Checkpoint quizes
Under the conduit theory of taxation, which of the following statements are true? A fund is not taxed on earnings it distributes if it distributes at least 90% of its net investment income. Investors are not taxed on earnings they reinvest. A fund is only taxed on interest income. Investors are taxed on earnings they receive in cash. A) I and IV B) III and IV C) II and III D) I and II
A By qualifying as a regulated investment company (the conduit, or pipeline, tax theory), the fund is liable only for taxes on retained income if it distributes at least 90% of its net investment income to shareholders. Investors will pay taxes on distributed income, whether it is received in cash or reinvested.
The performance of the XYZ Growth Fund has been in the top 1% of all funds in its category for the past 1-, 5-, and 10-year periods. Which of the following would be the biggest risk factor to an investor investing in this fund? A) Past performance is no assurance of future results B) The manager's tenure is six months C) A dividend yield of less than 2% D) Lack of diversification in the portfolio
A Explanation Although one cannot predict the future from the past, when a portfolio manager has consistently been ranked at the top, it is not considered a major risk to bet on a winner. The problem here is that almost all of that performance was achieved under the direction of previous management. With only six months on the job, the new manager is untested and there is no way to know how the future performance will rank. You might see this referred to as tenure risk. Diversification is one of the benefits, not risks, of a mutual fund. In a growth fund, one does not expect a high dividend yield.
A gain on the sale of a long equity put option is A) always a short-term capital gain. B) always a long-term capital gain. C) ordinary income. D) a short- or long-term capital gain.
A Explanation 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.)
If a customer with no other position sells 1 KLP Jul 80 call for 10 and buys 100 shares of KLP stock for $85 per share, he will break even when KLP stock is trading at A) $75. B) $95. C) $92. D) $70.
A Explanation Breakeven for a covered call writer is the purchase price less premiums received. In this case, breakeven is $85 minus $10, or $75 per share; below $75, the customer loses money.
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 $100 profit. C) a $200 loss. D) a $100 loss.
A Explanation 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.
A customer who seeks to supplement his retirement income and has a high risk tolerance would find which of the following securities most suitable? A) High-yield bond funds B) Investment-grade bond funds C) Municipal GOs D) Treasury STRIPS
A Explanation High-yield bonds yield more than investment-grade bonds. Because the client has a high risk tolerance, these bonds are more appropriate than investment-grade bonds, which yield less. Not only do the Treasury STRIPS provide zero income, but they certainly are not suitable for those with a high risk tolerance. Similarly, the municipal GO bonds are generally quite safe and, at least for test purposes, municipal bonds are never a suitable investment unless the investor is in a high tax bracket.
A client bought 100 XYZ at $65 per share and sold an XYZ 65 call at 8. Closing the short call at 10 and selling XYZ at 68 would result in A) a $100 profit. B) a $100 loss. C) a $500 loss. D) a $500 profit.
A Explanation Let's use the T-chart to show the flow of the money. The client bought 100 shares of the stock at $65 per share, so $6,500 went out (a debit). At the same time, the call was sold for a premium of 8, which brought in $800 (a credit). The short call was closed out (bought back something you sold) at 10, so we put $1,000 in the out (DR) column, and the stock was sold for $6,800, which goes in the in (CR) column. That means, $6,500 plus $1,000 went out, and $6,800 plus $800 came in. That is a total of $7,500 out and $7,600 in, for a net gain of $100.
Your client wishes to invest $50,000 into shares of the ACE Mutual Fund. This morning's financial news indicated that the POP for ACE was $10.86, while the NAV was $10 per share. The client's order is placed at 2:00 pm Eastern time. Based on this information, you could confirm to the client a purchase of A) nothing yet, as you must wait for the POP to be computed based on the day's close. B) 5,000 shares. C) more than 4,604.052 shares, but fewer than 5,000 shares. D) 4,604.052 shares.
A Explanation Mutual funds use forward pricing, so we never know what we'll be paying per share (if purchasing) or receiving per share (if redeeming) until the next calculated price.
