5.8 Derivative Securities-Options

The term, "derivative", would not apply to which of the following? A) REITs. B) Forwards. C) Futures. D) LEAPs.

A) REITs. REITs are not based on the value of something other than their own assets. LEAPs are options and futures and forwards are contracts whose value is based on some underlying asset.

The type of derivative that gives the holder the right, but not the obligation, to buy an asset at a specified price during a specified period is: A) a variable contract. B) a futures contract. C) a call option. D) a real estate investment trust (REIT).

C) a call option. A call option gives the holder the right, but not the obligation, to buy an asset at a specific price during a specific period.

An investor is short stock at 60. The current market price of the stock is 35, and he anticipates it will continue to decline. If he thinks the price will rise temporarily and if he does not wish to close out his short position, his best strategy to prevent a loss would be to: A) Buy an XYZ 35 call. B) Sell an XYZ 35 call. C) Buy an XYZ 35 put. D) Sell an XYZ 35 put.

A) Buy an XYZ 35 call. Short stock (bearish), buy call (bullish) "Best Buy" *This client is temporarily bullish on the stock, but, in the long term, feels that it will continue to decline so the short stock position is to be maintained. If the client is correct, a near-term rise in the price of XYZ will cause the long 35 call to be in the money and the investor can sell the call at a profit. When it comes to hedging a short stock position, buying a call is always the best strategy.

Among the benefits of PURCHASING derivatives would be: leverage. increased income. unlimited potential gain. protection against loss. A) I, III and IV. B) III and IV. C) I and II. D) I, II, III and IV.

A) I, III and IV. Any derivative offers the benefit of a small dollar outlay controlling a large investment (leverage). In the case of call options or some other long derivative positions, the gain potential is theoretically unlimited. The purchase of options and certain other derivatives can offer protection against loss. But, in order to generate income, you must sell the derivative, not buy.

Options positions can either create rights or obligations. In which option position has the investor created the possible obligation to purchase stock? A) Selling a put. B) Purchasing a put. C) Purchasing a call. D) Selling a call.

A) Selling a put. When you sell, (write, go short) an option, you create an obligation. In the case of a put, you are obligated to purchase stock that is "put" to you. In the case of a call, you are obligated to sell stock that is "called" away from you. Option buyers have rights, they can choose what they wish to do - there are no obligations.

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

A) buy a put. The purchase of a put limits the downside risk to the difference between the stock price and the put's strike price.

One of your advisory clients indicates that he would like to sell forward contracts in soybeans. It would be wise to warn the client that he will be facing the following risks: liquidity. creditworthiness of the buyer. lack of assurance that the delivery price will remain stable. the location for the delivery may change. A) I and IV. B) II and III. C) I and II. D) III and IV.

C) I and II. Because there is no standardization for forward contracts, they are considered to be illiquid. Since there is no entity backing up the contract (as the OCC does with listed options), a seller must always be concerned about the ability of the buyer to pay. Although the market price probably will change, the delivery price is always agreed upon at the time of the contract as is the method, location and time of delivery.

A customer believes that ABC's price will go up but does not have the money to buy 100 shares right now. How could the customer use options to profit from an increase in the stock's price? Buy calls. Write calls. Buy puts. Write puts. A) II or III. B) II or IV. C) I or IV. D) I or III.

C) I or IV. When an investor anticipates an increase in a stock's price, he is considered to be bullish on the stock. To profit from the anticipated upward movement in the stock price, he could either buy calls or sell (write) puts. Both are bullish option strategies.

Purchasers of options can have a number of different objectives. One of your clients who is a soft drink fan already has a long position in KO. What would be a possible reason for this client to go long a KO call option? A) To complete the other side of a spread. B) Owning a long call on stock you already own offers a hedge against a market decline. C) This would generate additional income. D) To fix the cost of acquiring additional stock to the portfolio.

