Series 7 Options

A customer should receive a current option disclosure document before or at the date of A) account approval. B) settlement. C) the first trade. D) the first account statement.

A Explanation The customer must receive a current disclosure document at or before the time their account receives approval for option trading.

An investor takes a short position in one XYZ Nov 140 call @7. Disregarding any commissions, on settlement date, the investor A) receives $700. B) must pay $700. C) must pay $14,000. D) receives $14,000.

A Explanation When an investor takes a short position in an option, it means the investor has sold, or written the option. As a seller, the investor receives the premium on the settlement date.

If an investor buys 300 shares of FLB, and one month, later buys 1 FLB Jul 50 put, how does this affect the holding period on his stock? A) It erases the holding period on 300 shares. B) It erases the holding period on 100 shares. C) It has no impact on the holding period for any of the shares owned by the investor. D) It ends the holding period on the put.

B Explanation Because the stock has not been held more than 12 months, the put purchase erases the holding period for any shares the put subsequently allows the holder to sell. Because the holder owns one put, this erases the holding period on 100 shares owned. The other 200 shares are unaffected.

If a customer buys 2 Canadian dollar 78 calls and writes 2 Canadian dollar 80 calls, this position is A) a diagonal call spread. B) a bull call spread. C) a credit call spread. D) a horizontal call spread.

B Explanation Bull positions in options spreads are established by buying the option with the lower strike price.

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) $950 gain B) $950 loss C) $700 gain D) $700 loss

C Explanation 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.

All of the following are suitable objectives for a covered call writer except A) increasing return on a long stock position. B) profiting from an increase in the price of stock. C) providing downside protection for a long stock position. D) speculating that a stock will not rise in price.

B Explanation Covered call writers are not able to benefit from an increase in the price of the underlying stock. For example, you buy stock at $40 and write a 40 call. Now, the stock is 80. Isn't that great? Your long stock position has doubled. Not so fast. With the stock at 80, it is certain that the 40 call will be exercised. So no matter how high the stock goes, the covered writer can't benefit because the call will be exercised and the stock will be sold at the $40 strike price. Why sell covered calls? This strategy provides downside protection to the extent of the premium received, and it increases the rate of return on a long stock position (because of the premium collected).

Which of the following would protect a short May 50 put? A) Long Jun 45 put B) Long Jun 55 put C) Long Apr 45 put D) Long Apr 55 put

B 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 new customer has been approved for all levels of options trading and has signed the options disclosure document. Even though approved for all levels of options trades, she notes that she will not be employing, and the registered representative (RR) should not recommend, any strategies with unlimited maximum loss potential. Given this criteria, an RR could suitably recommend A) short or long uncovered calls. B) short or long spreads. C) short or long straddles. D) short stock or short stock/short put hedge.

B Explanation Of the pairings offered, only short and long spreads both have defined loss potentials. Short stock, short calls, short straddles, and a short stock/short put hedge positions all have unlimited loss potentials.

A customer, long 100 shares of QRS at 62.50, writes 1 QRS Sep 65 call at 1.50. If the call is exercised, which two statements are true? The gain is $250. The gain is $400. For tax purposes, cost basis per share is $62.50. For tax purposes, cost basis per share is $61. A) I and IV B) II and III C) II and IV D) I and III

B Explanation The customer has paid $62.50 for the stock and has received 1.50 for the call. If the Sep 65 call is exercised, the customer will receive 65 for the sale of the stock. After exercise, the total received is $66.50 ($1.50 + $65). $66.50 received minus $62.50 paid equals four points profit ($400). If a covered call writer is exercised, the cost basis for tax purposes is the purchase price of the stock. Sales proceeds for tax purposes are 66.50 per share (strike price plus premium).

On which of the following positions does the potential loss equal the premium? A) Covered puts B) Long puts C) Covered calls D) Uncovered puts

B Explanation The premium paid to acquire the option represents the most an investor stands to lose on a long option position. Covered and uncovered are terms that relate to short option positions.

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) $258. B) $270. C) $250. D) $330.

B Explanation 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.

Which of the following statements regarding index options are true? Exercise is settled in cash. Exercise settlement value is based on the value of the index at the time exercise instructions are received. Exercise settlement value is based on the closing index value on the day exercise instructions are tendered. Exercise settlement is T+2. A) I and II B) II and IV C) I and III D) II and III

C Explanation All index option exercises are settled in cash. The amount a writer owes the holder is known as the intrinsic value of the option, and the settlement value is based on the closing index value on the day exercise instructions are tendered. Exercise settlement is the next business day.

Using yield-based options, which of the following hedging strategies offers a bond portfolio manager the greatest protection against rising long-term interest rates? A) Sell 30-year T-bond yield-based puts B) Buy 30-year T-bond yield-based puts C) Buy 30-year T-bond yield-based calls D) Sell 30-year T-bond yield-based calls

C Explanation In this example, the options would increase in value, as the actual yield on the 30-year Treasury bonds rose above the yield value represented by the strike price of the option.

