan 30 put at 2.10 His maximum loss is A) $560. B) $2,100. C) $2,600. D) $440.

D) Explanation The maximum loss on a debit spread is the net debit. LO 10.e == debit 6.5, credit 2.10 == net debit 4.4 == $440.

An investor establishes the following positions: Long 1 XYZ Apr 40 call for 6 Long 1 XYZ Apr 50 put for 8 If both options are sold for intrinsic value when XYZ trades at 44, the investor realizes a loss of A) $100. B) $200. C) $1,000. D) $400.

D) Explanation If the opening purchase of the XYZ Apr 40 call was made at 6, and the closing sale of that call was made at 4, the difference of 2 represents a $200 loss. If the opening purchase of the XYZ Apr 50 put was made at 8, and the closing sale of that put was made at 6, the difference of 2 represents a $200 loss. The total loss for the account is $400. LO 10.f

All of the following positions have limited loss potential except A) short stock/long call. B) long stock/long put. C) long stock/short call. D) short stock/short put.

D) Explanation If the stock rises, the put will expire, leaving the customer short stock with an unlimited loss potential. LO 10.d

If a customer is long ABC Sep 30 calls, and the stock becomes subject to a trading halt on the floor of the NYSE, the customer is permitted to A) establish a long call spread. B) enter a closing sale. C) establish a long straddle. D) issue exercise instructions.

D) Explanation If trading in the underlying security is halted, options trading on that security is also halted. However, the customer may still issue exercise instructions to the Options Clearing Corporation because this is an off-floor transaction. LO 10.i

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

D) Explanation 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). LO 10.e

A customer is long 1 XYZ Jan 50 put. To create a bull put spread, the customer must sell a Jan A) 50 call. B) 50 put. C) 45 put. D) 55 put.

D) Explanation In any spread, put or call, if the customer is buying the lower strike price, the spread is bullish. Therefore, to create a bull put spread, the customer (who is long the 50 put) must sell a put with a higher strike price. A bull put spread is also called a short put spread. LO 10.e

Listed options on U.S. exchanges are available on all of the following currencies except A) the Canadian dollar. B) the Euro. C) the Japanese yen. D) the U.S. dollar.

D) Explanation In the U.S., exchange-listed currency option contracts exist on foreign currencies, not on the U.S. dollar. With U.S. exchange-listed currency option contracts, the U.S. dollar is the base currency to which movements in the foreign currency is compared. LO 10.g

On Friday, September 15, an investor goes long 1 OEX Dec 575 call at 7 when the index is at 581.96. At expiration, the investor closes out the long position at intrinsic value when the index is at 580. What amount of money will be deposited in the investor's account on the following Monday, and what will the profit or loss be to the investor? A) $696/$196 gain B) $500/$200 gain C) $500/$196 loss D) $500/$200 loss

D) Explanation Index options settle in cash on the next business day. Each point in an index option is valued at $100. On settlement, the investor will receive the difference between 580 and 575 (5 × 100), or $500. With a cost of 7 ($700), this will create a $200 loss. LO 10.h

Your client's position is long 100 MNO purchased at 90. Which of the following strategies will limit the customer's loss to $700? A) Short one MNO 90 call at 4, short one MNO 90 put at 3 B) Buy a MNO 90 call at 7 C) Sell a MNO 90 call at 7 D) Long one MNO 90 call at 4, long one MNO 90 put at 3

D) Explanation It is the long put in this straddle position that limits the maximum loss on the long stock position. If the MNO stock drops to $0, the customer loses $9,000 on the long stock position but retains the right to sell the stock to someone at $9,000, to prevent loss beyond the premium of $300. The call would expire out of the money, for a total loss of $700. LO 10.f

A couple in retirement wants to add income to their account. Which of the following would be the least suitable? A) Credit put spreads B) Credit call spreads C) Writing covered calls D) Writing uncovered calls

D) Explanation It should be noted that, pending other factors, engaging in options transactions may not be suitable at all for someone in retirement. All of the selections would initially add income to the account, but based only on the information given, writing uncovered calls would be deemed the least suitable, as it is the only strategy listed with unlimited maximum loss potential. While the other strategies listed all have risk associated with them, the risk is limited to a defined amount. LO 10.d

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) $400. C) $600. D) unlimited.

