1
Q
A customer buys 100 shares of ABC stock at $50 and sells 2 ABC Jan 50 Calls @ $5. This is a:
A. short straddle
B. ratio call write
C. covered call write
D. ratio call spread
A
The best answer is B.
If a customer who is long stock sells call contracts against the stock position, then as long as the contract amount does not exceed the long stock position, the call writer is “covered.” This means that if the short call is exercised, the customer already has the stock for delivery. Hence the customer is covered against the risk of having to go to the market to buy the stock at a sky high price to make delivery. If a customer sells more call contracts than the stock position owned, this is a “ratio” call write. In this example, the customer is selling calls against the stock position at a 2:1 ratio.
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2
Q
A customer owns 100 shares of ABC stock in a margin account, valued at $39 per share. The customer sells 4 ABC Jul 40 Calls @ $4. The stock moves to $52 and the calls are exercised. The customer has a:
A. $300 gain
B. $1,900 loss
C. $3,600 loss
D. $4,800 loss
A
The best answer is B.
If the stock moves to $52, all 4 calls will be exercised. Since one of the calls is covered, 100 shares of the stock that was bought at $39 will be delivered at $40, for a 1 point or $100 gain. Since the stock is now at $52, this is the price that is paid to buy the stock to deliver at $40 on the remaining 3 naked calls, equals a 12 point loss x 300 shares = $3,600 loss. But don’t forget the premiums received of 4 x $400 = $1,600 gain. The net gain or loss is: + $100 - $3,600 + $1,600 = -$1,900 loss.
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3
Q
A customer owns 100 shares of ABC stock in a margin account, valued at $40 per share. The customer sells 2 ABC Jul 40 Calls @ $4. The customer will lose money at all of the following prices EXCEPT:
A. $30
B. $35
C. $50
D. $55
A
The best answer is B.
If the stock rises by more than the 8 points collected in premiums, there will be a loss on the one naked call (above $48). If the stock drops below $32 (40 - 8), there will be a loss on the long stock position (the 2 calls will expire unexercised). Therefore, breakeven occurs at $32 and $48. Between $32 and $48, the position is profitable. Below $32 or above $48, there is a loss.
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4
Q
A customer owns 100 shares of ABC stock in a margin account, valued at $40 per share. The customer sells 3 ABC Jul 40 Calls @ $4. The stock moves to $60 and the calls are exercised. The customer has a:
A. $400 gain
B. $2,800 loss
C. $4,000 loss
D. $4,800 loss
A
The best answer is B.
If the stock moves to $60, all 3 calls will be exercised. Since 1 of the calls is covered, 100 shares of the stock that was bought at $40 will be delivered at $40, for no gain or loss. On the 2 remaining calls, 200 shares must be delivered at $40. Since the market price is $60, there is a 20 point loss times 2 contracts for a total of $4,000 loss. Because 12 points were collected in premiums, the net loss is 28 points or $2,800. This is an extremely difficult question.
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5
Q
A customer owns 100 shares of ABC stock in a margin account, valued at $40 per share. The customer sells 3 ABC Jul 40 Calls @ $4. The maximum potential loss is:
A. $800
B. $3,200
C. $4,000
D. unlimited
A
The best answer is D.
One of the short calls is covered by the long stock position, while the 2 remaining short calls are naked. The loss potential on short naked calls is unlimited.
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6
Q
A customer buys 100 shares of ABC stock at $50 and sells 1 ABC Jan 50 Call @ $4 and sells 1 ABC Jan 50 Put @ $3. This strategy is:
Ibearish
IIneutral
IIIa covered straddle
IVa covered spread
A. I and III
B. I and IV
C. II and III
D. II and IV
A
The best answer is C.
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The customer has created a long stock/short straddle position. This is termed a “covered straddle,” however this name is not really accurate. The short call is covered by the long stock position, however the short put is naked. This is a neutral to slightly bullish market strategy.
If the market stays the same, both the short call and the short put expire, leaving the customer with a gain of $700 in total collected premiums.
If the market rises, the short call is exercised and the customer delivers the stock bought at $50 for the same $50 price. The short put expires “out the money” and the customer keeps the $700 in collected premiums. This is the maximum gain.
If the market drops, the customer loses on both the long stock position and the short naked put (since the short put will be exercised, forcing the customer to buy another 100 shares of stock). The customer can lose the full value of the 200 shares owned if the market falls to “0,” net of the premium collection.
