Chapter 4

An investor buys 2 RST 40 calls and pays a premium of 4 each. He also buys 2 RST 40 puts and pays a premium of 2.50 each. When purchased, RST is trading at $40.75. On the expiration date, RST is trading at $32.50 and the investor closes his positions for intrinsic value. Excluding commission, the investor realizes a

$200 profit

1. American style options can be exercised at... 2. European options can be exercised...

1. Any time 2. Only at expiration

What is the market position for the following: 1. Debit Call spread 2. Debit Put spread 3. Long Call 4. Long combination straddle

1. Bullish 2. Bearish 3. Bullish 4. Bearish and Bullish

For a long call to cover a short call it must...

1. Have the same or lower strike price 2. Same or longer expiration

What investors will sell stock if an option is exercised?

1. Owners of a Put 2. Writers of a call

What are factors that determine the price of an options contract?

1. Time remaining 2. Volatility of the underlying stock 3. Price of the stock

What strategies subject an investor to unlimited risk?

1. uncovered calls 2. Short a stock 3. short stock with writing a put

The exercise of equity options settles in how many business days?

3

A customer establishes the following positions: Buy 100 ABC at 28 Buy 1 ABC Dec 25 put at 2 What is the breakeven point?

30

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, the customer has a

500 gain

Floor Brokers

A firms representative on the floor of the exchange. They execute orders on behalf of the firm.

Designated Primary Market Maker (DPM)

A floor trader responsible for maintaining a two sided market for a specific product and is designated to ensure a fair and orderly market.

An XYZ June 40 put trading at 4 would be considered in the money if XYZ is trading:

A put is in-the-money, or has intrinsic value, whenever the price of the stock is below the strike price. The put would be in-the-money below $40.

In February, a customer sells 1 GHI Oct 60 put for 3 and buys 1 GHI Oct 70 put for 11. If the customer closes the Oct 70 put before expiration, which of the following statements regarding the resulting profit or loss is TRUE?

All listed options trades with resulting gains or losses are treated as capital gains or losses.

Trading in options produces what?

Any trading in options produces only short-term gains or losses

How do you find out what the customers cost basis is?

At exercise, the premium of the contract affects the cost basis of the stock acquired. Because the premium of 3.50 was received when the put was written, the cost basis of the stock will be $60 per share less the premium, or 56.50.

The OCC automatically exercises an open equity option contract if, at expiration, the contract is in-the-money by

At expiration, the OCC automatically exercises options that are in-the-money by .01 or more for both customer and member firm accounts.

A customer is long an ABC Apr 40 call and is also short an ABC Jul 40 call. Which of the following best describe his position?

Bearish and a Calendar straddle

What can you do to protect a short stock position?

Buy a call.

What is the intrinsic value or the "in the money" amount?

Calls are in the money if the market price exceeds the strike price. Take Market price - strike price to get intrinsic value. Then to get the time value of the contract you take the premium minus the intrinsic value.

All of the following actions must be completed prior to a customer entering his first option trade EXCEPT:

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

How do you determine the number of option contracts necessary to hedge?

Divide the portfolio value ($1.7 million) by the market value of the index (68,000). Multiply the result (25) by the beta of 1.20. The result is 30 contracts.

The OCC sets what?

Exercise prices and expiration dates (premiums that the buyers pay are determined by the market.

What classifies a short term gain?

Holding a stock for 12 mo or less.

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?

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.

Premium + Time Value of money =

Intrinsic Value or the amount it's in the money

Ratio Call Writing

Involves selling more calls than the long stock position covers. It generates additional premium for the investor but entails unlimited risk because of the short uncovered calls.

Options Clearing Corporation (OCC)

Issues, guarantees and handles the exercise and assignment of the listed options.

What positions are bullish?

Long call and short put

If an investor buys a LEAPS contract on issuance and allows it to expire unexercised, what is the investor's tax consequence at expiration?

Long-term capital loss.

LEAP contracts

Long-term equity anticipation securities have max expiration up to 39 mo

Long XYZ Jan 60 put at 3

Long: The investor has bought the put and has the right to exercise the contract. XYZ: The contract has 100 shares of XYZ stock Jan: The contract expires the Saturday after the third Friday of Jan at 11:59 pm ET. 60: The strike price of the contract is 60 Put: The investor has the right to sell the stock at 60 since he is long the put 3: The premium is $300 because 100 shares. The investor paid the premium to buy the put.

If you're Long Apr 40 call at 6 and short April 50 call at 2, what is the max gain, max loss and break-even point?

Max Gain: 6 (it could move up from 40 to 50 then minus the net premium of 4 so max gain is 6) Mas Loss: Premium of 6 you minus then add the premium of 2 to get a net premium of 4. Break-even: Take the net premium and add to the lower strike price, it will equal 44.

The exercise of index options settles when?

Next business day

Is a listed option adjusted for a cash dividend?

No

How many business days after an index option is exercised should a cash settlement occur?

One

Which of the following is a derivative security?

Options

Credit Spreads

Puts: When you buy a put then afterwards you're able to write it for less. (put down) Calls: When you buy a call then afterwards you're able to write it for more (call up)

At expiration, the market price of the underlying stock is the same as the strike price of the option. Which of the following positions result in a profit?

Short call and Short put

What positions are bearish?

Short call and long put

Short straddles are appropriate only in:

Short straddles are appropriate only in flat or neutral markets. The writer will lose in a rising market (the call will be exercised) or a falling market (the put will be exercised). Short calls and short call spreads are bearish, as are debit (long) put spreads.