D) Explanation 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). LO 10.f

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

D) Explanation 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. LO 10.d

An investor, with a well-diversified portfolio oriented toward growth, has 60% invested in the stocks of 28 different companies. She would like to hedge the downside risk for the equities and is comfortable using options to do so. Which of the following is most suitable? A) Write calls on each of the individual stocks B) Write index option calls C) Purchase puts on each of the individual stocks D) Purchase index option puts Explanation Selling options to hedge adds income to the account (premiums received), but the protection is limited. The best hedging protection is to purchase options, and to hedge long stocks, purchasing puts is the most suitable. With so many stocks to hedge, doing so individually would not be cost effective due to commissions. On the other hand, hedging the entire portfolio with index options allows the hedge to be done in fewer—if not a single—transaction. LO 10.d

D) Explanation Selling options to hedge adds income to the account (premiums received), but the protection is limited. The best hedging protection is to purchase options, and to hedge long stocks, purchasing puts is the most suitable. With so many stocks to hedge, doing so individually would not be cost effective due to commissions. On the other hand, hedging the entire portfolio with index options allows the hedge to be done in fewer—if not a single—transaction. LO 10.d

If a Japanese exporter wants to hedge a recent sale of stereo equipment to a U.S. buyer, and the exporter will be paid in U.S. dollars upon delivery of the goods, the best hedge would be to A) sell Japanese yen puts. B) sell Japanese yen calls. C) buy Japanese yen puts. D) buy Japanese yen calls.

D) Explanation The Japanese exporter will be paid in U.S. dollars upon delivery of the equipment. He would be adversely affected if the dollar dropped in value in relation to the yen. To protect his position, he should buy calls on his own currency—the yen. Then if the yen appreciates, his loss on the dollar is offset by his gain on the calls. Exporters buy puts on foreign currency to hedge, but there are no options on the U.S. dollar. The next best strategy is to buy calls on the home currency. LO 10.g

A U.S. company that sells stereo equipment places an order for Japanese stereo components for its inventory. Payment must be made in Japanese yen in three months. The U.S. company thinks that the U.S. dollar may weaken against the yen. Which of the following foreign currency option transactions would best protect the U.S. company from a weakening of the U.S. dollar against the yen? A) Sell puts on Japanese yen B) Buy puts on Japanese yen C) Sell calls on Japanese yen D) Buy calls on Japanese yen

D) Explanation The U.S. company is concerned that the value of the Japanese yen will rise. Therefore, the company should buy calls on the yen to lock in the lowest possible price to buy yen for payment of the contract. Importers buy calls to hedge. LO 10.g

Many options traders give attention to the VIX. The VIX A) was created by the Options Clearing Corporation (OCC). B) tends to rise during periods of high investor confidence. C) rises when call buying on the SPX (the S&P 500) increases. D) rises when put buying on the SPX (the S&P 500) increases.

D) Explanation The VIX is an indication of volatility. When there is more put buying than call buying, the VIX increases. Conversely, more call buying than put buying results in a decrease to the VIX. It is often called the "fear" index and, in fact, had its highest reading during the Covid-19 crisis of 2020. It was created by the CBOE, not the OCC. LO 10.g

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) $4 B) $40 C) $46 D) $44

D) Explanation 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. LO 10.e

The breakeven point for covered call writers is A) strike price plus premiums. B) strike price less premiums. C) cost of stock plus premiums. D) cost of stock less premiums.

D) Explanation The breakeven point for an investor who owns the underlying stock and writes a call is the cost of that stock less the premium received from the sale of the call. LO 10.h

A customer establishes the following positions: Buy 100 ABC at 28 Buy 1 ABC Dec 25 put at 2 What is the breakeven point? A) 27 B) 26 C) 23 D) 30

D) Explanation The breakeven point is where an investor neither makes nor loses money. In this hedged position, the buyer must recover the cost of the stock and the premium paid to break even (28 + 2 = 30). Please note that the call up and put down rule does not apply when there is a stock position. LO 10.h

Which of the following procedures are required to open and maintain an options account? I) The registered representative must document that the client has received a current Options Clearing Corporation (OCC) disclosure document. II) The client must verify and return his background and financial information within 15 days. III) If there is a material change in the client's financial status, amendment of the options agreement is required. IV) Any recommendations made must consider the financial needs and situation of the client. A) I and II B) II and III C) III and IV D) I, II, III, and IV