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7
Q
On the same day a customer buys 100 shares of ABC stock at $30 and sells 1 ABC Jan 30 Call @ $3 and sells 1 ABC Jan 30 Put @ $2. This strategy is known as a:
A. covered straddle
B. covered call writer
C. ratio write
D. butterfly spread
A
The best answer is A.
The customer has created a long stock/short straddle position. This is termed a “covered straddle,” however this name is not really accurate. The short call is covered by the long stock position, however the short put is naked.
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8
Q
On the same day a customer buys 100 shares of ABC stock at $30 and sells 1 ABC Jan 30 Call @ $3 and sells 1 ABC Jan 30 Put @ $2.
The maximum potential gain is:
A. $500
B. $2,500
C. $5,500
D. Unlimited
A
The best answer is A.
The customer has created a long stock/short straddle position. This is shown below:
Buy 100 Shares of ABC at $30
Sell 1 ABC Jan 30 Call @$3
Sell 1 ABC Jan 30 Put @$2
$5 Credit
The credit of $500 is the maximum potential gain occurring if both contracts expire “at the money.”
If the market rises above $30, the short call is exercised, while the short put expires “out the money.” The stock that was purchased at $30 is delivered for $30 - there is no further gain or loss on this position. Thus, in a rising market, the maximum gain is $500.
If the market falls below $30, the short put is exercised (requiring the customer to buy another 100 shares at $30), while the short call expires “out the money” As the market falls, the customer now owns 200 shares purchased at $30. Since $500 was collected in premiums, he can afford to lose 2.5 points per share and will still breakeven. Thus, the breakeven occurs at $30 - $2.50 = $27.50. If the market continues to drop to zero, the customer will lose the full value of the 200 shares purchased at $30, net of $500 collected in premiums, for a net loss of $5,500 ($27.50 per share).
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9
Q
A customer buys 100 shares of ABC stock at $50 and sells 1 ABC Jan 50 Call @ $4 and sells 1 ABC Jan 50 Put @ $3. The customer’s maximum potential loss is:
A. $700
B. $4,300
C. $9,300
D. Unlimited
A
The best answer is C.
This customer has a long stock position with a short straddle. The customer believes that the market will remain flat for the life of the options; and the customer will retain the total premium of $700 if this occurs. If the market falls, the short put is exercised and the short call expires. The exercise of the short put obligates the customer to buy 100 shares of ABC stock at $50, in addition to the 100 shares already owned at $50. In a falling market, the customer will sustain a loss on the 200 shares of ABC - with the maximum loss occurring if the stock falls to “0.” In this case, the customer loses $50 paid per share x 200 shares = $10,000 - $700 collected premiums = $9,300. On the other hand, if the market rises above $50, the short call is exercised and the short put expires. In this case, the customer must deliver the 100 shares owned for $50 received per share. Since the customer paid $50 per share, the only gain is the combined $700 premium received.
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10
Q
On the same day in a margin account, a customer buys 5 ABC January 40 Calls @ $6 and sells 10 ABC January 50 Calls @ $1 when the market price of ABC is at $43. The customer has created a:
A. short combination
B. long combination
C. ratio spread
D. back spread
A
The best answer is C.
This is a very difficult question. The customer is taking the following positions:
Buy 5 ABC Jan 40 Calls@ $6
Sell 5 ABC Jan 50 Calls@ $1
$5 Debit
Sell 5 ABC Jan 50 Calls@ $1 Credit
The customer is creating 5 “long call spreads” and has 5 naked calls. In effect, he is writing 2 times the number of short calls needed to create the spread. Therefore he is “writing at a 2:1 ratio.” This is termed a ratio spread. Long call spreads are used when a customer is moderately bullish, and wishes to reduce the cost of the long position by selling an equal number of “out the money” calls. This limits upside gain potential, but also reduces the cost of the positions. By writing twice the number of calls, the customer further reduces the cost of the positions, but also assumes unlimited upside risk on the 5 naked calls that are left.
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11
Q
On the same day in a margin account, a customer buys 5 ABC January 40 Calls @ $6 and sells 10 ABC January 50 Calls @ $1 when the market price of ABC is at $43. If the market moves to $48 and the contracts are closed at intrinsic value, the gain or loss is:
A. $2,000 gain
B. $2,000 loss
C. $2,500 gain
D. $2,500 loss
A
The best answer is A.
