Series 7 - Options: Ratio Strategies / Options Strategies

A customer owns 100 shares of ABC stock in a margin account, valued at $39 per share. The customer sells 4 ABC Jul 40 Calls @ $4. The stock moves to $52 and the calls are exercised. The customer has a: A $300 gain B $1,900 loss C $3,600 loss D $4,800 loss

The best answer is B. If the stock moves to $52, all 4 calls will be exercised. Since one of the calls is covered, 100 shares of the stock that was bought at $39 will be delivered at $40, for a 1 point or $100 gain. Since the stock is now at $52, this is the price that is paid to buy the stock to deliver at $40 on the remaining 3 naked calls, equals a 12 point loss x 300 shares = $3,600 loss. But don't forget the premiums received of 4 x $400 = $1,600 gain. The net gain or loss is: + $100 - $3,600 + $1,600 = -$1,900 loss.

A customer owns 100 shares of ABC stock in a margin account, valued at $40 per share. The customer sells 2 ABC Jul 40 Calls @ $4. The customer will lose money at all of the following prices EXCEPT: A $30 B $35 C $50 D $55

The best answer is B. If the stock rises by more than the 8 points collected in premiums, there will be a loss on the one naked call (above $48). If the stock drops below $32 (40 - 8), there will be a loss on the long stock position (the 2 calls will expire unexercised). Therefore, breakeven occurs at $32 and $48. Between $32 and $48, the position is profitable. Below $32 or above $48, there is a loss.

Which of the following options positions are on the same "side" of the market? I Long Calls II Short Calls III Long Puts IV Short Puts A I and II B I and IV C II and IV D III and IV

The best answer is B. Long calls and short puts are profitable as the market rises. These are "bull" strategies on the "upside" of the market. Long puts and short calls are profitable as the market falls. These are "bear" strategies on the "downside" of the market.

A customer is long 100 shares of ABC stock, believes that the market will remain flat for the next 6 months. To maximize income from the position, which strategy is best? A covered call write B ratio call write C short call spread D short against the box

The best answer is B. To get income from a long stock position, the customer would sell a call to collect the premium. If the customer is certain that the market will not move, even greater income can be generated by "ratio writing" - that is, selling more call contracts (collecting more premiums) than shares owned. However, for the extra income received also comes extra risk if the market should rise.

If the market price of ABC is at $60, which of the following customer positions will have a profit? I Long 1 ABC Jan 50 Call II Long 1 ABC Jan 50 Put III Long 1 ABC Jan 70 Call IV Long 1 ABC Jan 70 Put A I and III B I and IV C II and III D II and IV

The best answer is B. If the market is at $60, then the long $50 call is "in the money" by 10 points, for 10 point profit. the long 50 put is 10 points "out the money" and will expire worthless. The long 70 call is 10 points "out the money" and will expire worthless. The long 70 put is "in the money" by 10 points, for 10 point profit.

On the same day a customer buys 100 shares of ABC stock at $30 and sells 1 ABC Jan 30 Call @ $3 and sells 1 ABC Jan 30 Put @ $2. The maximum potential gain is: A $500 B $2,500 C $5,500 D Unlimited

The best answer is A. The customer has created a long stock/short straddle position. This is shown below: Buy 100 Shares of ABC at $30 Sell 1 ABC Jan 30 Call @ $3 Sell 1 ABC Jan 30 Put @ $2 => $5 Credit The credit of $500 is the maximum potential gain occurring if both contracts expire "at the money." If the market rises above $30, the short call is exercised, while the short put expires "out the money." The stock that was purchased at $30 is delivered for $30 - there is no further gain or loss on this position. Thus, in a rising market, the maximum gain is $500. If the market falls below $30, the short put is exercised (requiring the customer to buy another 100 shares at $30), while the short call expires "out the money" As the market falls, the customer now owns 200 shares purchased at $30. Since $500 was collected in premiums, he can afford to lose 2.5 points per share and will still breakeven. Thus, the breakeven occurs at $30 - $2.50 = $27.50. If the market continues to drop to zero, the customer will lose the full value of the 200 shares purchased at $30, net of $500 collected in premiums, for a net loss of $5,500 ($27.50 per share).