D) Explanation The client must have a current OCC disclosure document. An understanding of the client's financial situation is required to make any recommendations. Changes in the client's status must be updated as soon as possible, and the option agreement form must be returned within 15 days of account approval. LO 10.j

An investor writes 10 ZPF April 70 calls at a premium of 3 for each contract and shorts 10 ZPF April 70 puts at a premium of 1 for each contract. This investor's strategy is A) a bear spread. B) a short combination. C) a bull spread. D) a short straddle.

D) Explanation The customer has created a short straddle. A customer who writes (sells or shorts) a call and a put on the same underlying security, having the same strike prices and same expiration month, has created a short straddle. The investor's belief is that the market price of ZPF will remain stable and that will cause both options to expire. The investor's maximum profit is the combined premiums of $4,000 ($300 + $100) times 10 contracts. LO 10.f

One of your customers is long 400 shares of MMLJ common stock. The price of the stock has risen sharply since the customer purchased it. The customer is concerned about a price pullback and asks you to recommend a hedging strategy. You recommend that the client A) buy 1 MMLJ call. B) buy 4 MMLJ calls. C) buy 1 MMLJ put. D) buy 4 MMLJ puts.

D) Explanation The customer is long the stock and so needs protection should the price of the stock fall, and a long put could give such protection. Buying a put on a long position is the strategy known as a protective put. Because the customer is long 400 shares, they need four puts to hedge the position. If the customer had been short the stock, they would use long calls to hedge. LO 10.d

A customer holds 10 TRG May 60 calls. The stock splits 3:2. What is the number of contracts, adjusted strike price, and the adjusted number of shares per contract? A) 15 contracts @$40 for 100 shares B) 10 contracts @$60 for 150 shares C) 15 contracts @$60 for 100 shares D) 10 contracts @$40 for 150 shares

D) Explanation The number of contracts is not adjusted—there are still 10. However, with a 3:2 split, the number of shares per contract increases to 150. Because the aggregate exercise price must remain the same as before the split ($6,000 per contract), the price per share is reduced to 2/3rds of the original, or $40 per share. We check that by multiplying the new contract size (150) by the new contract price ($40) and the result is the original $6,000 per contract. LO 10.j

An investor opens the following options position: Long 1 ABC Aug 50 call @ 5½; short 1 ABC Aug 55 call @ 3½. What is the investor's maximum gain, maximum loss, and breakeven point? A) Maximum gain is $200; maximum loss is $300; breakeven is $53. B) Maximum gain is $200; maximum loss is $300; breakeven is $52. C) Maximum gain is $300; maximum loss is $200; breakeven is $53. D) Maximum gain is $300; maximum loss is $200; breakeven is $52.

D) Explanation The first step is to identify the position. This is a debit call spread. It is a debit spread because the option purchased costs more than the one sold. The investor purchased the 50 call for a premium of 5½ and sold the 55 call for a premium of 3½. That difference (5½ minus 3½), a debit of $200, is the most the investor can lose. This is a bullish spread (the investor bought the low strike price and sold the high strike price). If the investor is correct and the stock rises, the short call will be exercised. That means the writer will have to sell the stock at $55 per share. However, the investor will exercise the 50 call and deliver the stock purchased for $5,000 and receive proceeds of $5,500. The $500 profit is reduced by the $200 it cost to put on the spread. That means a net gain of $300. The fastest way to do a question like this is to subtract the debit from the strike price difference (5 points here) and you have your maximum gain. In this case, it is $5 ‒ $2 = $3. Breakeven follows the call-up rule; add the net premium (the debit of $2) to the lower strike price ($50) to arrive at $52. LO 10.h

An investor opens the following positions: Sell short 100 shares of FAB @72; buy 1 FAB Jun 70 call @5. What is the customer's maximum gain, maximum loss, and breakeven point? A) Maximum gain is $6,700; maximum loss is $300; breakeven point is $77. B) Maximum gain is $300; maximum loss is $6,700; breakeven point is $67. C) Maximum gain is $300; maximum loss is unlimited; breakeven point is $77. D) Maximum gain is $6,700; maximum loss is $300; breakeven point is $67.