If the market moves to $48, and the contracts are closed at intrinsic value, the short 50 calls expire since they are “out the money.” On the long 40 calls, the customer will have a gain of 8 points per contract. Thus, the customer will gain $800 per long call x 5 contracts = $4,000. Since the customer paid a true net debit of $400 per contract (5 points per spread - 1 point received on each of the naked calls) x 5 contracts = $2,000 paid, the net profit is $2,000.
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12
Q
On the same day in a margin account, a customer buys 5 ABC January 40 Calls @ $6 and sells 10 ABC January 50 Calls @ $1 when the market price of ABC is at $43. The maximum potential profit is:
A. $2,000
B. $3,000
C. $5,500
D. unlimited
A
The best answer is B.
The maximum potential profit must occur at $50 per share. At this price, the customer would profit on the long call spreads, without losing anything on the 5 short calls - which would expire “at the money.” At a $50 price, each long call spread results in a profit of 10 points (Buy the stock at $40 by exercising the long call and sell it at $50 in the market), net of $5 paid (net debit) in premiums per spread = $500 profit per spread x 5 spreads = $2,500 profit. The short naked 50 calls expire resulting in a $100 profit per contract ($1 credit) x 5 contracts = $500. The total profit is $2,500 + $500 = $3,000.
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13
Q
On the same day in a margin account, a customer buys 1 ABC January 45 Call @ $6 and sells 2 ABC January 60 Calls @ $1 when the market price of ABC is at $46. If the market moves to $58 and the contracts are closed at intrinsic value, the gain or loss is:
A. $100 gain
B. $100 loss
C. $900 gain
D. $1,300 gain
A
The best answer is C.
If the market moves to $58 and the contracts are closed at intrinsic value, the short 60 calls expire since they are “out the money” - the 60 calls have no intrinsic value. So, the customer sells the 45 call for $13 ($58 - $45 = $13) which is the intrinsic value of the contract. Since the customer paid $6 there is a $7 gain here, plus the $2 received from selling the 60 call contracts. The net profit is $900.
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14
Q
On the same day in a margin account, a customer sells 5 ABC January 40 Calls @ $6 and buys 10 ABC January 50 Calls @ $1 when the market price of ABC is at $43. The maximum potential loss is:
A. $2,000
B. $3,000
C. $5,500
D. unlimited
A
The best answer is B.
This customer has bought 10 ABC Jan 50 Calls @ $1 ($1,000 premium paid) and has sold 5 ABC Jan 40 Calls @ $6 ($3,000 premium collected). In this case, if the market falls below $40 and all of the calls expire “out the money,” the customer will gain $2,000 (Sell 5 Calls @ $6 for $3,000 profit offset by the purchase of the 10 Calls @ $1 or $1,000: $3,000 received - $1,000 paid = $2,000 profit).
If the market rises to $50, the customer will have the maximum potential loss. At $50, the short 5 ABC Jan 40 Calls are exercised, obligating the customer to deliver 500 shares @ $40 each. The customer is long 10 ABC Jan 50 Calls, which expire “at the money.” Therefore, the customer will buy 500 shares in the market @ $50 to deliver, losing $10 per share, or $5,000 on 500 shares. Since the beginning net credit was $2,000, the customer loses $3,000.
Above $50, all contracts are “in the money” and are exercised. The short 5 ABC Jan 40 Calls that are exercised are satisfied by exercising 5 of the long ABC Jan 50 Calls. On the remaining long 5 ABC Jan 50 Calls, there is a profit as the market continues to move higher than $50. If the market keeps on rising, there is unlimited gain potential.
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15
Q
On the same day when the market price of ABC stock is $59, a customer takes the following options positions:
Buy 1 ABC Jan 55 Call @ $7
Sell 2 ABC Jan 60 Calls @ $4
Buy 1 ABC Jan 65 Call @ $2
The maximum potential gain is:
A. $100
B. $200
C. $300
D. $400
A
The best answer is D.
