Chapter 6 - Options

Question 1

An individual who writes an uncovered call option believes
A) That the underlying stock price will rise above the strike price.
B) General stock market values will be very volatile in the coming weeks.
C) That the underlying stock price will fall below the strike price.
D) That positive news will be forthcoming.

Answer 1

Correct Answer:
C) That the underlying stock price will fall below the strike price.

Answer Explanation
The writer of an uncovered call believes that the market price of the underlying stock will remain below the strike of the option, thereby resulting in the option expiring and allowing the writer to retain the option premium.

Textbook Reference
Please see textbook section 6.2.2.1

Question 2

Two options contracts would be in the same series when they have common
A) Premiums and intrinsic values
B) Strike prices and premiums
C) Expiration months and strike prices
D) Premiums and expiration months

Answer 2

Correct Answer:
C) Expiration months and strike prices

Answer Explanation
Two option contracts are in the same series because they have the same expiration month and strike price.

Textbook Reference
Please see textbook section 6.1.1

Question 3

An investor believes ABC stock will increase in value. What is the most profitable options position that this investor can utilize?
A) Long puts
B) Long calls
C) Short calls
D) Short puts

Answer 3

Correct Answer:
B) Long calls

Answer Explanation
A long call would be the most profitable option position an investor can hold if the value of a particular stock increases in value.

Textbook Reference
Please see textbook section 6.2.1

Question 4

An investor writes an S&P 500 2025 put for 10. Just prior to expiration the S&P is 1980. Which two of the following statements are TRUE?

I. The contract will be exercised
II. The contract will expire
III. The investor profits in this transaction
IV. The investor has a loss in this transaction
A) I and IV
B) II and III
C) I and III
D) II and IV

Answer 4

Correct Answer:
A) I and IV

Answer Explanation
The investor received $1,000 to write the index put. The put is exercised because the index value is below the exercise price. Index options settle in cash so the writer must pay $4,500 (2025 — 1980 x 100 multiplier) at exercise. The investor’s loss on this transaction is $3,500 (Paid $4,500, received $1,000).

Textbook Reference
Please see textbook section 6.3.2.1

Question 5

An investor that previously established a long position in puts makes an offsetting transaction in an identical put. This transaction is a(n)
A) Closing purchase
B) Opening sale
C) Closing sale
D) Opening purchase

Answer 5

Correct Answer:
C) Closing sale

Answer Explanation
An investor that previously established a position by buying an option will close the position by selling an identical option to reduce or cancel the position.

Textbook Reference`
Please see textbook section 6.7.1

Question 6

An investor is long an ABC Jan 65 put for a premium of 7. If at expiration the price of ABC is 53, which two of the following statements are TRUE?

I. The contract is profitable to the holder at expiration
II. The contract is in-the-money at expiration
III. The contract will not be exercised
IV. The contract’s breakeven is 72
A) II and IV
B) I and II
C) II and III
D) I and IV`

Answer 6

Correct Answer:
B) I and II

Answer Explanation
A put is in the money whenever the price of the underlying stock is lower than the strike price. This contract is in the money, and profitable to the holder at expiration because the breakeven is 58 (strike price minus premium for puts). The put holder will exercise the contract, and has the right to sell stock at 65. The writer (the party that is short) must buy it, when the current market price is actually 53.

Textbook Reference
Please see textbook section 6.3.1.1

Question 7

With the market price at $67.25 at expiration, a long XYZ 65 call will
A) Be automatically exercised according to OCC provisions
B) Be exercised only if the holder gives exercise instruction
C) expire
D) Be exercised only if the counterparty to the contract has met the initial margin requirement for purchase of the stock

Answer 7

Correct Answer:
A) Be automatically exercised according to OCC provisions

Answer Explanation
The Options Clearing Corporation has provisions for the automatic exercise of certain in-the-money options at expiration. This procedure is also referred to as “exercise by exception.” Generally, the OCC will automatically exercise any expiring equity call or put in a customer account that is $0.01 or more in-the-money, and an index option that is $.01 or more in-the-money. However, the customer’s broker-dealer may have a different threshold for automatic exercise which may or may not be the same as the OCC’s.

Textbook Reference
Please see textbook section 6.6.1

Question 8

An investor sells 5 March 45 ABC put option contracts for a premium of $2.50. After the position turns bad, the investor wishes to cut losses and close out the contracts prior to maturity. How can this be done?
A) Sell 5 March 45 ABC calls
B) Buy 5 March 45 ABC calls
C) Sell 5 March 45 ABC puts
D) Buy 5 March 45 ABC puts

Answer 8

Correct Answer:
D)

Answer Explanation
To close out a contract, an investor takes the opposite side (buy or sell) of the same put or call contract, in the same number of contracts. The opposite side of this trade (sell puts) is to buy puts.

Textbook Reference
Please see textbook section 6.7.2

Question 9

Which of the following is a strategy that is used by investors to secure profits from a stock position that an investor had previously purchased?
A) Short put
B) Uncovered call
C) Protective put
D) Long call

Answer 9

Correct Answer:
C) Protective put

Answer Explanation
A protective put is used to “insure” profits on a long stock position. It gives the buyer the right to sell stock at the exercise price to protect profits that have already been made.