D) Explanation The first step is to identify the position. This is a short sale with a protective call. That is, the customer has shorted the stock and purchased a call to protect the upside. This investor will break even when the stock's price is equal to the sale price ($72) minus the premium paid ($5), or $67. Short sellers lose when the price of the stock goes up. That means a short sale has potentially unlimited risk of loss. A way to ensure that the loss is limited is to purchase a call on the stock. If the stock should rise significantly above the $72 received on the short sale, instead of having to cover the short in the market at that high price, the investor will exercise the long call and be able to cover at $70. That means the maximum loss is the $500 premium paid for the protection less the difference between the sale proceeds ($7,200) and the cost of exercising the call ($7,000). That is $500 minus $200, resulting in a maximum loss of $300. If the stock's price falls, and it can decline to zero, the investor's cost to cover is zero, resulting in a profit of $7,200 minus the premium of $500 ($6,700). Why doesn't the breakeven follow the "call-up" 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. LO 10.h

A customer opens the following positions: Buy 100 shares of CDL @$40; sell 1 CDL Apr 40 call @2. What is the customer's maximum gain, maximum loss, and breakeven point? A) Maximum gain is $200; maximum loss is $3,800; breakeven point is $42. B) Maximum gain is $200, maximum loss is unlimited; breakeven point is $38. C) Maximum gain is unlimited; maximum loss is $3,800; breakeven point is $38. D) Maximum gain is $200; maximum loss is $3,800, breakeven point is $38.

D) Explanation The first step is to identify the position. This long stock with a short call (i.e., a covered call position). Breakeven is the customer's net cost. The price of the stock ($40) minus the premium ($2) received equals the $38 per share breakeven point. The strategy is to generate some income with a little protection against a decline in the price of the CDL stock. The premium income is the most this client can make. If the stock should rise well above the cost of $40 per share, the short call will be exercised and the customer will deliver the stock purchased at $40 and receive $40. Regardless of how high the stock price rises, this customer can never make more than the $2 premium. If the stock's price should decline, the call will expire unexercised. That 2-point premium protects the long stock, but only for those 2 points. Once the market price falls below $38 (the breakeven point), it is all a loss for the customer, down to a maximum $3,800 if the price drops to zero. Why doesn't the breakeven follow the "call-up" 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. LO 10.h

Which of the following transactions in the same security will affect the holding period of a security held for 12 months or less? I) Buy a put II) Buy a call III) Sell short IV) Sell a put A) II and III B) I and II C) II and IV D) I and III

D) Explanation The holding period of a capital asset is based on the amount of time the asset is held at risk. When there is no longer the possibility of a loss, there is no longer any risk. Buying a put or selling short effectively removes the risk from a transaction and destroys any short-term holding period. The short-term holding period will not become a long-term holding period for tax purposes, as long as the offsetting position (put or short) is maintained. LO 10.i

A customer establishes the following positions: Buy 100 JMB at 28 Buy 1 JMB Dec 25 put at 2 What is the maximum potential loss? A) $200 B) $2,800 C) $3,000 D) $500

D) Explanation The investor loses money on the long stock position when the market value falls. With the purchase of the put, the investor can sell the stock for no less than the strike price, but also loses the premium. In this example, the investor loses a maximum of $3 on the stock (28 − 25) plus the premium of $2, for a total loss of $500 on 100 shares. LO 10.d

If an investor sells 1 TCB Jul 40 put and buys 1 TCB Jul 50 put, and subsequently sells the Jul 50 put, what is the consequence? A) Short-term capital gain if she sells at a profit, or long-term capital loss if she sells at a loss B) Long-term capital gain if she sells at a profit, or short-term capital loss if she sells at a loss C) Passive income or loss D) Capital gain or loss

D) Explanation The investor opens with a vertical (price) spread. If she closes out one of the legs of the spread, she has a capital gain or loss for tax purposes as of the closing trade date. LO 10.i

If an investor buys one KLP Oct 95 put at 6.50, what is the investor's maximum potential gain? A) $9,500 B) $9,650 C) $10,150 D) $8,850

D) Explanation The maximum gain on a long put is calculated by subtracting the premium from the strike price (95 − 6.50 = 88.50 per share). One contract represents 100 shares, so the buyer's maximum gain is $8,850 if the stock declines to zero. Because put buyers are bearish, they will make money if the stock falls below the breakeven point of 88.50. LO 10.h

An investor writes 1 IBS 280 put for 16.60. The position is closed, and the put is bought for its intrinsic value when IBS is trading at 265.25. The investor realizes A) a $145 profit. B) a $235 loss. C) a $185 loss. D) a $185 profit.