D) To fix the cost of acquiring additional stock to the portfolio. Those who are bullish on a stock, but don't have sufficient funds at this time to purchase the stock, can "lock-in" their future cost by going long a call. Income is generated only through selling options. Since a long call is on the same side of the market as long stock, there is no hedge. A spread involves a long and short option.

Due to an escalating trade war, the portfolio manager of an equity mutual fund anticipates a negative impact on his fund's assets. To protect his investment portfolio, the fund manager would: A) buy S&P 500 index calls. B) sell S&P 500 index calls. C) sell S&P 500 index puts. D) buy S&P 500 index puts.

D) buy S&P 500 index puts. A portfolio manager who expects a decline in the market as a result of a trade war (or any factor that might hurt stock prices) would buy puts on a broad market index such as the S&P 500 to protect his position. Selling calls limits upside potential, and only protects the portfolio to the extent of the income received from the sale of the calls.

For which of the following is there no active secondary market? A) Forward contracts. B) Futures contracts. C) Options. D) ETFs.

A) Forward contracts One of the disadvantages when investing in forward contracts is that there is no active secondary market. Because each contract is between one buyer and one seller and there is no standardization, no exchange trading is possible.

An investor owns 500 shares of RIF, a well-established company with a long history of paying liberal dividends. If this individual wishes to increase his income without any cash outlay and without increasing his risk, it would be most appropriate for him to: A) write five puts on the RIF. B) exercise his preemptive rights. C) write five calls on the RIF. D) buy five calls on the RIF.

C) write five calls on the RIF. This strategy is known as covered call writing, and it enables the investor to increase income without spending any money. The sale of the calls (each call represents 100 shares) generates immediate income and reduces the risk should the stock drop in price.

Writing an option provides all of the following EXCEPT: A) maximum protection against loss. B) income. C) limited downside protection when long the underlying asset. D) hedging.

A) maximum protection against loss. Writing an option provides only limited protection for a long or short position. That protection is limited to the amount of the premium received.

The type of security that gives the holder the right, but not the obligation, to sell a certain number of shares of stock for a specified price during a specified period is a: A) put option. B) call option. C) currency swap. D) stock index future.

A) put option. A put option gives the holder the right to sell a certain number of shares of stock for a certain price within a certain period. A call option gives the holder the right to buy shares of stock for a certain price during a certain period.

An investor is long stock in a cash account and does not expect the price to change in the immediate future. His best strategy to generate income may be to: A) sell a call. B) sell a put. C) buy a call. D) buy a put.

A) sell a call. ***Selling a call against a security will generate additional income (the premium). An investor who writes a put receives additional income from the position but must also be willing to increase his position should the put be exercised. An investor who buys a call is speculating that the stock will soon rise dramatically. An investor who buys a put is speculating the stock will soon fall, not stay steady in price.

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

B) Buy a call. Purchasing a call on the security protects the customer from a loss in excess of the strike price plus the cost of the call should the security rise in price.

Which of the following is not considered to be a derivative? A) Warrant. B) Unit investment trust. C) Call option. D) Futures contract.

B) Unit investment trust. All of the other choices "derive" their value from some underlying asset. A UIT is an investment company and its value is based on its own assets.

If your customer owns 100 shares of a volatile stock and wants to limit downside risk, you may recommend: A) shorting the same stock. B) buying puts. C) writing calls and selling puts. D) buying calls.

B) buying puts. Downside risk is reduced by purchasing a put with a strike price at or close to the stock's purchase price. Should the stock decline below the strike price, the investor can exercise the put at the strike price. Selling put options will increase the downside risk. Buying calls is a bullish strategy that increases downside risk. Shorting stock will lock in the current price but will limit upside potential.

A client calls to say he has just read about a European option and doesn't know what it is. You would explain that it is a derivative because: A) the currency used is generally something other than the U.S. dollar. B) its value is based on some underlying asset. C) it can only be exercised on the expiration date. D) intrinsic value does not affect the premium.