On the same day in a margin account, a customer buys 5 ABC January 40 Calls @ $6 and sells 10 ABC January 50 Calls @ $1 when the market price of ABC is at $43. If the market moves to $48 and the contracts are closed at intrinsic value, the gain or loss is: A $2,000 gain B $2,000 loss C $2,500 gain D $2,500 loss

The best answer is A. The customer is taking the following positions: Buys 5 ABC Jan 40 calls @ $6 Sells 10 ABC Jan 50 calls at @ $1 => 5 x 100 x $6 = $3,000 debit 10 x 100 x $1 = $1,000 credit => $2 debit or $2,000 debit Market moves to $48 and contracts are closed at intrinsic value. The formula for Intrinsic Value of long call option: IV = Current Stock Price - Strike Price IV = $48 - $40 IV = $8 So, in order to close the long call at its intrinsic value customer must sell back the 5 ABC Jan 40 calls @ $8 Intrinsic Value of short call option: IV = Strike Price - Current Stock Price IV = $50 - $48 IV = $2 So, in order to close the short call at its intrinsic value, customer must buy back the 10 ABC Jan 50 calls @ $2 Thus, the customer now has the following position: Sells back 5 ABC Jan 40 calls @ 8 Buys back 10 ABC Jan 50 calls @ $2 => $2,000 credit Therefore, customer has a $2,000 gain

Which option strategy has the greatest gain potential? A long call B long call spread C long put D long put spread

The best answer is A. A long call has unlimited gain potential in a rising market. A long call spread has limited upside gain potential but costs less than a simple long call position. Long puts and long put spreads are profitable in a falling market. Since there is a limit to how far the market can fall, the gain potential is limited.

Which option strategy has the greatest loss potential? A short call B short call spread C short put D short put spread

The best answer is A. A short call has unlimited loss potential in a rising market. As the market goes up, the customer must purchase the stock in the market for delivery. A short call spread has limited upside loss. Short puts and short put spreads are profitable in a rising market as the contracts will expire "out the money" with the gain being the premium collected.

On the same day a customer buys 100 shares of ABC stock at $30 and sells 1 ABC Jan 30 Call @ $3 and sells 1 ABC Jan 30 Put @ $2. This strategy is known as a: A covered straddle B covered call writer C ratio write D butterfly spread

The best answer is A. The customer has created a long stock/short straddle position. This is termed a "covered straddle," however this name is not really accurate. The short call is covered by the long stock position, however the short put is naked.

A customer would receive protection on a long stock position from which TWO of the following? I Buy a call II Sell a call III Buy a put IV Sell a put A I and III B II and III C I and IV D II and IV

The best answer is B. In order to hedge a long stock position against a downside market move, the best choice is to buy a put. The long put option allows the holder to put the stock at the exercise price if the market falls - protecting the stock position from downside market risk. However, buying a put is not given as a stand alone choice. If one were to sell a call against a long stock position, then if the stock's market price falls, the call expires out the money. The premium received is a form of limited protection as the market drops. However, if the stock's price falls greatly, then the premium received is not enough to compensate for the loss in the value of the stock. Buying a call would not give downside protection - if the market drops, the call expires out the money and the premium is lost, in addition to any loss on the stock position. Writing a put does not give downside protection - in a falling market, the short put would be exercised, obligating the put writer to buy the stock at the strike price. The writer would lose on this stock position, in addition to losing on the original stock position, in a falling market.

On the same day in a margin account, a customer sells 5 ABC January 40 Calls @ $6 and buys 10 ABC January 50 Calls @ $1 when the market price of ABC is at $43. The maximum potential loss is: A $2,000 B $3,000 C $5,500 D unlimited

The best answer is B. This customer has bought 10 ABC Jan 50 Calls @ $1 ($1,000 premium paid) and has sold 5 ABC Jan 40 Calls @ $6 ($3,000 premium collected). In this case, if the market falls below $40 and all of the calls expire "out the money," the customer will gain $2,000 (Sell 5 Calls @ $6 for $3,000 profit offset by the purchase of the 10 Calls @ $1 or $1,000: $3,000 received - $1,000 paid = $2,000 profit). If the market rises to $50, the customer will have the maximum potential loss. At $50, the short 5 ABC Jan 40 Calls are exercised, obligating the customer to deliver 500 shares @ $40 each. The customer is long 10 ABC Jan 50 Calls, which expire "at the money." Therefore, the customer will buy 500 shares in the market @ $50 to deliver, losing $10 per share, or $5,000 on 500 shares. Since the beginning net credit was $2,000, the customer loses $3,000.

