chapter 4

Question 1

Covered call

Answer 1

Long stock, short the call
Draw it out to find max gain/loss/breakeven
Normally done in stable market
Limits upside
Can be used by pension (not risky)

Question 2

Protective Put

Answer 2

Long stock, buy put
Draw out
Max again unlimited
used to protect portfolio

Question 3

OCC

Answer 3

standardize, guarantee performance of ptions, exercise of options guaranteed, (market determines premium)
Excercise notice on random basis
option contract w/o certificate
OCC exercise rules limit the maximum number of contracts in the same underlying security that can be exercised within a 5 business day period. Three customers, all related, and all giving instructions to exercise their long calls in the same underlying security within 3 business days should, at a minimum, raise the question of whether or not they are acting in concert in order to circumvent the OCC exercise limit rules.
The client must have a current OCC disclosure document. This is verified by the client’s signature on the options agreement form which must be signed and returned within 15 days of account approval. The client must agree to notify the firm of any changes in financial status as soon as possible and the options agreement amended if necessary. OCC approval for an options account is not required nor do they verify any information given by the client.

Question 4

Price/Vertical Spread

Answer 4

Same expiration date, different strike price

Most common spread (heavily tested)

Question 5

Time/Calendar/horizontal spread

Answer 5

Different expiration dates but the same strike price, expect limited volatility

Question 6

Debit call spread

Answer 6

Used by investors to reduce cost of long options
Bullish
Long lower SP option
Pay net premium
To find breakeven: Add the net premium to the lower SP
Buy call/ sell call
Debit spread profitable when widen and exercise

Question 7

Long straddle

Answer 7

expect substantial volatility
Purchase a long put and call with the same strike price and same expiration date on the same stock
Two breakevens; adjust by net premium on both sides
Draw out

Question 8

Foreign currency options

Answer 8

Cash settled in USD, no physical delivery
1 point - $100
Options expire third Friday of expiration month
Settle on next biz day
USD not available

Question 9

Put-Call Ratio

Answer 9

Higher the ratio, more bearish investors have been up to that point in time
Can be contrarian indicator

Question 10

Married put

Answer 10

Customer buys stock and buys put option on that stock

Cost basis of stock must be adjusted upward by the premium

Question 11

Timing OCC Disclosure book

Answer 11

at the time of or before account approval

Question 12

How to tell if spread (call or put) is bullish

Answer 12

If buying the lower strike price, BULLISH

Question 13

Diagonal spread

Answer 13

two options of the same type with different expiration dates and strike prices

Question 14

Tax consequences call buyers, option expires worhtless

Answer 14

Buyer reports capital loss equal to premium, seller CG equal to premium

Question 15

LEAPS writers at expiration

Answer 15

Must report short term capital gains at expiration

Question 16

solving for # options to hedge, taking into account beta

Answer 16

Portfolio value/ market value of index

Multiply the result by beta

Question 17

Solving breakevens for Call spreads and put spreads

Answer 17

CAL: Call spreads, add net premium to lower SP
PSH: Put spreads, subtract net premium from higher SP

Question 18

Yield based options settle

Answer 18

Yield based options settle in cash if the option is exercised. The writer must deliver the in-the-money amount in cash.

Question 19

Buy LEAP

Answer 19

A LEAPS contract has an expiration of more than one year. Upon expiration, the buyer incurs a long-term capital loss equal to the amount of the premium paid.

Question 20

Index option settlement

Answer 20

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 next business day.

In contrast equity options settle regular way (T+2)
Reference: 4.5.1 in the License Exam Manual

Question 21

Adjusted options for stock dividends

Answer 21

When adjusting options contracts for stock dividends and fractional splits, the number of contracts held will not change. The number of shares covered by each contract is increased (100 shares × 120%) so that in this example each adjusted contract now represents 120 shares. The effective exercise price is adjusted so that the position value remains the same before and after the adjustment. Therefore the new strike price will be 50 ($6,000 / 120 shares = $50).

Question 22

Currency Quotes

Answer 22

Currency options are quoted in U.S. cents per dollar and one point equals $100. A quote of 11.00 is equal to $1,100 per contract.