Short XYZ Jan 60 call at 3

Short: The investor has sold the call and has obligations to perform if the contract is exercised. XYZ: The contract includes 100 shares of XYZ stock Jan: the contract expires the Saturday following the third Friday in January at 11:59 ET. When contract expires the writer keeps the premium without any obligations 60: Strike price is 60 Call: The investor is obligated to sell the stock at 60, if exercised, because he is short the call. 3: Total premium is $300 because there are 100 shares.

Short XYZ Jan 60 put at 3

Short: The investor has sold the put and has obligations to perform if the contract is exercised. XYZ: The contract includes 100 shares of XYZ stock Jan: The contract expires the Saturday following the third Friday at 11:59 pm ET. If expiration occurs, the writer keeps the premium without any obligation. 60: The strike price is 60 Put: The investor is obligated to buy the stock at 60, if exercised, because he is short the put. 3: The premium is $300 because there are 100 shares.

What is the max gain of an option writer?

The Premium received

Options Clearing Corporation (OCC)

The clearing agent for options. Is owned by the exchange that trades options. It determines: 1. When new option contracts should be offered 2. Designates strike prices and expiration dates 3. Assigns exercise notices on a random basis (brokers assign notices on a random or FIFO method)

Jan

The contract expires on the Saturday following the third Friday of January at 11:59 pm ET.

XYZ

The contract includes 100 shares of XYZ stock

Longing a call

The investor has bought the call and has the right to exercise it.

What is the multiplier?

The multiplier indicates contract size.

When must a new options customer return a signed option agreement?

The option agreement must be signed and returned within 15 days of account approval. This agreement states the customer will abide by the rules of the options exchange and the OCC, and will not violate position or exercise limits. If it has not been returned, the customer can only close out existing positions. No new positions may be opened.

What is the breakeven for the buyer and seller of a put?

The option's strike price minus the premium

Which of the following will halt trading in listed options when there is a trading halt in the underlying stock?

The options exchange on which the option is listed.

What is the cost basis for a stock?

The original purchase price

An option is at parity when:

The premium equals intrinsic value ( "in the money amount")

What is the premium?

The premium is the cost or price at which the option can be bought or sold in the market.

3

The premium of the contract is $3 per share. Contracts are issued with 100 shares, so the total premium is $300. The investor paid the premium to buy the call.

What is a long straddle?

The purchase of a put and a call on the same stock when both options have the same terms. The long call is profitable if the market rises, while the long put is profitable if the market falls. An investor purchases a straddle if sharp market movement is expected but the direction is uncertain.

What is a short straddle?

The sale of a put and a call on the same stock with both options having the same terms. If the market value remains stable, the options expire and the seller keeps the premium, thereby generating income.

60

The strike price of the contract is 60

What is the strike price or the exercise price?

The strike price or exercise price is the cost to exercise the option

If an XYZ Aug 80 put is trading at 2, at which price would the option be at parity with the stock?

The term "at parity" means the premium equals the intrinsic value that occurs for an in-the-money option prior to expiration when the time value has eroded. An 80 put is in-the-money by 2 points (the premium) when the underlying stock is trading at 78.

Call

The type of option is a call, and the investor has the right to buy the stock at 60 since he is long the call

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:

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 less the purchase price of $9,000, plus $600 in premiums received). Since the maximum profit possible is $1,600, it is impossible to have a profit of $2,000.

If the strike price of a yield-based option is 62.50, this represents a yield of:

To calculate the percentage yield of the underlying Treasury security, divide the strike price by 10 (62.50 / 10 = 6.25%).

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?

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 less 1.50) × 100 shares which equals $300.

Which of the following securities underlies a yield-based option?

Treasury securities

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:

Unlike equity options, index options are settled in cash only. Upon exercise, cash equal to the amount that the option is in-the-money

If a customer is long a call at 11 and short a call at 5 what is the loss potential?

Unlimited. 1 call in uncovered.

Index Options

Used to speculate on movement of market. If investor believes the market will rise, he can purchase index calls or write index puts. If investor believes market will fall, he can purchase index puts or write index calls.

Chicago Board Options Exchange (CBOE)

Where are options are traded in a double auction market. (public orders must be filled before member orders

A customer wishes to close a short option position. The order ticket must be marked as:

a closing purchase.

An option writer liquidates a position by purchasing an option. This order must be marked as:

a closing purchase.

All of the following accounts are permitted to write calls EXCEPT:

a corporation against its own stock.

Any description of options must include:

a description of the risks. This rule applies to all communications with the public, written, electronic, or in person.

If a customer bought a put option and the underlying security declined, the put would probably:

be exercised.

The breakeven point for covered call writers is:

cost of stock less premiums.

The put-call ratio can be used to:

gauge investor sentiment as being either bullish or bearish

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:

hedging.

Options contracts known as mini-options

overly 10 shares of the underlying equity and have premium multipliers of $10

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.

A customer who writes (sells) a naked call will profit if:

the option contract expires without being exercised by the owner.

The breakeven point for a call is:

the strike price plus the premium

Listed stock options cease to trade on the

third Friday of the month of expiration

It would be fair and equitable for a brokerage firm to assign an option exercise notice to a customer:

who first wrote that option. The assignment of options contracts can be done on a FIFO basis (first in, first out) or by any other method that the OCC considers fair (i.e., random). Determining assignment by size of contract or on a LIFO (last in, first out) basis is not considered fair.