Which of the following option strategies are profitable in a rising market? I Long Call II Long Put III Short Call IV Short Put A I and II B I and IV C II and III D III and IV

The best answer is B. Buying a call and selling a put are profitable strategies in a rising market. Buying a put and selling a call are profitable in a falling market.

A customer would receive protection on a short stock position from which TWO of the following? I Buy a call II Sell a call III Buy a put IV Sell a put A I and III B II and III C I and IV D II and IV

The best answer is C. In order to hedge a short stock position against an upside market move, the best choice is to buy a call. The long call option allows the holder to buy the stock at the exercise price if the market rises - protecting the short stock position from upside market risk. However, buying a call is not given as a stand alone choice. If one were to sell a put against a short stock position, then if the stock's market price rises, the put expires out the money. The premium received is a form of limited protection as the market rises. However, if the stock's price rises greatly, then the premium received is not enough to compensate for the loss on the short stock position. Buying a put would not give upside protection - if the market rises, the put expires out the money and the premium is lost, in addition to any loss on the stock position. Writing a call does not give downside protection - in a rising market, the short call would be exercised, obligating the call writer to deliver the stock at the strike price. The writer would lose on this stock position, in addition to losing on the original stock position, in a rising market.

On the same day a customer buys 100 shares of ABC stock at $30 and sells 1 ABC Jan 30 Call @ $3 and sells 1 ABC Jan 30 Put @ $2. The maximum potential loss is: A $500 B $2,500 C $5,500 D Unlimited

The best answer is C. The customer has created a long stock/short straddle position. This is shown below: Buy 100 Shares of ABC at $30 Sell 1 ABC Jan 30 Call @ $3 Sell 1 ABC Jan 30 Put @ $2 => $5 Credit The credit of $500 is the maximum potential gain occurring if both contracts expire "at the money." If the market rises above $30, the short call is exercised, while the short put expires "out the money." The stock that was purchased at $30 is delivered for $30 - there is no further gain or loss on this position. Thus, in a rising market, the maximum gain is $500. If the market falls below $30, the short put is exercised (requiring the customer to buy another 100 shares at $30), while the short call expires "out the money" As the market falls, the customer now owns 200 shares purchased at $30. Since $500 was collected in premiums, he can afford to lose 2.5 points per share and will still breakeven. Thus, the breakeven occurs at $30 - $2.50 = $27.50. If the market continues to drop to zero, the customer will lose the full value of the 200 shares purchased at $30, net of $500 collected in premiums, for a net loss of $5,500 ($27.50 per share).

On the same day in a margin account, a customer buys 5 ABC January 40 Calls @ $6 and sells 15 ABC January 50 Calls @ $1 when the market price of ABC is at $43. The customer has created a: A short combination B long combination C ratio spread D back spread

The best answer is C. This is a very difficult question. The customer is taking the following positions: Buy 5 ABC Jan 40 Calls @ $6 Sell 5 ABC Jan 50 Calls @ $1 => $5 Debit Sell 10 ABC Jan 50 Calls @ $1 Credit The customer is creating 5 "long call spreads" and has 10 naked calls. In effect, he is writing 3 times the number of short calls needed to create the spread. Therefore he is "writing at a 3:1 ratio." This is termed a ratio spread. Long call spreads are used when a customer is moderately bullish, and wishes to reduce the cost of the long position by selling an equal number of "out the money" calls. This limits upside gain potential, but also reduces the cost of the positions. By writing three times the number of calls, the customer further reduces the cost of the positions, but also assumes unlimited upside risk on the 10 naked calls that are left.

If the market price and the strike price are the same at expiration, which of the following open options positions will result in a loss? I Long Call II Short Call III Long Straddle IV Short Straddle A I and II B III and IV C I and III D II and IV

The best answer is C. "At the money" contracts will expire unexercised. Any holders lose the premium, while writers gain the premium.

Which TWO of the following are fully hedged stock positions? I Long stock / Long call II Long stock / Long put III Short stock / Long call IV Short stock / Long put A I and III B I and IV C II and III D II and IV

The best answer is C. To hedge a long stock position, buy a put (buy the right to sell the stock at a fixed price in a falling market). To hedge a short stock position, buy a call (buy the right to buy the stock at a fixed price in a rising market).