D) Explanation The opening sale of the IBS put was made for 16.60, and the closing purchase was made for the intrinsic value of 14.75. The put's intrinsic value is determined by how far the stock's market price is below the strike price. (In this case, 280 minus 265.25.) 16.60 − 14.75 = 1.85 × 100 shares = $185.00. The investor profits because the sale's proceeds exceed the purchase price. LO 10.h

If MCS is trading at 43 and the MCS Apr 40 call is trading at 4.50, what is the intrinsic value and the time value of the call premium? A) Intrinsic value 4.50, time value 0 B) Intrinsic value 3, time value 4.50 C) Intrinsic value 1.50, time value 3 D) Intrinsic value 3, time value 1.50

D) Explanation The option is in the money by three points (the strike price on the call is 40 and the market price is 43). Because the actual premium is 4.50, the balance of 1.50 represents time value. Remember P - I = T (Premium minus intrinsic value equals the time value). LO 10.c

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) Explanation 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. LO 10.a

On February 7, a customer buys 100 shares of LMN at $39 per share and simultaneously writes an LMN Oct 35 call option at 6. If the call is exercised on July 19, what will she report for tax purposes? A) A $200 loss B) A $600 gain C) A $600 loss D) A $200 gain

D) Explanation The premium received for writing a call becomes part of the stock sales proceeds, for a total of $4,100. Because the investor bought the stock five months earlier for $3,900, she incurred a $200 capital gain (short-term). LO 10.i

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

D) Explanation The purchase of a put limits the downside risk to the difference between the stock price and the put's strike price. LO 10.d

In March, a customer sells 1 ABC Oct 50 put for 3 and buys 1 ABC Oct 60 put for 11. The customer will experience a pretax profit from these positions if I) the difference between the premiums narrows to less than $8. II) the difference between the premiums widens to more than $8. III) both puts are exercised at the same time. IV) both puts expire unexercised. A) I and III B) II and IV C) I and IV D) II and III

D) Explanation This debit spread becomes profitable if the spread widens between the premiums. Credit spreads are profitable if the spread narrows between the premiums. If both puts are exercised, the spread is profitable. If the short 50 put is exercised, the customer buys the stock and sells it for 60 by exercising the long 60 put ($1,000 profit − $800 premiums = net $200 profit). LO 10.e

A client writes 1 Dec 45 put and buys 1 Dec 60 put. This is A) a debit bull spread. B) a credit bear spread. C) a credit bull spread. D) a debit bear spread.

D) Explanation This is a debit bear spread, and bears buy puts. The 60 put is worth more than the 45 put because it has a higher strike price. LO 10.e

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

D) Explanation 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. LO 10.h

The purchase of 200 shares of HGF at 45, and the subsequent sale of 2 HGF 50 calls at 3, could produce all of the following except A) a profit of $1,600. B) a loss of $8,400. C) a loss of $6,000. D) a profit of $2,000.

D) Explanation This is covered call writing. The maximum loss that could be incurred is $8,400 ($9,000 paid for shares less premiums of $600 received). If you can lose $8,400, then you can certainly lose $6,000 (if, for example the value of the stock drops to 12). The maximum profit that can be expected is $1,600 (strike price of $10,000 received when calls are exercised minus the purchase price of $9,000 plus $600 in premiums received). Because the maximum profit possible is $1,600, it is impossible to have a profit of $2,000. LO 10.h

With XYZ trading at $47.50, your customer writes 1 XYZ Jan 50 put and simultaneously writes 1 XYZ Jan 45 call, receiving $600 in combined premiums. Your customer's market attitude is A) speculative. B) bearish. C) bullish. D) neutral.

D) Explanation This position is a short combination where both contracts are in the money. Breakeven points are 51 and 44. Above or below these points, the customer will lose money. LO 10.f

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) $550. C) $537. D) $525.