A butterfly spread is a market neutral position that is created by combining a “long” spread with a “short spread.” It is called a “butterfly” because the 2 “outer” long positions are the wings of the butterfly, while the 2 short positions at the same strike are the “body” of the butterfly/
The position is established with a small debit that establishes the maximum potential loss if the market moves broadly up or down. If the market stays right in the middle ($60 in this example), the gain is maximized. Here is what happens as the market moves:
Market is at $55 or lower: All positions expire and the net $1 debit is lost.
Market moves to $56: $1 is gained on the long 55 call, offsetting the $1 debit = breakeven.
Market moves to $57: $2 is gained on the long 55 call, offset by the $1 debit = $1 profit
Market moves to $58: $3 is gained on the long 55 call, offset by the $1 debit = $2 profit
Market moves to $59: $4 is gained on the long 55 call, offset by the $1 debit = $3 profit
Market moves to $60: $5 is gained on the long 55 call, offset by the $1 debit = $4 profit. This is the maximum potential gain.
Market moves to $61: $5 is gained on the exercise of the long 55 call and one of the short 60 calls, offset by a $1 loss on the other short 60 call and the $1 debit = $3 profit
Market moves to $62: $5 is gained on the exercise of the long 55 call and one of the short 60 calls, offset by a $2 loss on the other short 60 call and the $1 debit = $2 profit
Market moves to $63: $5 is gained on the exercise of the long 55 call and one of the short 60 calls, offset by a $3 loss on the other short 60 call and the $1 debit = $1 profit
Market moves to $64: $5 is gained on the exercise of the long 55 call and one of the short 60 calls, offset by a $4 loss on the other short 60 call and the $1 debit = $0 profit. This is the upside breakeven.
Market moves to $65 or higher: All positions are exercised. $5 is gained on the exercise of the long 55 call and one of the short 60 calls, offset by a $5 loss on the exercise other short 60 call and the long 65 call. The loss is the debit of $1.
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16
Q
On the same day when the market price of ABC stock is $59, a customer takes the following options positions:
Buy 1 ABC Jan 55 Call @ $7
Sell 2 ABC Jan 60 Calls @ $4
Buy 1 ABC Jan 65 Call @ $2
The maximum potential gain occurs if the market moves:
A. below $55
B. above $65
C. either below $55 or above $65
D. to $60
A
The best answer is D.
A butterfly spread is a market neutral position that is created by combining a “long” spread with a “short spread.” It is called a “butterfly” because the 2 “outer” long positions are the wings of the butterfly, while the 2 short positions at the same strike are the “body” of the butterfly/
The position is established with a small debit that establishes the maximum potential loss if the market moves broadly up or down. If the market stays right in the middle ($60 in this example), the gain is maximized. Here is what happens as the market moves:
Market is at $55 or lower: All positions expire and the net $1 debit is lost.
Market moves to $56: $1 is gained on the long 55 call, offsetting the $1 debit = breakeven.
Market moves to $57: $2 is gained on the long 55 call, offset by the $1 debit = $1 profit
Market moves to $58: $3 is gained on the long 55 call, offset by the $1 debit = $2 profit
Market moves to $59: $4 is gained on the long 55 call, offset by the $1 debit = $3 profit
Market moves to $60: $5 is gained on the long 55 call, offset by the $1 debit = $4 profit. This is the maximum potential gain.
Market moves to $61: $5 is gained on the exercise of the long 55 call and one of the short 60 calls, offset by a $1 loss on the other short 60 call and the $1 debit = $3 profit
Market moves to $62: $5 is gained on the exercise of the long 55 call and one of the short 60 calls, offset by a $2 loss on the other short 60 call and the $1 debit = $2 profit
Market moves to $63: $5 is gained on the exercise of the long 55 call and one of the short 60 calls, offset by a $3 loss on the other short 60 call and the $1 debit = $1 profit
Market moves to $64: $5 is gained on the exercise of the long 55 call and one of the short 60 calls, offset by a $4 loss on the other short 60 call and the $1 debit = $0 profit. This is the upside breakeven.
Market moves to $65 or higher: All positions are exercised. $5 is gained on the exercise of the long 55 call and one of the short 60 calls, offset by a $5 loss on the exercise other short 60 call and the long 65 call. The loss is the debit of $1.
17
Q
On the same day when the market price of ABC stock is $59, a customer takes the following options positions:
Buy 1 ABC Jan 55 Call @ $7
Sell 2 ABC Jan 60 Calls @ $4
Buy 1 ABC Jan 65 Call @ $2
This position is profitable when the market:
A. moves sharply down
B. moves sharply up
C. is stable
D. is volatile
A
The best answer is C.
