series 7TO- options unit 10

When does a customer have to receive the options disclosure document? A) At or before the first order B) With the confirmation of his first options transaction C) Within 15 days of account approval by the firm's registered options principal D) Within five business days of the first options trade

A) At or before the first order When opening an account to trade options, the owner must be told about the risks involved with trading options. By providing the owner with an options disclosure document entitled Understanding the Risks and Uses of Options, the broker-dealer satisfies the risk disclosure requirements. Furthermore, no member or person associated with a member shall accept an order from a customer to purchase or write an option contract, or approve the customer's account for the trading of options unless the broker-dealer furnishes or has furnished to the customer the ODD, and the customer's account has been approved for options trading. The 15-day rule applies to the customer's need to return the options account agreement. LO 10.j

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

A) Index options 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. LO 10.g

Which of the following will halt trading in listed options when there is a trading halt in the underlying stock? A) The options exchange on which the option is listed B) The Options Clearing Corporation C) The Securities and Exchange Commission D) The exchange on which the stock is listed

A) The options exchange on which the option is listed

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

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

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

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

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

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

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) the need to determine if the customer is of legal age. C) obtaining the name of the customer's employer (if employed). D) the requirement to obtain the signature of the principal approving the account.

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

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

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

If the strike price of a yield-based option is 62.50, this represents a yield of A) 0.0625%. B) 6.25%. C) 0.625%. D) 0.00625%.

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

If the holder of a call tenders an exercise notice after the ex-dividend date for a cash dividend, which of the following statements is true? A) He is entitled to the dividend only if he sells the underlying stock. B) He is not entitled to the dividend. C) He is entitled to the dividend. D) He must pay the dividend to the writer.

B) He is not entitled to the dividend. If the holder of a call exercises before the ex-date, the trade settles on or before the record date, and he is on record for the dividend. If the holder exercises on or after the ex-date, the trade settles after the record date, and he is neither on record for the dividend nor entitled to it. LO 10.b

A customer has entered an option order with your broker-dealer. At which of the following locations could such an order be executed? 1. NYSE 2. CBOE 3. Nasdaq PHLX 4 None of these A) II and III B) I, II, and III C) IV only D) I and II

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

For a regular standardized option, any gain on the sale of the contract is A) a long-term capital gain. B) a short-term capital gain. C) a short-term or long-term capital gain depending on the holding period. D) deferred until the underlying asset is sold.

B) a short-term capital gain. Regular standardized options have a maximum expiration of 9 months, so a gain on these types of contracts can only be short term for tax purposes. It is only the LEAPS options where it is possible to hold a long option position for more than 12 months. That is the only case where a long option can realize long-term treatment. The question is dealing solely with the options contract, not the underlying security. LO 10.i

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

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

Which of the following affects the holding period of XYZ stock, a position that has been held for six months? 1. Buying an in-the-money put 2. Buy an out-of-the-money put 3. Writing an in-the-money call 4. Writing an out-of-the-money call A) III and IV B) I and IV C) I and II D) II and III

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

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

C) Maximum gain is $425; maximum loss is unlimited; breakeven point is $64.25. The first step is to identify the position. This is a short sale of stock and a sale of a put option. The sale of the put provides some income and offers protection only to the extent of the premium. Short sellers want the stock's price to decline. They lose when it rises. The investor has received $6,425 ($6,100 from the sale of the stock and $325 from the sale of the option). That makes the breakeven point $64.25 per share. Once the price of the BAF stock goes above that, the investor loses money. Because there is no limit as to how high the stock's price can go, the maximum loss is unlimited. If, on the other hand, the stock's price declines into the 50s or lower, the owner of the 60 put will exercise and our investor will pay $6,000 to purchase the stock. That stock will be used to cover the short sale. That means the investor sold the stock (short) at $61 and bought it back at $60 for a gain of $100. At that point, the investor's profit is the $300 from the premium on the sale of the put plus the $100 gain (the difference between 61 and 60). That is why the maximum gain is $425. Why doesn't the breakeven follow the "put-down" rule? That rule applies when the only positions are options. Once there is a long or short stock position along with an option position, it is the stock controlling the breakeven. LO 10.h

Which of the following terms are synonymous? A) Price spread and horizontal spread B) Vertical spread and time spread C) Price spread and vertical spread D) Price spread and debit spread

C) Price spread and vertical spread A spread is the simultaneous purchase of one option and sale of another option of the same class. A call spread is a long call and a short call. A put spread is a long put and a short put. A price spread or vertical spread is one that has different strike prices but the same expiration date. Without knowing the specific options, we do not know if the spread is a credit or a debit spread. A time spread or calendar spread, also known as a horizontal spread, includes option contracts with different expiration dates but the same strike prices. LO 10.e

When determining position limits for listed options contracts and LEAPS contracts on the same side of the market, which of the following statements is true? A) The contracts are considered separately. B) The contracts are added to increase the position limits. C) The contracts must be aggregated. D) The contracts do not have position limits.