D) Explanation 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. LO 10.f

Your client with a short call position in the S&P 100 index (OEX) is assigned an exercise notice. The obligation is fulfilled by delivering A) a long call in the OEX at the same or lower strike price. B) 100 shares of a particular stock in the index selected by the option holder. C) 100 shares of each of the 100 stocks in the index. D) cash equal to the difference between the closing value of the index and exercise price.

D) Explanation Unlike equity options, index options are settled in cash only. Upon exercise, cash equal to the amount that the option is in the money (i.e., excess of market value over strike for a call or excess of strike over market value for a put) is delivered on the settlement date. LO 10.g

If a writer of an XYZ equity call option is assigned, which of the following should be delivered to the Options Clearing Corporation? A) Any listed security of comparable value to XYZ B) Rights or warrants exercisable to purchase the underlying XYZ security C) Cash equal to the market value of the underlying XYZ security D) The underlying XYZ security

D) Explanation When a call is exercised, that specific security must be delivered by the assigned writer. The option contract does not allow for exercise settlement in cash, securities of equivalent value, or securities exercisable to purchase the underlying securities such as rights or warrants. LO 10.b

Which of the following options transactions settles T+2? A) Opening purchase of a long equity put option B) Exercise of long index option C) Closing sale of a long equity put option D) Exercise of a long equity put option

D) Explanation When a long equity put option is exercised, from a settlement standpoint, it is the same as anyone selling stock. That is T+2 settlement date. The trading of options, not the exercise, is T+1. When it comes to index options, because they settle in cash, exercise settlement is T+1 rather than T+2 like equity options. LO 10.g

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

D) Explanation When an investor takes a short position in an option, it means the investor has sold, or written the option. When a call option is exercised, the seller is obligated to deliver the stock at the exercise (strike) price. A strike price of $140 for 100 shares results in the seller receiving $14,000 on settlement date. LO 10.a

With ABC stock selling for $49, a client sells one ABC 50 Nov call option in his cash account with your firm. One week later, ABC is now at $51 per share and his spouse sells two ABC 50 Nov calls in her account. In early November, ABC is selling for $62 per share and the spouse is assigned an exercise notice on one of the calls. The client calls and asks you, "Why was the exercise notice assigned to my spouse and not me?" You should respond: A) The OCC assigns exercise notices based on the market price at the time the option was written. B) The OCC assigns exercise notices based on the larger position. C) The OCC assigns exercise notices based on LIFO. D) The OCC uses random allocation when assigning exercise notices.

D) Explanation When an option is exercised, the OCC determines to whom it will be assign by random selection. Broker-dealers can elect to use that or FIFO. The size of the position is never taken into consideration, nor is the market price at the time of the write. LIFO is not an acceptable manner for assigning options. LO 10.b

A foreign currency investor is long 40,000 Swiss francs at $0.81. If the investor buys 4 Jul 80 SF puts at 1.25 to hedge, the breakeven point is A) 0.4975. B) 0.5125. C) 0.4875. D) 0.8225.

D) Explanation When hedging with puts, the breakeven point is the cost of the underlying investment plus premium paid ($0.81 plus $0.0125 equals $0.8225, or 82.25 cents). LO 10.g

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

D) Explanation 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. LO 10.g

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

Explanation 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. LO 10.d

With regard to position limits, what is the bullish, or buy side of the market? I) Long calls II) Short calls III) Long puts IV) Short puts A) I and IV B) I and II C) III and IV. D) II and III

a) Explanation Long calls give the holder the right to purchase stock, while short puts obligate the writer to buy stock, and both are bullish strategies. LO 10.j

An investor is long 1 ABC Mar 200 call at 4, and long 1 ABC Mar 200 put at 2. The customer has created A) a short combination. B) a long straddle. C) a short straddle. D) a long combination.

b) Explanation This is a long straddle. With a long straddle, the customer expects the stock's price to be volatile, but does not know the direction. A short straddle would be the short call and short put. With a short straddle, the customer expects price stability and hopes both options expire unexercised. A straddle, long or short, involves the same underlying stock, same expiration month, and same strike price. A combination is the same underlying stock, but either the expiration month and/or the strike price of the options would be different. LO 10.f