Textbook Reference
Please see textbook section 6.3.4

Question 10

An investor writes 3 XYZ June 65.35 puts at 4.50. Just before expiration, XYZ is trading for 66. Which of the following statements is TRUE?
A) The investor is required to sell 100 shares of stock at 65.35
B) The investor has a profit of $450
C) The investor has a profit of $1,350
D) The investor receives 200 shares of stock at 73

Answer 10

Correct Answer:
C) The investor has a profit of $1,350

Answer Explanation
These puts are out of the money and will expire, so the writer is not obligated to purchase the stock. The buyer will not exercise the right to sell stock at the strike price of 65.35 when it could be sold on the market for 66. The writer profits from the premium of $1,350 received for writing 3 contracts at $450 each.

Textbook Reference
Please see textbook section 6.3.2.1

Question 11

An investor purchases 2 ABC Mar 76 calls for 2.50. Which two of the following statements are TRUE?

I. The breakeven is 73.50
II. The breakeven is 78.50
III. The contract will be profitable if it expires
IV. The investor wants the contract to be exercised
A) I and IV
B) II and IV
C) I and III
D) II and III

Answer 11

Correct Answer:
B) II and IV

Answer Explanation
The breakeven of a call is the strike price + the premium. The buyer of a call will profit if the stock price is above the breakeven. Exercise of the contract allows the holder to buy stock at the strike price when the market price is higher. A call buyer loses the premium paid if the contract expires.

Textbook Reference
Please see textbook section 6.2.1

Question 12

Which of the following equity type instruments will give an investor the longest amount of exposure to the future price movements of the underlying common stock?
A) Convertible bond
B) LEAP
C) Stock rights
D) Traditional equity option contract

Answer 12

Correct Answer:
B) LEAP

Answer Explanation
A LEAP is a long-term equity option contract. This longer maturity, as compared to a traditional short-term contract, can provide an investor with exposure to the price movement of the underlying common stock for a greater period of time.

Textbook Reference
Please see textbook section 6.1.1.1

Question 13

An investor buys an S&P 500 2025 put for 15. Just prior to expiration the S&P is 1980. Which two of the following statements are TRUE?

I. The investor will exercise the contract
II. The contract will expire
III. The investor profits in this transaction
IV. The investor has a loss in this transaction
A) I and IV
B) II and III
C) II and IV
D) I and III

Answer 13

Correct Answer:
D) I and III

Answer Explanation
The investor paid $1,500 to purchase the index put. The put is exercised because the index value is below the exercise price. Index options settle in cash, so the holder realizes $4,500 (2025 – 1980 x 100 multiplier) at exercise. The investor’s profit on this transaction is $3,000 (Paid $1,500, received $4,500).

Textbook Reference
Please see textbook section 6.3.1.1

Question 14

An investor writes 2 ABC Mar 76 calls for 2.50. Which two of the following statements are TRUE?

I. The breakeven is 73.50
II. The breakeven is 78.50
III. The contract will be profitable if it expires
IV. The investor wants the contract to be exercised
A) II and IV
B) I and IV
C) II and III
D) I and III

Answer 14

Correct Answer:
C) II and III

Answer Explanation
The breakeven of a call is the strike price + the premium. The writer of a call will profit if the stock price is below the breakeven and the contract expires. The writer will keep the premium received and is not obligated to sell the stock.

Textbook Reference
Please see textbook section 6.2.2

Question 15

A customer buys 100 shares of XYZ stock for 57 and writes a 60 call for 4. The stock price rises to 65 and the option is exercised. The profit or loss to the investor is
A) Profit of $700
B) Loss of $400
C) Profit of $300
D) Loss of $100

Answer 15

Correct Answer:
A) Profit of $700

Answer Explanation
The stock is purchased for $5,700 and sold for $6,000. In addition, the customer received a premium of $400 for writing the call. The investor has a profit of $700.

Textbook Reference
Please see textbook section 6.2.2.2

Question 16

To reduce loss in a previously established position a call writer will engage in which of the following transactions?
A) Opening sale
B) Opening purchase
C) Closing purchase
D) Closing sale

Answer 16

Correct Answer:
C) Closing purchase

Answer Explanation
An investor that previously established a position by selling an option (writing a call or put) will close the position by purchasing an identical option to reduce or cancel the position.

Textbook Reference
Please see textbook section 6.7.1

Question 17

An investor bought a June 65 call when the stock price was $63. It will be exercised only if
A) the underlying stock is below $65 before expiration date.
B) the underlying stock is above $65 before expiration date.
C) the underlying stock is above $63 before expiration date.
D) the underlying stock is below $63 before expiration date.

Answer 17

Correct Answer:
B) the underlying stock is above $65 before expiration date.

Answer Explanation
Call options contracts are exercised only when they are in-the-money – i.e., the market value of the stock is above the strike price before expiration date.

