Series 7 Unit 10

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) Short-term capital gain B) Long-term capital loss C) Short-term capital loss D) Long-term capital gain

C 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.

If a customer buys 5 ABC Jan 40 puts and writes 5 ABC Jan 45 puts, which of the following statements are true? The customer profits if the spread widens. The customer profits if the spread narrows. The customer is a bull. The customer is a bear. A) I and III B) II and IV C) I and IV D) II and I

2 and three Because a put is a right to sell, the premium on the 45 puts is higher than that of the 40 puts. The customer is writing the put with the higher premium, so this is a credit spread, and the bullish investor will profit at expiration if the difference between the two premiums narrows as the contracts lose value.

How many business days after an index option is exercised should a cash settlement occur? A) One B) Two C) Three D) Five

A

To create a credit calendar spread, an investor should buy the near expiration. buy the distant expiration. sell the near expiration. sell the distant expiration. A) I and IV B) II and IV C) I and III D) II and III

A

An investor buys a yield-based Sep 70 call on a 30-year T-bond for a premium of 2.50. At expiration, if the yield on the most recently issued T-bond is 7.95%, what is the investor's gain or loss? A) $700 gain B) $950 loss C) $950 gain D) $700 loss

A A Sep 70 call means that the holder is buying a 7% yield. The investor can close the option at its intrinsic value (7.95 − 7.00 = 0.95; 0.95 × 10 × $100 = $950 received upon close). Subtract the $250 premium paid for a total profit of $700.

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

A 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.

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 buy stock. C) write a straddle and short the stock. D) buy a straddle.

A 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.

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) Short stock C) A long call D) A long put

A 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.

In April, a customer sold short 100 shares of QRS stock at $50 and simultaneously wrote 1 QRS Jan 50 put for a premium of $7. If the January put is exercised when the market value of QRS is 43 and the stock acquired is used to cover the short stock position, what is the customer's profit or loss per share? A) $7 gain B) $7 loss C) $14 loss D) $0

A Because the stock is purchased on exercise of the short put for $50 and is used to cover the $50 short sale, the investor incurs no gain or loss on the stock. The customer keeps the $700 collected in premiums for a profit of $7 per share.

If a registered options principal is asked to approve a discretionary order to buy 1 XYZ Oct 60 put and sell 1 XYZ Oct 55 put for a net debit of $5, he should A) not approve the order. B) approve the order if the customer has sufficient funds in her accounts. C) obtain the best execution for the order. D) approve the order in writing.

A Because this is a debit spread, the maximum gain occurs if both sides are exercised. If this occurs, the investor earns $5 (buy stock at 55 when the short put is exercised and sell stock at 60 by exercising the long put). Because the net premium paid for the spread is $5, there can never be any gain. This spread is not economical.

An investor holding a broad-based diversified portfolio of stocks feels that the market, which has slowed recently, may be poised for a brief fall before it continues an upward trend long term. The investor does not want to incur the cost of selling a portion of their holdings or assume the risk of mistiming the market. A possible strategy would be to A) buy an index put option. B) sell an index call option. C) buy an index call option. D) sell an index put option.

A By not liquidating, the client can benefit if the market increases. Because the portfolio is broad-based and diversified, it should move with the market. An index option also moves with the market, and therefore, would be a good hedge vehicle. A long put should be used because it will increase in value if the market should decline.

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 $200 loss. C) a $100 loss. D) a $100 profit.

A 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.

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 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.

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

A Holders of yield-based call options profit if rates rise. Prices of debt securities fall if rates rise.

IBM sold computers to a Soho retailer and agreed to accept payment of 10 million British pounds in 65 days. In which of the following ways could the company protect the payment against adverse foreign currency fluctuations? A) Buy pound puts B) Buy pound calls C) Buy U.S. dollar calls D) Buy U.S. dollar puts

A If the company wants to protect its investment, it has to protect against the payment going down in value relative to the cost. To protect against the value of the payment going down in relation to the cost, the company would buy puts on the payment currency. To offset the cost of the puts, the company will also sell calls. The calls will be covered by the ownership of the actual currency. Remember the acronym EPIC: Exporters buy Puts and Importers buy Calls.