B) its value is based on some underlying asset. Although the unique characteristic of a European option is that it can only be exercised on its expiration date, that doesn't answer this question. It is a derivative like any other option because its value is based on the underlying asset.

An option that may be exercised prior to its expiration date is said to be: A) Premature style. B) Flexible style. C) American style. D) European style.

C) American style. There are two forms of option exercise - American and European. American style can be operationally exercised any day that the market is open before the expiration date. With European style, the only time you can operationally exercise your contract is the last trading day before expiration. Remember, even though there is only one day in which you can exercise your contract, you can always close out your option position in the secondary market any day prior to expiration.

If an investor purchases 500 shares of an aggressive growth stock, which strategy would limit his downside risk? A) Writing 5 puts on the stock. B) Writing 5 straddles. C) Buying 5 puts on the stock. D) Buying 5 calls on the stock.

C) Buying 5 puts on the stock. A put gives the investor the right to sell stock at a set price (the strike price) for a period of time, and protects against losses below the strike price. Buying calls can protect a short stock position. If the customer is long stock, the purchase of calls on that security increases leverage and risk. Writing a put creates the obligation to buy more stock at the strike price, which increases downside risk.

Nonsecurities derivatives would include: Forward contracts. Futures contracts. Hedge funds. REITs A) I, II, and III. B) I, II and IV. C) I and II. D) I and IV.

C) I and II. Forward contracts and futures contracts are known as nonsecurities derivatives because they derive their value from something that is not a security. REITs are not derivatives.

An investor who is long XYZ stock would consider going long an XYZ call to: A) hedge the long position. B) obtain income from the premium. C) protect against an increase in the market price of XYZ stock. D) protect against a decrease in the market price of XYZ stock.

C) protect against an increase in the market price of XYZ stock. Going long a call means that you have bought it. Only sellers of options generate income. If you wish to hedge your long stock position, you buy a put, not a call. That leaves us with two choices that are polar opposites. Good test taking skills teach us that, in almost all cases, when we see that, one of those must be the right answer. Buying a call is bullish. Forget the first part (you are long the stock). You would buy a call so that, if the price of the stock went up, you could exercise at the lower strike price of your call option.

A portfolio manager using index options is trying to reduce which of the following types of risks? A) Financial. B) Purchasing power. C) Selection. D) Systematic.

D) Systematic. Systematic risk (sometimes called market risk) refers to the impact the overall market has on an equity portfolio's value. Index options help insure portfolios against systematic risk. The purchase of index puts to protect a portfolio is termed portfolio insurance.

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

D) Writing naked calls. Writing naked calls provides unlimited liability and the most risk. Buying a call would be an attractive strategy in a bull market with risk limited to calls paid. Writing naked puts risks only the difference between the strike price and zero, less any premium received. Buying a put is a bearish strategy with risk limited to the amount paid for the put.

You have a client who has sold short 100 shares of RIF, a stock listed on the NYSE. If the client wished to use options to protect against unlimited loss, you would suggest the client: A) buy 1 RIF put. B) sell 1 RIF call. C) sell 1 RIF put. D) buy 1 RIF call.

D) buy 1 RIF call. Buying a call option on a stock you are short will give you a guaranteed covering cost, thus preventing against unlimited loss. This is the best way to hedge a short position.

An investor would write a call option to: A) protect the premium. B) fix the purchase price to add stock to his portfolio. C) seek long-term capital gain. D) obtain income.

D) obtain income. The writing (selling) of an option always generates premium income to the writer. If the call is exercised, the writer must sell the stock so this is not a way to add to your portfolio. In general, option writers only realize short-term gains, not long-term. If the question had said this was a covered call, then the second best choice would have been to protect the long position (not the premium).

When an investment's value is based upon some underlying asset, it is known as a: A) swap. B) hedge fund. C) separate account. D) derivative.

This is why the term is used - the value is derived from some other asset.