A unit investment trust has 90% of its portfolio invested in high-grade bonds with an average maturity of almost 25 years. If the industry consensus was that long-term interest rates were about to increase sharply, which of the following actions would most likely be taken? A) No action would be taken B) Switch to short-term bonds C) Ladder the maturities D) Liquidate and begin to move into cash or cash equivalents
A Explanation One of the key distinctions of a UIT is its lack of management. Once the portfolio has been created, it is fixed until maturity, in the case of debt securities, or until some predetermined liquidation point, in the case of an equity trust.
If an investor buys 1 DWQ Apr 70 call at 5, giving him the right to buy 100 shares of DWQ at $70 per share, which aspect of the transaction is not set or standardized by the Options Clearing Corporation (OCC)? A) Premium of 5 B) Expiration date in April C) Contract size of 100 shares D) Exercise price of 70
A Explanation The OCC sets standard exercise prices and expiration dates for all listed options, but the options premiums that buyers pay are determined by the market.
If a customer is short 100 XYZ shares at 54 and long 1 XYZ 55 call at 2, what is the maximum potential loss? A) $300 B) $200 C) $100 D) Unlimited
A Explanation The customer has protected his short stock position from a market advance by purchasing the call. If the market rises, the call is exercised, allowing the customer to buy stock at the options strike price of 55 to cover the short position. Therefore, the most the customer can lose is $100 on the stock position (the difference between the option strike price and short sale price), plus the premium paid for the option ($100 + $200 = $300).
A customer buys 200 XYZ at 32, 2 XYZ JUN35 calls at 3, and 1 XYZ JUN 35 put at 6.50. Two months later, the customer purchases 1 XYZ JUN 35 put at 4. Before expiration, with XYZ trading at 37, he sells his stock and closes his calls at 2.10 and his puts at 0.25 for A) a loss of $180. B) a gain of $180. C) a gain of $450. D) a loss of $450.
A Explanation The customer opens four positions with debits to his account: 200 shares at $32 per share equals a debit of $6,400; two calls at $300 each equals $600; one put at $650 equals a debit of 650; and finally, an additional put at $400. Let's do the math on this. The total cost of the purchases is $6,400 + $600 + $650 + 400 = $8,050. The stock position is sold for $37 per share for a credit of $7,400. The calls are closed for 2.10 each (a credit of $420), and the puts are closed for a credit of $25 each. The proceeds from the sales are $7,400 + $420 +$50 = $7,870. The difference between the cost ($8,050) and the proceeds ($7,870) represents a loss of $180.
An investor opens the following options position: Buy 1 FOZ Mar 40 call @3; buy 1 FOZ Mar 40 put @2. What is the investor's maximum gain, maximum loss, and breakeven point? A) Maximum gain is unlimited; maximum loss is $500; breakeven points are $35 and $45. B) Maximum gain is $3,500; maximum loss is $500; breakeven points are $35 and $45. C) Maximum gain is $500; maximum loss is unlimited; breakeven point is $40. D) Maximum gain is unlimited; maximum loss is $500; breakeven point is $40.
A Explanation The first step is to identify the position. This is a long straddle—a long put and a long call with identical terms. That means we are going to have two breakeven points. The maximum gain is unlimited because one of the positions is a long call. The maximum loss is the amount paid for the straddle (the two premiums totaling $500). Breakeven follows the call-up and put-down rules. Add the premium to the strike of the call ($40 + $5 = $45) and subtract the premium from the strike of the put ($40 ‒ $5 = $35).
An investor purchases 1,000 shares of PLEX common stock at a price of $153 per share. Shortly afterward, with PLEX selling for 149 per share, a purchase of 10 PLEX 150 puts at 4 takes place. What is the investor's breakeven point? A) $157 per share B) $153 per share C) $149 per share D) $113 per share
A Explanation This investor is looking for the price to go up. The purchase price was $153 and the cost of the "insurance" (the put option) was 4. That means that the investor will not start making money until the stock rises above the cost of the stock plus the cost of the put ($153 plus $4 = $157). In a question like this, the current market price of the stock and the exercise price of the option are irrelevant. Breakeven on long stock and long put is the cost of the stock plus the cost of the put. As is always the case when computing breakeven, the number of shares and number of option contracts is meaningless−breakeven is the same price for one or one thousand.