An options trader goes long 1 XYZ Oct 60 put at 6 and purchases 1 XYZ Oct 60 call for 6. If XYZ is at 68 at expiration, what is the investor's gain or loss? A) $400 loss B) $400 gain C) $1,200 loss D) $200 gain

A If the market price of XYZ is at $68 per share, the put is out of the money and will expire worthless. The call could be sold for the intrinsic value of 8. (There is no time value because the option is at the expiration date.) Because the investor originally spent $1,200 (a premium of $600 was paid for each option), the net result is a loss of $400.

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 combination. C) a price spread. D) a long straddle.

A 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.

Which of the following could be used to protect an equity portfolio against systematic risk? A) Index options B) Currency options C) Interest rate option D) Stock options

A Systematic risk is the market risk applied to the value of an entire portfolio instead of just one stock. Therefore, an investor would use index options to protect against systematic risk.

If a customer does not anticipate that a stock's price will change, and she wants to take an option position, she would most likely A) write a straddle. B) buy a call. C) buy a put. D) buy a straddle.

A The customer earns combined premiums when selling a straddle (sale of a call and put with same terms). She hopes the market price will not move, both positions will expire unexercised, and she will keep the premiums. This position has unlimited loss potential, should the underlying stock rise (because of the short call)

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

A The customer opens two short positions on 10 contracts each, so his account is credited with premiums of $2,500 for the calls and $3,500 for the puts. The calls expire worthless, but the short puts are exercised, so the investor must buy the stock at the strike price. This results in a debit of $50,000 ($5,000 per contract × 10 contracts), and the stock is then sold at a credit of $45,000.

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 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).

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 $52. B) Maximum gain is $200; maximum loss is $300; breakeven is $53. C) Maximum gain is $200; maximum loss is $300; breakeven is $52. D) Maximum gain is $300; maximum loss is $200; breakeven is $53.

A 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 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.

An investor opens the following positions: Buy 100 shares of RJN @46; buy 1 RJN Mar 45 put @2½. What is the customer's maximum gain, maximum loss, and breakeven point? A) Maximum gain is unlimited; maximum loss is $350; breakeven point is $48.50. B) Maximum gain is unlimited; maximum loss is $350; breakeven point is $42.50. C) Maximum gain is $350; maximum loss is $4,250; breakeven point is $42.50. D) Maximum gain is $4,250; maximum loss is $250; breakeven point is $48.50.

A The first step is to identify the position. This is a long stock position with a protective put. That is, the customer has purchased the stock and purchased a put to protect the downside. Using an option as a form of insurance is the primary reason why the industry refers to the price of an option as the premium. On questions with stock and an option, it is usually best to compute the breakeven point first. Breakeven is when the long stock can be sold at the customer's total cost. That cost is the price of the stock ($46) plus the price paid for the option ($2½), or $48.50. If the stock should rise above $45, the customer will let the 45 put expire and maintain the long stock position. An investor with a long stock position has unlimited potential gain. If the stock price should decline, no matter how low it drops, the customer can exercise the long put and sell the stock for $45 per share. That means the maximum loss is the premium paid for the option, ($250) plus the difference between the cost of the stock and the proceeds from the put ($100), or $350. 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.

Index options differ from stock options in which of the following ways? A) The exercise settlement is in cash. B) The trade settlement date is the next business day. C) They are subject to closing purchases as well as closing sales. D) The expiration date is the third Friday of the expiration month.

A When an index option is exercised, cash is paid to the option holder for the amount in the money. In contrast, exercising a stock option involves delivering the underlying stock. Both index options and stock options have the same expiration date and the same trade settlement date. Closing transactions can be purchases or sales for any option, regardless of the underlying asset.