C) The contracts must be aggregated. LEAPS and listed options on the same side of the market, on the same underlying security, must be aggregated and remain within position limits. LO 10.j

A customer establishes the following positions: Long 1 ABC Jun 25 call at 2 Long 1 ABC Jun 25 put at 2 At expiration, the position is profitable if the stock price is A) greater than 21. B) above 21 or below 29. C) below 21 or above 29. D) above 25 or below 25.

C) below 21 or above 29. The investor purchased a long straddle (both a call and put with the same strike prices and expiration months). While straddle investors are uncertain about the direction of the market, long straddles require substantial price movement (volatility) for profit because the two premiums paid must be recovered. In this example, the breakeven of the call is found by adding the total premiums of four to the call strike price of 25 (25 + 4 = 29). The breakeven of the put is found by subtracting the total premiums of four from the put strike price of 25 (25 − 4 = 21). The market must either move up by four (total premiums paid) or down by four to be at breakeven. For profit, the market must be above or below the breakeven points. LO 10.h

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

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

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

C) sells a put on a stock he has sold short. The customer sells the put to generate income. The short stock position provides the necessary cash should his short put be exercised, forcing him to buy the stock. LO 10.d

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

D) A time spread 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. LO 10.e

Which of the following would be in compliance with the Chicago Board Options Exchange and Options Clearing Corporation rules concerning the nondiscriminatory assignment of an option exercise notice by a firm to one of its customers? A) Assignment to the customer with the smallest position in the option B) Assignment to the customer with the largest position in the underlying security C) Assignment to the customer with the largest position in the option D) Assignment to the customer with the oldest position in the option

D) Assignment to the customer with the oldest position in the option You cannot discriminate between large and small customers. First-in, first-out is not considered to be discriminatory. LO 10.b

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

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

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

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

The derivative-based strategy known as portfolio insurance involves A) the sale of a call on the underlying security position. B) the sale of a put on the underlying security position. C) the purchase of a call on the underlying security position. D) the purchase of a put on the underlying security position.

D) the purchase of a put on the underlying security position. The purchase of a put option to hedge the downside risk of an underlying security holding is called a protective put position, one of many derivative-based strategies collectively known as portfolio insurance. LO 10.g

All of the following can be advantages of buying an option contract except A) to limit risk. B) leverage. C) to position against a written option. D) time value dissipation.

D) time value dissipation. The purchase of an option allows an investor to speculate and fully participate in the price movement of the underlying security at a fraction of the cost of the shares involved, thus leveraging his investment. When used to position against a written option (a spread), the purchase of an option will reduce the risk of loss involved with a single written option. Used in conjunction with a securities position, the purchase of an option can act as an insurance policy to reduce the risk of loss (hedging); therefore, options offer all of these advantages but only for a limited time. As the contract gets nearer to expiration, its time value dissipates. Time decay may be the term used on the exam. This is not considered an advantage of owning options contracts. LO 10.c

Debit Call Spread

Debit call spreads are used by investors to reduce the cost of a long option position. There is, however, a trade-off, because the potential reward of the investor is also reduced. The investor who establishes a debit call spread is bullish. Example: Buy 1 RST Nov 55 call for 6 Sell 1 RST Nov 60 call for 3 Instead of paying $600 to buy the call, the investor reduced its cost to $300 by also selling a call. If the market price of the stock rises above 60, both calls will be exercised. The investor has the right to buy the stock for 55 but must then sell the stock for 60. The $500 profit on the stock is reduced by the $300 net premium paid, for a net profit of $200. This is the investor's maximum gain on the position. If the stock price remains below 55, both options will expire, and the investor will lose the net premium paid. The investor's maximum loss is the $300 net premium. The investor's breakeven point is always between the two strike prices in a spread. For call spreads, breakeven is found by adding the net premium to the lower strike price. Adding the net premium of 3 to the lower strike price of 55 results in a breakeven point of 58. Because this is a debit spread, the investor profits if exercise occurs. The difference in premiums on the two options widens as exercise becomes likely. Investors always want net debit spreads to widen. *See more info. on pg 203

Which of the following 2 covers a short call? Long stock Short stock Long put Stock rights

Long stock Stock rights Covering a short call requires taking action to eliminate the risk of being exercised. If the customer owns the stock or has the right to acquire it, the customer is covered. Stock rights (preemptive rights) give the holder the right to purchase the stock. Short stock and long puts both have the same market attitude as a short call (bearish), and therefore, would not cover the risk associated with a short call. LO 10.d

Protective Put

long stock and long put BE: Stock Price + Premium MG: Unlimited ML: Stock Price + Premium - Strike Price

Covered Call

long stock, short call BE= Stock Price - Premium MG= Stock Price + Premium - Strike Price ML= BE

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.

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