A butterfly spread is a market neutral position that is created by combining a “long” spread with a “short spread.” It is called a “butterfly” because the 2 “outer” long positions are the wings of the butterfly, while the 2 short positions at the same strike are the “body” of the butterfly/
The position is established with a small debit that establishes the maximum potential loss if the market moves broadly up or down. If the market stays right in the middle ($60 in this example), the gain is maximized. Here is what happens as the market moves:
Market is at $55 or lower: All positions expire and the net $1 debit is lost.
Market moves to $56: $1 is gained on the long 55 call, offsetting the $1 debit = breakeven.
Market moves to $57: $2 is gained on the long 55 call, offset by the $1 debit = $1 profit
Market moves to $58: $3 is gained on the long 55 call, offset by the $1 debit = $2 profit
Market moves to $59: $4 is gained on the long 55 call, offset by the $1 debit = $3 profit
Market moves to $60: $5 is gained on the long 55 call, offset by the $1 debit = $4 profit. This is the maximum potential gain.
Market moves to $61: $5 is gained on the exercise of the long 55 call and one of the short 60 calls, offset by a $1 loss on the other short 60 call and the $1 debit = $3 profit
Market moves to $62: $5 is gained on the exercise of the long 55 call and one of the short 60 calls, offset by a $2 loss on the other short 60 call and the $1 debit = $2 profit
Market moves to $63: $5 is gained on the exercise of the long 55 call and one of the short 60 calls, offset by a $3 loss on the other short 60 call and the $1 debit = $1 profit
Market moves to $64: $5 is gained on the exercise of the long 55 call and one of the short 60 calls, offset by a $4 loss on the other short 60 call and the $1 debit = $0 profit. This is the upside breakeven.
Market moves to $65 or higher: All positions are exercised. $5 is gained on the exercise of the long 55 call and one of the short 60 calls, offset by a $5 loss on the exercise other short 60 call and the long 65 call. The loss is the debit of $1.
18
Q
In which of the following choices are both the stock and options positions on different sides of the market?
ILong Call / Short Stock
IIShort Call / Long Stock
IIILong Put / Short Stock
IVShort Put / Long Stock
A. I and II
B. II and III
C. II and IV
D. I and III
A
The best answer is A.
Long Calls are profitable in bull markets; short stock positions are profitable in a bear market. Short Calls are profitable in a stable or falling market; long stock positions are profitable in a rising market. Long Puts and short stock positions are profitable as the market drops. Short Puts and long stock positions are profitable as the market rises.
19
Q
Which option strategy has the greatest gain potential?
A. long call
B. long call spread
C. long put
D. long put spread
A
The best answer is A.
A long call has unlimited gain potential in a rising market. A long call spread has limited upside gain potential but costs less than a simple long call position. Long puts and long put spreads are profitable in a falling market. Since there is a limit to how far the market can fall, the gain potential is limited.
20
Q
Which option strategy has the greatest gain potential?
A. long straddle
B. short straddle
C. long put
D. long put spread
A
The best answer is A.
A long straddle consists of a long call and a long put. In a rising market, the long call has unlimited gain potential.
A short straddle consists of a short call and a short put. In a rising market, the short naked call has unlimited loss potential. In a falling market, the short naked put has ever increasing loss potential to “0.” The maximum gain on a short straddle is the collected premium if the market does not move.
A long put is profitable as the market drops - but the market can only fall to “0.”
A long put spread gives a limited profit in a falling market (the gain is limited to the difference in the strike prices, net of the premium debit paid).
21
Q
Which option strategy has the greatest loss potential?
A. short call
B. short call spread
C. short put
D. short put spread
A
The best answer is A.
A short call has unlimited loss potential in a rising market. As the market goes up, the customer must purchase the stock in the market for delivery. A short call spread has limited upside loss. Short puts and short put spreads are profitable in a rising market as the contracts will expire “out the money” with the gain being the premium collected.
22
Q
Which of the following options positions has the greatest risk?
A. long straddle
B. short straddle
C. long spread
D. short spread
A
The best answer is B.