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 $67. B) Maximum gain is $300; maximum loss is unlimited; breakeven point is $77. C) Maximum gain is $6,700; maximum loss is $300; breakeven point is $77. D) Maximum gain is $300; maximum loss is $6,700; breakeven point is $67.

A 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.

An investor opens the following options position: Sell 1 RIF Sep 70 call @ 6; sell 1 RIF Sep 70 put @1. What is the investor's maximum gain, maximum loss, and breakeven point? A) Maximum gain is $700; maximum loss is unlimited; breakeven points are $63 and $77. B) Maximum gain is $700; maximum loss is $6,300, breakeven points are $63 and $77. C) Maximum gain is $700; maximum loss is unlimited; breakeven point is $70. D) Maximum gain is unlimited; maximum loss is $700, breakeven point is $70.

A The first step is to identify the position. This is a short straddle—a short put and a short call with identical terms. That means we are going to have two breakeven points. The maximum loss is unlimited because one of the positions is an uncovered call. The maximum profit is the premiums (credit) received of $700. Breakeven points follow the call-up and put-down rule. That is, add the premiums of $7 to the strike price of the call ($7 + $70 = $77) and subtract the premiums of $7 from the strike price of the put ($70 ‒- $7 = $63).

An investor who believes the U.S. dollar will strengthen against the Canadian dollar should profit from which of the following strategies? Buying puts on the Canadian dollar Writing puts on the Canadian dollar Writing a straddle on the Canadian dollar Establishing a call credit spread on the Canadian dollar A) I and IV B) II and IV C) III and IV D) I and III

A 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.

All of the following are fixed option contract terms except A) the premium in a stock option. B) the units of currency in a currency option. C) the expiration month in a debt option. D) the multiplier in an index option.

A 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.

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 gain B) A $600 loss C) A $200 loss D) A $600 gain

A 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).

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

A 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.

If a customer buys 200 XYZ at $58 and writes 5 XYZ Jan 60 calls at 2, the maximum potential loss is A) unlimited. B) $1,400. C) $10,600. D) $12,600.

A This is an example of ratio writing. Short calls are covered by long stock, but in this example, it would take 500 shares of stock to cover the five calls written. Because there are three uncovered calls, the maximum loss is unlimited.

With the market price of Lepidoptera Corporation trading at $40 in June, an options trader purchases a JUL 30 call for $1,100, writes two JUL 40 calls for $400 each, and purchases another JUL 50 call for $100. This strategy is called A) a long call butterfly spread. B) a long double combination. C) a long double straddle. D) a strangle.

A This position is a butterfly spread. Technically, it is a long call butterfly spread because all the options are calls and the two short positions are at-the-money. Why the term butterfly? If you drew this on a graph, you would see the two options at 40 in the center with the 30 and the 50 on either side making it resemble a butterfly with the body and two wings. Will that be tested? No, but you might see butterfly as an incorrect answer to another options question. Here is something you should be able to do: What is the investor's maximum loss? The two long options cost $1,200 and the two short options bring in $800. That means a net debit of $400, and that debit is the maximum loss.

An investor owns 500 shares of JKL common stock. The investor's cost is $50 per share and the last quote on JKL was $60. One method the investor could use that would increase current income and offer some downside protection would be to A) sell five JKL $60 calls @4. B) buy five JKL $60 puts @4. C) buy a JKL $60 put @4. D) sell a JKL $60 call @4.

A Understand that with 500 shares, the protection needs five options. Selling five calls @4 generates $2,000 of premium income credited to the account one day after the sale. In addition, the sale has effectively lowered the cost from $60 to $56 per share. That is the partial protection offered when writing a covered call. Full protection would come from buying five JKL 60 puts, but the question specifically mentions receiving income and buying an option costs money rather than receiving money. Please note that some questions, like this one, do require you to consider the number of shares or options. Others, such as breakeven points, ignore the number of contracts.