With XYZ trading at $47.50, your customer writes 1 XYZ Jan 50 put and simultaneously writes 1 XYZ Jan 45 call, receiving $600 in combined premiums. Your customer's market attitude is A) neutral. B) bullish. C) bearish. D) speculative.
A Explanation This position is a short combination where both contracts are in the money. Breakeven points are 51 and 44. Above or below these points, the customer will lose money.
A customer writes 1 OEX (S&P 100) Jun 820 call at 13 and buys 1 OEX Jun 830 call at 6 when the index is trading at 826. The breakeven point is A) $827. B) $826. C) $823. D) $830.
A Explanation To compute the breakeven point for a call spread, add the net premium (debit or credit) to the lower strike price (a net credit of 7 plus 820 equals a breakeven point of 827). This is a bear spread. The customer will profit if the index is below 827 at expiration.
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) A 65-year-old who is attempting to increase the yield of a portfolio containing equity securities C) An 28-year-old who is saving to buy a house before turning 30 D) An investor whose market outlook for the next three years is strongly bullish
B Explanation 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.
A sophisticated client has expressed an interest in becoming more aggressive with their investment strategy. Her current portfolio consists of the following: $50,000 cash $200,000 in retirement accounts $100,000 in various individual stocks in different industries $100,000 in a balance fund She is willing to invest $25,000 for a minimum of 7 to 10 years and accepts that the investment can and will fluctuate in value over time. Which of the following investments would be the most appropriate? A) MNO High-Yield Bond Fund B) ABC Capital Appreciation Small-Cap Fund C) XYZ Value Equity Fund D) DEF Asset Allocation Fund
B Explanation For someone who is willing to take the risk and invest for the long haul, a small- or mid-cap growth fund would be appropriate.
With no other positions, a customer sells short 100 TIP at 40 and sells 1 TIP Oct 40 put at 5. At what stock price will the customer break even? A) $50 B) $45 C) $35 D) $40
B Explanation On the downside, the short position fully covers the short put, and the profit is the $500 premium. On the upside, above $40, the short put expires, and the short stock position loses money. The first five points of loss (40 to 45) on the short stock position are offset by the premiums received. Above $45, losses begin and are potentially unlimited. The other way to look at this is with the T-chart. When the stock is sold short, $4,000 is credited to the account. When the put is sold, $500 is credited to the account. That means $4,500 has been credited. How much needs to go on the debit side (the other side of the T to make things even?) $4,500, so when the stock rises to $45 per share, the investor breaks even. Anything above that and losses begin.
An investor has unexpectedly received $30,000 from an old debt he had written off. This money will come in handy for a business venture planned for three years from now. Meanwhile, he would like to generate some income on the money with as little risk and as little expense as possible. Which of the following recommendations is likely to be the most suitable for this customer? A) Class B shares of the XYZ Growth Fund B) Class C shares of the ABC Investment-Grade Bond Fund C) Class B shares of the ABC Investment-Grade Bond Fund D) Class A shares of the MNO High-Yield Bond Fund
B Explanation The customer wants income with as little risk as possible, so our answer must be one of the choices that offer an investment-grade bond fund. Of those offered, Class C shares would be best, because the customer would pay no front-end sales charge and no CDSC after a short time, probably one year. He will pay somewhat higher 12b-1 fees than with Class A shares, but this will amount to only a fraction of 1% per year, and only for the three years of his investment.
A customer opens the following positions: Buy 100 shares of HDH @60; buy 1 HDH Feb 60 put @4. What is the customer's maximum gain, maximum loss, and breakeven point? A) Maximum gain is $6,400; maximum loss is $400; breakeven point is $64. B) Maximum gain is unlimited; maximum loss is $400; breakeven point is $64. C) Maximum gain is unlimited; maximum loss is $5,600; breakeven point is $56. D) Maximum gain is $400; maximum loss is $5,600; breakeven point is $56.