A long straddle is the purchase of a call and put on the same stock with the same strike price and expiration. The maximum loss is the premiums paid. A short straddle is the sale of a call and put on the same stock with the same strike price and expiration. The maximum loss is unlimited on the short call if the market rises; if the market drops, the customer loses all the way to zero on the short put. Spreads are risk limiting and gain limiting positions. The maximum loss on a long (debit) spread is the debit. The maximum loss on a short (credit) spread is the difference in the strike prices net of the credit received.
23
Q
Which of the following positions has unlimited upside gain potential?
ILong Call
IIShort Naked Call
IIIShort Straddle
IVLong Stock / Short Call
A. I only
B. I and III
C. II and III
D. I, II, III, IV
A
The best answer is A.
Purchasing a call entitles the holder to purchase the stock at a fixed price, whatever the prevailing market price. Thus, the gain potential is unlimited.
In a rising market, the seller of a naked call has unlimited loss potential, since he is obligated to deliver stock at a fixed price (and he does not own the stock).
A short straddle consists of the sale of a naked call and a naked put, in return for double collected premiums. If the market should rise, the short naked call will be exercised and has unlimited loss potential, since the writer is obligated to deliver stock at a fixed price (and he does not own the stock).
Long stock / short call is a covered call writer. In a rising market, the call is exercised, and the customer must deliver the stock at the fixed price. Thus, there is no gain potential above this fixed price.
24
Q
Which positions are profitable in a rising market?
IDebit put spread
IICredit put spread
IIILong straddle
IVShort stock
A. II only
B. II, III
C. II, III, IV
D. I, II, III, IV
A
The best answer is B.
Credit put spreads (being a net seller), like simply selling a put, are profitable if the market rises. the puts expire “out the money” and the premium credit received is the profit. Long straddles are profitable if the market falls or rises. Short stock positions are profitable when the market falls.
25
Q
Which positions are profitable in falling markets?
IDebit put spread
IICredit put spread
IIILong straddle
IVShort stock
A. I and IV
B. II and III
C. I, III, IV
D. I, II, III, IV
A
The best answer is C.
Debit put spreads (being a net buyer), like simply buying a put, are profitable if the market falls. Credit put spreads (being a net seller), like simply selling a put, are profitable if the market rises. Long straddles are profitable if the market falls or rises. Short stock positions are profitable when the market falls.
26
Q
Which positions are profitable in falling markets?
ILong put spread
IIShort put spread
IIIShort straddle
IVShort stock
A. I only
B. I, IV
C. II, III, IV
D. I, II, III, IV
A
The best answer is B.
Long put spreads, like simply buying a put, are profitable if the market falls. Short put spreads, like simply selling a put, are profitable if the market rises. Short straddles are profitable if the market stays flat. Short stock positions are profitable when the market falls.
27
Q
If a bear market is expected, all of the following strategies are appropriate EXCEPT:
A. covered call writing
B. long put spreading
C. long put buying
D. naked short call writing
A
The best answer is A.
In a falling market, any long put strategy is appropriate, since long puts increase in value as the market falls. The sale of naked calls also makes sense, since the calls will expire “out the money” if the market falls, and the writer will earn the premiums. The sale of covered calls does not make sense, since short calls are “covered” by a long stock position. If the market drops, the short call will expire with the writer earning the premiums, but the customer will still lose on the long stock position as the market falls.
28
Q
Which of the following option strategies are profitable in a falling market?
ILong Call
IILong Put
IIIShort Call
IVShort Put
A. I and II
B. I and IV
C. II and III
D. III and IV
A
The best answer is C.
Buying a call and selling a put are profitable strategies in a rising market. Buying a put and selling a call are profitable in a falling market.
29
Q
If the market price of ABC is at $60, which of the following customer positions will have a profit?
ILong 1 ABC Jan 50 Call
IILong 1 ABC Jan 50 Put
IIILong 1 ABC Jan 70 Call
IVLong 1 ABC Jan 70 Put
A. I and III
B. I and IV
C. II and III
D. II and IV
A
The best answer is B.
If the market is at $60, then the long $50 call is “in the money” by 10 points, for 10 point profit. the long 50 put is 10 points “out the money” and will expire worthless. The long 70 call is 10 points “out the money” and will expire worthless. The long 70 put is “in the money” by 10 points, for 10 point profit.
30
Q
If the market price is much higher than the strike price at the time of expiration, which of the following open options positions is likely to result in a gain?