A customer creates a long straddle by buying 5 ABC Nov 50 calls and 5 ABC Nov 50 puts, paying premiums of $3,750. If ABC is at 56.50 at expiration, the customer has A) a gain of $500. B) a loss of $500. C) a gain of $1,000. D) a loss of $1,000

B

If XYZ is trading at 39, and a customer sells 1 XYZ Jun 40 put and buys 1 XYZ Jun 35 put, he will profit if the spread widens. the spread narrows. the contracts expire. the contracts are exercised. A) I and IV B) II and III C) II and IV D) I and II

B

What is the size of one LEAPS contract? A) 1,000 shares B) 100 shares C) No standard LEAPS contract size D) More than 1,000 shares

B

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

B 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 customer buys 300 LMN at $45 per share and writes 3 LMN Aug 45 calls at 4. The customer will profit under all of the following circumstances except A) if LMN rises, and the calls are exercised. B) if LMN is below $41 at expiration. C) if LMN is between $41 and $45 at expiration. D) if LMN remains at $45 through expiration.

B Breakeven is $41 ($45 − $4). The stock price must be above breakeven for the investor to make a profit.

An investor has a diversified portfolio of common stock with a market value of $1.7 million and a beta of 1.20. If the OEX (S&P 100) is currently quoted at 680, to protect the portfolio against a decline in value, the investor's best strategy is to buy A) 25 calls. B) 30 puts. C) 25 puts. D) 30 calls

B Buying puts is the most effective strategy to hedge the risk of decline in a stock portfolio's market value. To 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.

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

B 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.

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) 0.4875. B) 0.8225. C) 0.5125. D) 0.4975.

B 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

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 call on the stock D) Go long a put on the stock

B 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.

At expiration, if the market price of the underlying common stock and the strike price are the same, all of the following customer positions will show a profit except A) short puts. B) long straddles. C) short calls. D) short straddles.

B The contracts will not be exercised if options expire at the money. Therefore, writers will show a profit, but buyers will no

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 $200 loss. B) a $200 gain. C) a $600 gain. D) a $600 loss

B 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.

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 @$60 for 100 shares B) 10 contracts @$40 for 150 shares C) 15 contracts @$40 for 100 shares D) 10 contracts @$60 for 150 shares

B 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.

Which of the following would not be a concern for an investor writing a naked option? A) The possibility of exercise B) The premium the investor must pay for the contract C) The loss potential D) The risk/reward ratio

B The writer of any option contract receives the premium; she does not pay it. A naked option writer would consider the risk/reward ratio, the loss potential, and the possibility that the contract would be exercised by the party who purchased it.

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

B 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.

An investor holding which of the following positions is exposed to a potentially unlimited loss? Short 1 IBS Jul 50 put Short 100 shares of IBS stock Short 1 IBS Jul 50 uncovered call Short 1 IBS Jul 50 covered call A) II or IV B) II or III C) I or III D) I or II

B There are two investment strategies on the exam that can lead to a potentially unlimited loss. A short stock position gives an investor unlimited risk potential if the stock should rise because the investor must eventually buy back the stock at the higher price. Because stock can rise an unlimited amount, there is unlimited risk. The sale of a naked call requires that, if exercised, the writer must buy the stock in the market and deliver it at the strike price.

A client writes 1 Apr 30 call and buys 1 Apr 40 call. This is a bull spread. a bear spread. a debit spread. a credit spread. A) II and III B) II and IV C) I and III D) I and IV

B This is a call credit spread, and bears sell calls. The 30 call is worth more because it has a lower strike price. Long the lower is bullish; short the lower is bearish.

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) $550. B) $525. C) $537. D) $545.

B 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.

If XYZ is trading at 39, and a customer sells 1 XYZ Jun 40 put and buys 1 XYZ Jun 35 put, he will profit if the spread widens. the spread narrows. the contracts expire. the contracts are exercised. A) I and IV B) II and III C) II and IV D) I and II

B When a spread's premiums are not available, the more valuable option is found by examining the strike price. A put with a higher strike price has a higher premium because a put represents the right to sell. Because the investor is selling the more valuable put (the one with the higher strike price), this is a credit spread, and profit occurs if the options expire worthless (in this case, the customer keeps the net credit) or the spread narrows between the premiums.