B Explanation 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 ($60) plus the price paid for the option ($4), or $64. If the stock should rise above $64, the customer will let the 60 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 $60 per share. That means the maximum loss is the premium paid for the option, $400. 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.
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 $325; maximum loss is unlimited; breakeven point is $57.75. B) Maximum gain is $425; maximum loss is unlimited; breakeven point is $64.25. C) Maximum gain is $425; maximum loss is $5,775; breakeven point is $57.75. D) Maximum gain is $5,775; maximum loss is $425; breakeven point is $64.25.
B Explanation 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.
If a customer buys 1 XYZ Jan 40 call and 1 XYZ Jan 40 put, paying total premiums of $650, and XYZ becomes worthless, the result is A) a loss of $650. B) a gain of $3,350. C) a gain of $650. D) a loss of $3,350.
B Explanation This is a long straddle in which breakeven points are established by adding and subtracting the combined premiums (6½ points) from strike (breakeven points are 46½ and 33½). The customer makes money if the stock moves above 46½ or below 33½. As the stock becomes worthless, the customer earns a 33½ point gain on 100 shares, or $3,350.
The purchase of 200 shares of HGF at 45, and the subsequent sale of 2 HGF 50 calls at 3, could produce all of the following except A) a profit of $1,600. B) a profit of $2,000. C) a loss of $8,400. D) a loss of $6,000.
B Explanation This is covered call writing. The maximum loss that could be incurred is $8,400 ($9,000 paid for shares less premiums of $600 received). If you can lose $8,400, then you can certainly lose $6,000 (if, for example the value of the stock drops to 12). The maximum profit that can be expected is $1,600 (strike price of $10,000 received when calls are exercised minus the purchase price of $9,000 plus $600 in premiums received). Because the maximum profit possible is $1,600, it is impossible to have a profit of $2,000.
Under the Investment Company Act of 1940, which of the following statements regarding the renewal provisions of an investment adviser's contract is not true? A) The contract must be terminable upon no more than 60 days' notice. B) The renewal may be executed orally, provided it is done within two years of the initial contract. C) The renewal must state the adviser's compensation. D) The renewal must be approved by either majority vote of the board or majority vote of the outstanding shares, as well as majority vote of the noninterested members of the board.
B Explanation When an investment company employs an outside investment advisory firm to manage its portfolio, the act requires a written contract setting forth the adviser's compensation. The contract is for two years initially and must be renewed annually thereafter. The contract must be initially approved by a majority vote of the outstanding shares and the noninterested members of the board of directors and annually renewed by either a majority vote of the board of directors or of the outstanding shares, as well as a majority vote of the noninterested members of the board. The contract must be terminable at any time, with a maximum of 60 days' notice and with no penalty, upon a majority vote of the board of directors or of the outstanding shares, and it must terminate automatically if assigned.
Breakeven on long stock and long put is the cost of the stock ________ the cost of the put. Breakeven on short stock and a long call position is the proceeds _________ the premium.
Breakeven on long stock and long put is the cost of the stock plus the cost of the put. Breakeven on short stock and a long call position is the proceeds minus the premium.
Which of the following would protect a short May 50 call? A) Long Apr 45 call B) Long Apr 55 call C) Long Jun 45 call D) Long Jun 55 call
C Explanation For a long call to cover a short call, it must have the same or lower strike price and the same or longer expiration. This ensures that the investor may purchase the stock without financial loss and deliver it at 50 if the short call is exercised.
Which of the following would protect a short May 50 put? A) Long Jun 45 put B) Long Apr 55 put C) Long Jun 55 put D) Long Apr 45 put
C Explanation For a long put to cover a short put, it must have the same or higher strike price and the same or longer expiration. This ensures the investor may sell the stock without financial loss if the short put is exercised, and she is forced to buy.