On the same day when the market price of ABC stock is $59, a customer takes the following options positions: Buy 1 ABC Jan 55 Call @ $7 Sell 2 ABC Jan 60 Calls @ $4 Buy 1 ABC Jan 65 Call @ $2 The maximum potential gain occurs if the market moves: A below $55 B above $65 C either below $55 or above $65 D to $60

The best answer is D. The 2 long calls are the "wings" of the butterfly, while the 2 short calls are the "body" of the butterfly. The position starts at a $1 debit paid (-$7 + $8 - $2). If the market is at $60, the maximum gain occurs (5 points gained on the 55 call, offset by $1 debit paid). If the market drops below $55, all positions expire and the $1 debit is lost. If the market rises above $65, all positions are exercised - the options positions cancel each other out and the $1 debit is lost. Max Profit = Strike B - Strike A - Net Debit Paid Max Profit = $60 - $55 - $1 Max Profit = $4 or $400 There are 2 breakeven points: 1) Strike A + Net Debit Paid = $55 + $1 = $56 2) Strike C - Net Debit Paid = $65 - $1 = $64

On the same day in a margin account, a customer buys 5 ABC January 40 Calls @ $6 and sells 15 ABC January 50 Calls @ $1 when the market price of ABC is at $43. The maximum potential loss is: A $1,500 B $2,000 C $3,000 D unlimited

The best answer is D. This is a very difficult question. The customer is taking the following positions: Buy 5 ABC Jan 40 Calls@ $6 Sell 5 ABC Jan 50 Calls@ $1 $5 Debit Also Sell 10 ABC Jan 50 Calls@ $1 Credit The customer is creating 5 "long call spreads" and has 10 naked calls. In effect, he is writing 3 times the number of short calls needed to create the spread. Therefore he is "writing at a 3:1 ratio." This is termed a ratio spread. Long call spreads are used when a customer is moderately bullish, and wishes to reduce the cost of the long position by selling an equal number of "out the money" calls. This limits upside gain potential, but also reduces the cost of the positions. By writing three times the number of calls, the customer further reduces the cost of the positions, but also assumes unlimited upside risk on the 10 naked calls that are left.

On the same day in a margin account, a customer buys 5 ABC January 40 Calls @ $6 and sells 10 ABC January 50 Calls @ $1 when the market price of ABC is at $43. The maximum potential loss is: A $2,000 B $3,000 C $5,500 D unlimited

The best answer is D. This is a very difficult question. The customer is taking the following positions: Buy 5 ABC Jan 40 Calls @ $6 Sell 5 ABC Jan 50 Calls @ $1 => $5 Debit Sell 5 ABC Jan 50 Calls @ $1 Credit The customer is creating 5 "long call spreads" and has 5 naked calls. In effect, he is writing 2 times the number of short calls needed to create the spread. Therefore he is "writing at a 2:1 ratio." This is termed a ratio spread. Long call spreads are used when a customer is moderately bullish (in this case, the customer believes that the stock will rise no higher than 50), and wishes to reduce the cost of the long position by selling an equal number of "out the money" calls. This limits upside gain potential, but also reduces the cost of the positions. By writing twice the number of calls, the customer further reduces the cost of the positions, but also assumes unlimited upside risk on the 5 naked calls that are left.

If the market price is much higher than the strike price at the time of expiration, which of the following open options positions is likely to result in a gain? I Long Put II Short Put III Long Straddle IV Short Straddle A I and II B III and IV C I and III D II and III

The best answer is D. If the market price is higher than the strike price, the long put contract would expire "out the money," so the buyer will lose the premium paid for the position. Conversely, if a customer sells a put, and the market goes up, the contract will expire "out the money" and the customer earns the premium. A long straddle contains a long call and a long put. The call would be exercised at a profit if the market goes up. A short straddle contains a short call and a short put. If the market rises, the naked short call will be exercised, obligating the writer to deliver shares at a fixed (lower) price. The loss potential is unlimited as the market rises.

A customer owns 100 shares of ABC stock in a margin account, valued at $40 per share. The customer sells 3 ABC Jul 40 Calls @ $4. The maximum potential loss is: A $800 B $3,200 C $4,000 D unlimited

The best answer is D. One of the short calls is covered by the long stock position, while the 2 remaining short calls are naked. The loss potential on short naked calls is unlimited.