With ABC trading at 39, a customer buys 1 ABC Mar 40 call and sells 1 ABC Mar 35 call. A profit occurs if the spread widens. the spread narrows. ABC declines sharply. both contracts are exercised. A) III and IV B) II and III C) I and III D) II and IV

B Whenever there is a question where the choices are widen or narrow, you first need to determine if the spread is a debit or a credit. A debit spread is one where the option you buy costs more than what you receive for the one you sell. A credit spread is the opposite—the one you are selling has a higher price than the one you are buying. In this question, the premiums are not given, so we have to figure out which is the more expensive option. We have a 35 call and a 40 call. Which of those is more valuable? The ability to buy the stock at 35 or buy it at 40? The lower the exercise (strike) price of a call, the greater the value, so we know the premium on the 35 call will be higher than that of the 40 call. Therefore, selling the 35 and buying the 40 is going to be a credit spread because more money will come from the sale of the 35 that will go out for the purchase of the 40. Once we know it is a credit spread, we go to the answer choice narrow. And, when we want the spread to narrow, we want the options to expire, so IV cannot be correct. That sort of backs us into knowing that III is true, but let's be sure. We identify spreads as bullish or bearish, and the way to see that is, bulls buy low and sell high. When looking at this question, we see the option bought is the high strike price, and the one sold is the low strike price, so this must be a bearish position. Bears want the market price to fall, so yes, III is accurate.

A customer creates a long straddle by buying 5 ABC Nov 50 calls and 5 ABC Nov 50 puts, paying premiums of $3,750. If ABC is at 56.50 at expiration, the customer has A) a gain of $500. B) a loss of $500. C) a gain of $1,000. D) a loss of $1,000.

B While the puts would expire, the customer may close out the calls by selling them at 6.50 (56.50 − 50) for $3,250 (6.50 × 5 × $100). The result is a loss of $500 ($3,750 − $3,250).

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

B 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.

Which of the following transactions would be acceptable investments for a pension fund? A) Writing an S&P Index option B) Writing a covered call C) Writing a put D) Writing a naked call

B Writing a covered call has less risk than writing a naked option. A covered call writer is merely using options to increase the income on his portfolio. Fiduciaries, such as those who invest for pension fund portfolios, should avoid risky transactions.

Which of the following securities underlies a yield-based option? A) Revenue bonds B) Treasury securities C) Income bonds D) Debentures

B Yield-based interest rate options are based on the yields of Treasury bills, notes, and bonds.

Listed options expire at A) 4:30 pm ET on the Saturday immediately following the third Friday of the expiration month. B) 3:00 pm ET on the third Saturday of the expiration month. C) 11:59 pm ET on the third Friday of the expiration month. D) 4:00 pm ET on the third Friday of the expiration month.

C

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

C

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

C 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.

Which of the following positions has an unlimited dollar risk? A) Short 1 ABC Jan 35 call; long 1 ABC Jan 40 call B) Short 100 shares of ABC; long 1 ABC call C) Short 1 ABC Jan 50 put; short 100 shares of ABC D) Short 1 ABC Jan 50 put

C An investor faces unlimited dollar risk when short stock, short a naked call, or when a short stock position is combined with a short put. In this position, the unlimited risk of the stock is only protected on the upside by the premium received.

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

C 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.)

The covered call writing strategy would be most suitable for which of the following investors? A) A married couple that is saving for a grandchild's higher education B) An 28-year-old who is saving to buy a house before turning 30 C) A 65-year-old who is attempting to increase the yield of a portfolio containing equity securities D) An investor whose market outlook for the next three years is strongly bullish

C 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.