A customer buys 100 DEF at 70, but several months later, the stock is trading at 82.85. The customer, concerned about a possible pullback, buys 1 DEF Aug 80 put at 1.50. If the stock subsequently falls to 77.25, and the customer sells her stock by exercising the put, the result is A) a gain of $850. B) a gain of $575. C) a gain of $875. D) a loss of $150.
C Explanation The customer bought 100 shares at 70 and sold them at 80 by exercising the put for a gain of $1,000. However, it cost $150 to buy the put, so the customer's gain is $850. In other words, breakeven for long stock-long put is the cost of stock purchased (70) plus the premium paid (1.50). Breakeven is 71.50, and the customer sold stock at 80 (80 − 71.50 = 8.50-point gain).
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) $14 loss B) $7 loss C) $0 D) $7 gain
D Explanation 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.
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 Explanation 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.
In early September, a customer buys 100 shares of QRS stock for $83 per share and simultaneously writes 1 QRS Mar 90 call for $4 per share. If the QRS Mar 90 call was exercised and the QRS stock delivered, what would be the customer's per-share profit? A) $4 B) $0 C) $7 D) $11
D Explanation If the stock rises above $90, the writer will be exercised and make $700 on the stock (buy at $83, deliver at $90) and keep the $400 received in premiums. Alternatively, the breakeven point is $79 ($83 − $4), and the stock was sold (delivered) at $90 for an 11-point gain.
A customer buys 100 DEF at 70, but several months later, the stock is trading at 82.85. The customer, concerned about a possible pullback, buys 1 DEF Aug 80 put at 1.50. If the stock subsequently falls to 77.25, and the customer sells her stock by exercising the put, the result is A) a gain of $575. B) a gain of $875. C) a loss of $150. D) a gain of $850.
D Explanation The customer bought 100 shares at 70 and sold them at 80 by exercising the put for a gain of $1,000. However, it cost $150 to buy the put, so the customer's gain is $850. In other words, breakeven for long stock-long put is the cost of stock purchased (70) plus the premium paid (1.50). Breakeven is 71.50, and the customer sold stock at 80 (80 − 71.50 = 8.50-point gain).
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) $200. B) $400. C) $1,600. D) $800.
D Explanation 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 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) $1,600. C) $200. D) $800.
D Explanation 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).
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 $325; maximum loss is unlimited; breakeven point is $57.75. B) Maximum gain is $425; maximum loss is $5,775; breakeven point is $57.75. C) Maximum gain is $5,775; maximum loss is $425; breakeven point is $64.25. D) Maximum gain is $425; maximum loss is unlimited; breakeven point is $64.25.
D Explanation 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.
An investor opens the following positions: Sell short 100 shares of FEW @80; buy one FEW Jan 80 call @5. What is the customer's maximum gain, maximum loss, and breakeven point? A) Maximum gain is unlimited; maximum loss is $500; breakeven point is $75. B) Maximum gain is $500; maximum loss is $7,500, breakeven is $75. C) Maximum gain is $7,500; maximum loss is unlimited; breakeven point is $85. D) Maximum gain is $7,500; maximum loss is $500; breakeven point is $75.
D Explanation 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 breakeven when the stock's price is equal to the sale price ($80) minus the premium paid ($5), or $75. 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 $80 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 $80. That means the maximum loss is the $500 premium paid for the protection. 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 $8,000 minus the premium of $500. 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 goes long an XYZ May 30 put for 4¼ points. What is the investor's maximum gain, maximum loss, and breakeven point? A) Maximum loss is unlimited; maximum profit is $2,575; breakeven point = $25.75 per share. B) Maximum loss is $425, maximum profit is unlimited; breakeven point is $25.75 per share. C) Maximum loss = $425, maximum profit = $2,575; breakeven point is $34.25 per share. D) Maximum loss = $425; maximum profit = $2,575; breakeven point = $25.75 per share.