Several years ago, a client purchased 1,000 shares of RADAK common stock at $50 per share. Today, the stock is selling for $100 per share and the investor is nervous about the future for the market. An order is turned in to sell 10 RADAK 105 calls at a premium of 2 and buy 10 RADAK 95 puts at a premium of 2. This strategy is A) a diagonal. B) exposing the investor to potential unlimited loss. C) a cashless collar. D) a combination.

C Explanation The answer is a cashless collar. It is cashless is because the calls are sold for 2 and the puts bought for 2. That means no out-of-pocket cash. The investor has "put a collar" on the long position in the stock by selling an out-of-the-money call and buying an out-of-the-money put. If the option purchase was more expensive than the one sold, it is still a collar, but not cashless because the investor would have to come up with the difference. For example, if the cost of the put was 3 while the proceeds from the call was 2, the client's cost would be one point to establish the collar. The exam will want you to know that collars (cashless or not) are used to protect an existing profit.

A customer buys 200 ABC at 76 and simultaneously writes 2 ABC Mar 80 calls at 2. If the stock rises to 83, and the customer is assigned on the short calls, the customer has a gain of A) $800. B) $1,800. C) $1,200. D) $1,400.

C Explanation The customer bought 200 shares at 76 and was forced to sell those shares at 80 for a gain of $800. In addition, the customer received $400 for writing the calls, so the overall gain is $1,200. The price of 83 is irrelevant. It only explains why the customer was exercised (the 80 calls are in the money). Breakeven for covered call writing is the cost of stock (76) less premiums (2). The breakeven point is 74, and the customer sold at 80 (6 points × 200 shares = $1,200).

A customer purchases 200 shares of XYZ at 17.50 and writes 2 XYZ Jan 20 calls at 1. At expiration, with the stock trading at 19, the options expire worthless. If the customer sells his long stock at the current market price, the gain is A) $250. B) $700. C) $500. D) $350.

C Explanation The customer buys stock at $17.50 and sells his shares at $19 for a gain of $300. In addition, the customer keeps the $200 in premiums, for an overall gain of $500.

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 $42.50. B) Maximum gain is $350; maximum loss is $4,250; breakeven point is $42.50. C) Maximum gain is unlimited; maximum loss is $350; breakeven point is $48.50. D) Maximum gain is $4,250; maximum loss is $250; breakeven point is $48.50.

C 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 ($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.

An investor purchases a GFC Jan 40 call @ 4 and sells a GFC April 30 call @ 9. This is an example of A) a vertical spread. B) a horizontal spread. C) a diagonal spread. D) a variable hedge.

C Explanation The investor has created a diagonal spread. An investor that buys and sells the same type of option has created a spread. If the strike prices and/or the expiration months of the options are different, it is a diagonal spread.

A customer establishes the following positions: Buy 100 JMB at 28 Buy 1 JMB Dec 25 put at 2 What is the maximum potential loss? A) $2,800 B) $200 C) $500 D) $3,000

C Explanation The investor loses money on the long stock position when the market value falls. With the purchase of the put, the investor can sell the stock for no less than the strike price, but also loses the premium. In this example, the investor loses a maximum of $3 on the stock (28 − 25) plus the premium of $2, for a total loss of $500 on 100 shares.

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 buy an XYZ 35 call. sell an XYZ 35 call. buy an XYZ 35 put. sell an XYZ 35 put. A) II or IV B) I or III C) I or IV D) II or III

C Explanation 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. Likewise, the short 35 put will be out of the money and will expire, with the investor earning the premium.

An investor opens a long position in one XYZ Nov 140 put @7. Disregarding any commissions, if the option is exercised, on settlement date the investor A) must pay $700. B) receives $700. C) receives $14,000. D) must pay $14,000.

C Explanation When an investor takes a long position in an option, it means that the investor has purchased the option. When a put is exercised, the holder must deliver the stock on settlement date. At that time, proceeds representing the strike price ($140) for 100 shares ($14,000) are received.

On exercise of the option, the holder of a put will realize a profit if the price of the underlying stock A) exceeds the exercise price plus the premium paid. B) falls below the exercise price. C) exceeds the exercise price. D) falls below the exercise price minus the premium paid.

D Explanation Breakeven for the buyer of a put is the strike price of the option minus the premium paid for the option.

Individuals with diversified stock holdings in their portfolios write covered calls to A) benefit from share price increases. B) lock in profits. C) increase the number of shares they own. D) increase their rate of return on the stocks held in their portfolio.

D Explanation Covered call writing is frequently used by persons who own the underlying stock to increase rate of return. If the options expire unexercised, the writer keeps the premium, which provides additional portfolio income.

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 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. B) He has an acquisition cost of $4,800 and a date of acquisition of February 22, 2019. C) He has an acquisition cost of $5,000 and a date of acquisition of March 16, 2019. D) He has an acquisition cost of $4,800 and a date of acquisition of March 15, 2019.

D Explanation 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).