The net asset value (NAV) of an international bond fund can be expected to increase if interest rates rise abroad. interest rates fall abroad. the U.S. dollar strengthens. the U.S. dollar weakens. A) I and IV B) II and III C) II and IV D) I and III

C If interest rates fall, bond prices will rise, thus increasing the NAV of a bond portfolio. If the U.S. dollar weakens, the value of other currencies will rise. This would also increase the NAV for a portfolio of international bonds

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

C If the stock rises, the put will expire, leaving the customer short stock with an unlimited loss potential.

One of your customers takes a short position in 300 shares of LOP common stock. The sale price is $70 per share. One month later, with the stock selling at $73 per share, the investor purchases 3 LOP Sep 75 calls at a premium of 3.25. What is the investor's breakeven point? A) $69.75 per share B) $71.75 per share C) $66.75 per share D) $60.25 per share

C This customer is looking for the price of the stock to decline. The proceeds of the sale were $70 per share and the cost of the "insurance" (the call option) was 3.25. That means that the customer will not start making money until the stock falls below proceeds minus cost or 66.75. In a question like this, the current market price of the stock and the strike price of the option are irrelevant. Breakeven on short stock and a long call position is the proceeds minus the premium. As is always the case when computing breakeven, the number of shares and number of option contracts is meaninglessbreakeven is the same price for one or one thousand.

A client purchased 500 shares of JSSP common stock at $28 a share in July of 202X. The following June, the client wrote 2 October 35 calls at 5 each against the stock position. If the market price of JSSP was $39 at expiration, what was the client's realized gain? A) $1,000 B) $1,700 C) $2,400 D) $4,300

C Investors have a gain or loss only upon the sale of an asset. In this case, the only shares involved are the 200 shares covering the two short call options. The investor paid $5,600 ($28 times 200 shares). With the stock selling at 39 at expiration date of those two calls, they will be exercised because they are 4 points in-the-money. That means the investor will receive $7,000 ($35 times 200). The investor adds to that the $1,000 premium ($500 times 2) when the calls were written. The total credit to the account is $8,000. That is $2,400 more than the $5,600 the investor paid for those 200 shares. See the T-chart below. Bear in mind that although the customer was long 500 shares of JSSP stock, only two (covered) calls were written. When the market price reached 39 at expiration, the two calls were in-the-money and were exercised; however, the customer was not obligated to sell the remaining 300 shares of stock and there was no indication in the question that the customer liquidated the entire position. DR= 5,600 Cr=1,000+7,000=8,000 8,000-5600=2400

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? Bullish Bearish Calendar spread Vertical spread A) II and IV B) I and III C) II and III D) I and IV

C 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.

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

C 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.

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) $400. B) $200. C) $800. D) $1,600.

C 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).

A customer buys 1 XYZ Aug 60 call at 4 and 1 XYZ Aug 60 put at 2 when XYZ is at 61.25. If the stock rises to 68, and the customer lets the put expire and closes out the call at intrinsic value, the result is A) a loss of $600. B) a loss of $200. C) a gain of $200. D) a gain of $600.

C The customer has established a long straddle. To determine profit or loss, compute the breakeven points by both adding and subtracting the combined premiums (6 points) from strike (breakeven points are 54 and 66). Because the customer profits if the stock moves outside these points, at 68, the customer has a two-point ($200) gain.

A customer shorts 100 XYZ at 51 and buys 1 XYZ Aug 50 call at 4. The stock falls to 45, at which time, the customer closes the options contract at 1 and covers his short position at the current market price for A) a $400 loss. B) a $300 loss. C) a $300 gain. D) a $400 gain.

C The customer shorted stock at 51 and covered at 45 for a $600 gain, and then he bought a call at 4 and sold it at 1 for a $300 loss. Overall, the gain is $300.

If an American exporter will be paid 25 million Japanese yen when her goods arrive in 45 days, her best hedge is to A) sell yen puts. B) sell yen calls. C) buy yen puts. D) buy yen calls.

C The exporter does not want to see the value of the yen fall. If she owns yen puts, and the yen does fall, her profit on the puts would help compensate for the decrease in the value of the yen. Selling yen calls would also provide protection if the yen fell in value, but only to the extent of the premium received. Exporters buy puts to hedge; importers buy calls on the foreign currency to hedge.