D Explanation The initial action is a $425 purchase. That debit is the most the investor can lose. To figure maximum profit, you must think! What kind of strategy is buying a put option—bearish! The investor anticipates a falling market. The maximum profit will be realized when the market price of the stock falls as low as it can, which is zero. If the market price does fall to zero, the investor can sell the put for its intrinsic value. In this case, the 30 put would be in the money by 30 points, or $3,000. Therefore, the maximum profit to the put buyer is the entire difference between the strike price and zero, offset (reduced) by the premium paid (strike price minus premium). Breakeven uses the put-down rule. You subtract the premium from the strike price and that is $30 minus $4.25, which = $25.75.
If a client bought 100 shares of GM at $88.50, and on the same day, he went long a put at 90 for 4.25 on GM due to expire within the month, what is the breakeven point? A) $85.25 B) $84.25 C) $90.25 D) $92.75
D Explanation The stock is the dominant position. The breakeven point is calculated by adding the cost of the option to the cost of the stock. The stock must rise to $92.75 to break even.
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 credit bull spread; the investor breaks even at a price less than 50. C) a debit bear spread; the investor breaks even at a price greater than 60. D) a credit bull spread; the investor wants the price to stay above 60.
D Explanation 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.
In July, a customer invested $10,000 in the ABC Mutual Fund. In December of the same year, ABC announced a long-term capital gains distribution. In May of the next year, the customer decided to redeem his shares for a capital gain. How are both of the capital gains treated for tax purposes? The capital gain distribution is treated as long term. The capital gain from redemption is treated as long term. The capital gain from redemption is treated as short term. The capital gain distribution is treated as short term. A) I and II B) II and IV C) III and IV D) I and III
D Explanation When long-term capital gains are distributed, the length of time an investor has owned the fund is not relevant; it's still a long-term distribution. However, redemption of shares follows the normal holding period rules. Therefore, when this customer sold shares 10 months (July to May) after the purchase, the gain, like any other gain from a holding period that does not exceed 12 months, is short term.
An investor with no other positions sells 4 DWQ Jun 45 calls at 4. The calls are exercised when the stock is trading at 47.25. What is the investor's profit or loss? A) $175 profit B) $700 loss C) $175 loss D) $700 profit
D Explanation When the calls were exercised, the investor had the obligation to sell the stock to the owner of the call at 45. Because the investor had no other positions, we know that to fulfill the obligation to sell, they will first need to purchase the stock in the open market for 47.25. 4 was received when the call was sold, and 45 was received when the stock was sold to the owner of the call. Therefore, a total of 49 was received. 47.25 had to be paid to purchase the stock in the open market. Therefore, 47.25 paid and 49 received equals 1.75 point profit ($175) per contract. $175 × 4 contracts = $700 total profit.
An investor purchases a U.S. Treasury bond put option. The option is in the money on the last trading day and the investor exercises the put. Which of the following statements is correct? A) On the settlement date, the investor will pay cash in the amount of the intrinsic value. B) The investor will sell the option for its intrinsic value. C) On the settlement date, the investor will deliver the bonds and receive cash in the amount of the intrinsic value. D) On the settlement date, the investor will receive cash in the amount of the intrinsic value.
D Explanation Yield-based options settle in cash. The settlement amount is the intrinsic value. When an investor holding a put option exercises, the debt security is, in essence, being sold to (put to) the writer of the option. Instead of physical delivery of the bonds, settlement is made in cash. It is quite possible the investor will simply sell the option for its intrinsic value. That isn't the correct answer to this question because you are told the investor exercises the put.
If a customer buys 100 XYZ at 49 and writes 1 XYZ Nov 50 call, receiving $350 in premiums, the breakeven point is A) $53.50. B) $52.50. C) $46.50. D) $45.50.
D (wanted price to fall, it did 50-49 = 1in, + 3.5in from premium = 4.5 subtract that from your strike (50-4.5=45.50) Explanation This is a covered call, so the investor is protected against declining stock prices to the extent of the premium received, and the breakeven is $45.50 $49 − $3.50).
An investor opens the following positions: Sell short 100 shares of FEW @80; buy one FEW Jan 80 call @5. What is the customer's maximum gain, maximum loss, and breakeven point?
Maximum gain is $7,500; maximum loss is $500; breakeven point is $75.