ILong Put
IIShort Put
IIILong Straddle
IVShort Straddle
A. I and II
B. III and IV
C. I and III
D. II and III
A
The best answer is D.
If the market price is higher than the strike price, the long put contract would expire “out the money,” so the buyer will lose the premium paid for the position. Conversely, if a customer sells a put, and the market goes up, the contract will expire “out the money” and the customer earns the premium. A long straddle contains a long call and a long put. The call would be exercised at a profit if the market goes up. A short straddle contains a short call and a short put. If the market rises, the naked short call will be exercised, obligating the writer to deliver shares at a fixed (lower) price. The loss potential is unlimited as the market rises.
31
Q
If the market price and the strike price are the same at expiration, which of the following open options positions will result in a loss?
ILong Call
IIShort Call
IIILong Straddle
IVShort Straddle
A. I and II
B. III and IV
C. I and III
D. II and IV
A
The best answer is C.
“At the money” contracts will expire unexercised. Any holders lose the premium, while writers gain the premium.
32
Q
Which of the following positions is profitable if the market is at $50?
ILong 1 ABC Jan 50 Call @ $5
IILong 1 ABC Jan 50 Put @ $5
IIIShort 1 ABC Jan 50 Straddle @ $5
IVLong 100 shares of ABC @ $50 / Short 1 ABC Jan $50 Call @ $5
A. II only
B. I and II
C. III and IV
D. I, II, III, IV
A
The best answer is C.
If the market is at $50, the long 50 call expires “at the money” and the $5 premium is lost. The long 50 put also expires “at the money” and the $5 premium is lost. A short 50 straddle consists of a short 50 call and a short 50 put. Both expire “at the money” and the $5 collected premium is gained. If the stock is at $50, the long stock / short call position is profitable because the call expires “at the money” and the customer keeps the $5 premium. There is no loss on the stock position, so the net gain is $5.
33
Q
Which TWO of the following are fully hedged stock positions?
ILong stock / Long call
IILong stock / Long put
IIIShort stock / Long call
IVShort stock / Long put
A. I and III
B. I and IV
C. II and III
D. II and IV
A
The best answer is C.
To hedge a long stock position, buy a put (buy the right to sell the stock at a fixed price in a falling market). To hedge a short stock position, buy a call (buy the right to buy the stock at a fixed price in a rising market).
34
Q
A customer would receive protection on a long stock position from which TWO of the following?
IBuy a call
IISell a call
IIIBuy a put
IVSell a put
A. I and III
B. II and III
C. I and IV
D. II and IV
A
The best answer is B.
In order to hedge a long stock position against a downside market move, the best choice is to buy a put. The long put option allows the holder to put the stock at the exercise price if the market falls - protecting the stock position from downside market risk. However, buying a put is not given as a stand alone choice. If one were to sell a call against a long stock position, then if the stock’s market price falls, the call expires out the money. The premium received is a form of limited protection as the market drops. However, if the stock’s price falls greatly, then the premium received is not enough to compensate for the loss in the value of the stock. Buying a call would not give downside protection - if the market drops, the call expires out the money and the premium is lost, in addition to any loss on the stock position.
Writing a put does not give downside protection - in a falling market, the short put would be exercised, obligating the put writer to buy the stock at the strike price. The writer would lose on this stock position, in addition to losing on the original stock position, in a falling market.
35
Q
A customer would receive protection on a short stock position from which TWO of the following?
IBuy a call
IISell a call
IIIBuy a put
IVSell a put
A. I and III
B. II and III
C. I and IV
D. II and IV
A
The best answer is C.
In order to hedge a short stock position against an upside market move, the best choice is to buy a call. The long call option allows the holder to buy the stock at the exercise price if the market rises - protecting the short stock position from upside market risk. However, buying a call is not given as a stand alone choice. If one were to sell a put against a short stock position, then if the stock’s market price rises, the put expires out the money. The premium received is a form of limited protection as the market rises. However, if the stock’s price rises greatly, then the premium received is not enough to compensate for the loss on the short stock position. Buying a put would not give upside protection - if the market rises, the put expires out the money and the premium is lost, in addition to any loss on the stock position.
Writing a call does not give downside protection - in a rising market, the short call would be exercised, obligating the call writer to deliver the stock at the strike price. The writer would lose on this stock position, in addition to losing on the original stock position, in a rising market.