An investor with no other positions buys 1 CDE May 65 put at 3.50. If the investor buys the stock at 63.50 and exercises the put, what is the investor's profit or loss? A) $200 profit B) $350 profit C) $200 loss D) $350 loss

C The investor has the right to sell the stock for 65 when it is currently worth 63.50 for a gain of 1.50. The investor paid a premium of 3.50 minus the gain of 1.50 for a loss of 2 (2 × 100 = $200).

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

C 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.

The manager of a portfolio that consists predominately of large- and mid-cap stocks could hedge against a market downturn and generate additional income by A) buying broad index puts. B) selling broad index puts. C) selling broad index calls. D) buying broad index calls.

C The only way to generate income through the use of options is to sell them. If concerned that the market may fall, selling calls is the appropriate strategy.

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) Buy British pound calls B) Sell British pound puts C) Buy British pound puts D) Sell British pound calls

C 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.

A client writes 1 Jan 60 put and buys 1 Jan 50 put. This is A) a debit bear spread; the investor wants the price fall below 50. B) a debit bear spread; the investor breaks even at a price greater than 60. C) a credit bull spread; the investor wants the price to stay above 60. D) a credit bull spread; the investor breaks even at a price less than 50.

C This is a put credit spread, and bulls sell puts. The 60 put is worth more because it has a higher strike price. Long the lower put is bullish; short the lower put is bearish.

A customer sells 1 ABC Corporation put for 2 on February 22, 2019, with a strike price of 50 and an expiration date of March 16, 2019. On March 15, 2019, ABC is put to the customer. Which of the following statements about this transaction is correct? A) He has an acquisition cost of $4,800 and a date of acquisition of February 22, 2019. B) He has a $200 short-term gain on the sale of his put. His cost of acquisition is $5,000, and the date of acquisition is February 22, 2019. C) He has an acquisition cost of $4,800 and a date of acquisition of March 15, 2019. D) He has an acquisition cost of $5,000 and a date of acquisition of March 16, 2019.

C When a put is exercised, the cost of acquisition is the cost that the writer has to pay (strike price) less the amount of premium the writer originally received. The date of acquisition is the trade date in exercising the option. Let's do the math. The sale of the put brings in a credit of $200. Almost one month later, the seller of the put receives an exercise notice. This means the seller is obligated to purchase 100 shares at the strike price of $50. That is a cost of $5,000. For tax purposes, the cost of $5,000 is reduced by the $200 premium received making the acquisition cost, $4,800. The date of acquisition (the date the holding period begins) is the date the option is exercised (March 15, 2019).

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

C 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.

A customer wishes to buy 1 XYZ Jan 40 call and write 1 XYZ Jan 45 call. At the time the order is placed, the options are trading as follows: Jan. 40 calls - 4.30 bid, 4.35 ask Jan. 45 calls - 2.25 bid, 2.30 ask If the transaction is effected at the market, the spread will be established at A) a 1.50 debit. B) a 1.85 debit. C) a 2.10 debit. D) a 1.75 debit.

C buy at bid and sell at ask

European-style foreign currency options can be exercised at any time. only be exercised at expiration. be traded at any time. only be traded at expiration. A) II and IV B) I and III C) I and IV D) II and III

D All U.S. exchange-listed currency contracts are European-style exercise, which can only be exercised at expiration. However, positions can be closed at any time until expiration.

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

D 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.

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

D 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.

Your clients' option position has been adjusted due to a 2-for-1 stock split. Which of the following regarding this 2-for-1 adjustment is true? A) The strike price will remain unchanged. B) The strike price will increase. C) The number of shares per contract will increase. D) The number of contracts owned will increase.

D For even splits (i.e., 2 for 1 or 3 for 1), the number of contracts owned will increase proportionately. The number of shares per contract will remain unchanged, and the strike price will decrease proportionately.