Question 23

Yield based debt options

Answer 23

Yield-based debt options are European style contracts meaning that they can only be exercised on the last day of trading. All yield-based contracts when exercised are settled in cash. There is no delivery of debt instruments when these contracts are exercised. All strike prices reflect yield (35 strike price represents 3.5% yield).

Question 24

Ratio writing

Answer 24

ratio writing where a customer writes more calls than he has stock to cover. Because only one of the calls is covered, the other is uncovered and loss potential is unlimited.
The client is writing more calls than he has stock to cover. The first call is covered by the 100 shares of stock owned, but the second call is uncovered, or naked. A short naked call has unlimited loss exposure.

Question 25

options impacting holding perios

Answer 25

Buying a put (in or out-of-the-money) on a stock held short term (one year or less) stops the holding period until the put is disposed of.

Question 26

Solve # option contract

Answer 26

To determine the number of option contracts necessary to hedge, divide the portfolio value ($1.7 million) by the market value of the index (68,000). Multiply the result (25) by the beta of 1.20. The result is 30 contracts.

Question 27

Short straddle

Answer 27

Use if believe little volatility
Sell calls or puts
Unlimited loss potential

Question 28

Buy Call and exercise(Solve for cost basis)

Answer 28

Strike price+ premium = cost basis

Question 29

Options, settlement, expiration

Answer 29

9 month expiration and expire on third Friday of the expiration month of 11:59PM ET
Expire third Friday of the month at 11:59PM ET
T+1
At least 0.01 exericse ITM unless other instruction

Question 30

Option disclosure document

Answer 30

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

Question 31

Stop holding period

Answer 31

Buy a put

Question 32

Covered put

Answer 32

Short stock, short put
Unlimited loss possible
Max gain is premium

Question 33

Premium equation

Answer 33

Premium = IV + TV

Question 34

Holding period

Answer 34

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

Question 35

Combination

Answer 35

Call and put with different strike price, expiration dates or both. Cheaper to establish than straddles

Question 36

ODD

Answer 36

all investors must receive an ODD (Options risk Disclosure Document) prior to the first transaction. The ODD is not an advertisement; it contains the pitfalls of investing in options. After the customer receives the ODD, the ROP (Registered Options Principal) has to approve the account. Next, you can do the trade, and after that, the customer has to sign and return an OAA (Options Account Agreement).

Rice, Steven M.. Series 7 Exam For Dummies (For Dummies (Business & Personal Finance)) (p. 332). Wiley. Kindle Edition.

Question 37

Option tax

Answer 37

Options are always taxed as capital gains or capital losses. This investor purchased an option that expired worthless, and, therefore, he lost money. Because the investor held the LEAP for over one year, it’s taxed as a long-term capital loss.

Rice, Steven M.. Series 7 Exam For Dummies (For Dummies (Business & Personal Finance)) (p. 336). Wiley. Kindle Edition.

Question 38

Corporate actions affect options

Answer 38

Cash dividends don’t affect listed options because they don’t change the amount of shares a company has outstanding. However, if a company splits its stock or gives a stock dividend, the terms of an option contract change (in other words, the more option contracts, the lower the strike price and/or the more shares per contract).

Rice, Steven M.. Series 7 Exam For Dummies (For Dummies (Business & Personal Finance)) (p. 365). Wiley. Kindle Edition.

Question 39

Option expiration

Answer 39

Listed options expire at 11:59 p.m. EST (10:59 p.m. CST) on the Saturday following the third Friday of the expiration month. The last time to trade an option is 4:00 p.m. EST (3:00 p.m. CST) on the third Friday of the expiration month. The last time to exercise an option is 5:30 p.m. EST (4:30 p.m. CST) on the third Friday of the expiration month.

Rice, Steven M.. Series 7 Exam For Dummies (For Dummies (Business & Personal Finance)) (p. 377). Wiley. Kindle Edition.

Question 40

Position limits

Answer 40

Apply to the same side of the market (Bull or bear side)

Question 41

Receive dividend if option exercised

Answer 41

Holder call, writer put

Question 42

Option timing

Answer 42

The last time a customer can trade (close) an option is 4:00 p.m. EST (or thereabout) on the third Friday of the expiration month. The last time a customer can exercise an option is 5:30 p.m. EST on the third Friday of the expiration month; options expire at 11:59 p.m. EST on the third Friday of the expiration month.