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 buy U.S. dollars. sell U.S. dollars. buy foreign currency. sell foreign currency. A) II and IV B) III and IV C) I and III D) II and III

D 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

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

D 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.

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

D 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.

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

D 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).

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

D 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.

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 in stocks B) $381 in securities C) $325 cash D) $600 cash

D 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.

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

D 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.

A customer sells short 100 shares of XYZ at 58 and buys 1 XYZ Jan 60 call for 3. If the stock price falls to $52, the customer buys back the stock and closes the option at 1 for A) a gain of $300. B) a loss of $300. C) a loss of $400. D) a gain of $400.

D The customer made $600 on the short stock position ($58 to $52) and lost $200 on the call (bought for 3, sold at 1). Overall, the gain is $400.

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 $8,700; maximum loss is $300; breakeven point is $87. C) Maximum gain is $300; maximum loss is $8,700; breakeven point is $87. D) Maximum gain is $300; maximum loss is unlimited; breakeven point is $93.

D 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.

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

D 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.

An investor with no other positions sells 1 ABC Jun 25 put at 1.50. If the put is exercised when the stock is trading at 24, and the investor immediately sells the stock in the market, what is the investor's profit or loss? A) $150 profit B) $150 loss C) $50 loss D) $50 profit

D The investor has the obligation to buy the stock at the strike price of 25. The stock is currently worth 24, which is a loss of 1. The investor's premium of 1.50 minus the loss of 1 leaves a net profit of 0.50 (0.50 × 100 = $50).

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

D 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).

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 the difference between the premiums narrows to less than $8. the difference between the premiums widens to more than $8. both puts are exercised at the same time. both puts expire unexercised. A) I and IV B) I and III C) II and IV D) II and III

D 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

The OEX index (Standard & Poor's 100) closes at 379.70, up 0.60 from the prior day's close. The holder of 10 in-the-money calls makes an unrealized gain of A) $6. B) $6,000. C) $60. D) $600.

D This unrealized gain is $600 (10 calls × 0.60 × $100 = $600).

An options investor wishing to follow a market-neutral strategy would be most likely to find which of the following most appropriate? A) A long straddle B) A debit put spread C) A long broad index call D) A time spread

D Time spreads, also called calendar or horizontal spreads, consist of two options of the same type with the same strike price, but different expiration months. The strategy expects the market to stay relatively level. The profit arises from the time decay of the later expiration date. A long straddle is profitable only if there is market movement. The same is true with the long call - the market price must go up. A debit put spread is a bearish strategy, so this strategy requires the market price to decline.

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) $275 B) $225 C) $250 D) $300

D 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.

Index options contracts that are commonly referred to as the fear gauge, and are based on the expected or implied volatility of the S&P 500 index, are known as A) the SPX or S&P 500 index options. B) the banking sector index options. C) the OEX or S&P 100 index options. D) the VIX or volatility market index options.

D VIX options contracts are based on expected or implied volatility of the S&P 500. The VIX is commonly referred to as the fear gauge or index. When the VIX is high, it is neither a bullish nor bearish indicator, but rather, an indication of expected volatility in the market. LO 10.g

Customers will have a potentially unlimited loss if they are A) long 1 ABC Jan 50 put and long 100 shares of ABC stock. B) long 100 shares of ABC stock and short 1 ABC 50 call. C) short 1 ABC Jan 50 put and long 100 shares of ABC stock. D) short 1 ABC Jan 50 call and short one ABC Jan 50 put.

D When trading options, there is one way in which to have a potentially unlimited loss. That is the uncovered (naked) call. When a call option is written without a corresponding long position in the underlying, the writer loses when the price goes up. Because there is theoretically no limit as to how high a stock's price can go, the potential loss is unlimited. In this short straddle position, it is the short call that creates this possibility. With a short put, the lowest a stock's price can go is to zero. With a 50 put, that is a maximum loss of $50 less the premium received. The maximum loss on any long position, stock or option, is what the investor paid for it.