Textbook Reference
Please see textbook section 6.2

Question 18

An investor that is short 100 shares of XYZ stock could best protect the stock position with which of the following?
A) Sell a put
B) Buy a put
C) Buy a call
D) Sell a call

Answer 18

Correct Answer:
C) Buy a call

Answer Explanation
An investor that has established a short stock position could best protect the position by purchasing a call. The call holder has the right to buy in the short stock position at the pre-determined exercise price of the call.

Textbook Reference
Please see textbook section 6.2.4

Question 19

An investor has purchased an ABC 93 call for 9. If ABC stock is trading at 88.50 just prior to expiration,
A) The investor will exercise the right to sell 100 shares of ABC for 93
B) The investor will exercise the right to buy 100 shares of stock at 88.50
C) The contract will expire and the investor will lose the premium
D) The investor will be obligated to sell 100 shares of ABC for 88.50

Answer 19

Correct Answer:
C) The contract will expire and the investor will lose the premium

Answer Explanation
An investor that has purchased a call has the right to buy stock at the exercise price if the contract is exercised. This contract will not be exercised because it is out of the money (the market price of 88.50 is below the strike price of 93; calls are in the money when the market price is above the strike price).

Textbook Reference
Please see textbook section 6.2.1.1

Question 20

An investor writes a 6-month XYZ 45 put for 4.75. Excluding commissions, this investor
A) Receives $475 for the put
B) Pays $475 for the put
C) Pays $450 for the put
D) Receives $450 for the put

Answer 20

Correct Answer:
A) Receives $475 for the put

Answer Explanation
An investor that writes puts receives a premium. The premium for a standard option contract is a price per share, and 100 shares are included in the contract. $4.75 x 100, or $475 is what this investor receives.

Textbook Reference
Please see textbook section 6.1.1.2

Question 21

An investor writes a call to increase income to his portfolio. In establishing this position this investor has engaged in an
A) Opening sale
B) Opening purchase
C) Closing sale
D) Closing purchase

Answer 21

Correct Answer:
A) Opening sale

Answer Explanation
This investor enters the market by writing a call. Creating an opening sale to establish the position.

Textbook Reference
Please see textbook section 6.7.1

Question 22

A customer sells short 100 shares of XYZ stock for 72 and buys one XYZ 75 call for 1.50. The stock price rises to 77 and the option is exercised. The profit or loss to the investor is
A) Profit of $450
B) Profit of $650
C) Loss of $450
D) Loss of $650

Answer 22

Correct Answer:
C) Loss of $450

Answer Explanation
The stock is sold short for $7,200. To protect the position the investor buys a call for $150. The call is exercised when the market price of the stock rises, so the investor buys the stock to cover the short position for $7,500. The customer received $7,200 from the short sale, but paid a total of $7,650 (premium + stock purchase price) for a loss of $450.

Textbook Reference
Please see textbook section 6.2.4

Question 23

Today, Vladimir sold 15 Landmark Inc. May 65 puts for 2.15. On settlement date, Vladimir
A) will receive a total of $3,225
B) will receive $2.15 per share when he delivers his Landmark shares to his broker-dealer
C) must pay a total of $3,225
D) must pay $65 per share

Answer 23

Correct Answer:
A) will receive a total of $3,225

Answer Explanation
Since Vladimir sold 15 put options for 2.15 each, he will receive a total of $3,225 in his account when this trade settles.

Textbook Reference
Please see textbook section 6.1.1

Question 24

A holder of a call option contract would like to receive a cash dividend declared by the issuer of the underlying stock. In order to receive the dividend, what action must the holder take?
A) The holder must exercise the option before the record date
B) The holder will receive the dividend automatically, and no action is required
C) The holder must exercise the option before the ex-dividend date
D) The holder is not entitled to receive the dividend under any circumstances

Answer 24

Correct Answer:
C) The holder must exercise the option before the ex-dividend date

Answer Explanation
Cash dividends are paid by issuers to owners of the stock as of the date of record. To receive a cash dividend, a call holder must exercise the option prior to the ex-date of the dividend. For an American-style call option, early exercise is possible and the investor needs to weigh whether the benefit of being long the underlying stock and receiving the dividend outweighs the cost of surrendering the option early. Typically, this makes sense only for call options that are deeply in the money before the dividend is paid.

Textbook Reference
Please see textbook section 6.7.3.2

Question 25

Which two of the following options contracts are subject to automatic exercise at expiration if the market price of ABC is 45.25?

I. Long ABC 42 call
II. Long ABC 46 put
III. Long ABC 48 call
IV. Long ABC 44 put
A) I and IV
B) II and IV
C) I and II
D) II and III

Answer 25

Correct Answer:
C) I and II

Answer Explanation
The Options Clearing Corporation has provisions for the automatic exercise of certain in-the-money options at expiration. Generally, OCC will automatically exercise any expiring equity call or put in a customer account that is $0.01 or more in-the-money, and an index option that is $.01 or more in-the-money. Calls are in the money when the market price is higher than the exercise price; puts are in the money when the market price is lower than the exercise price.

Textbook Reference
Please see textbook section 6.6.1

Question 26

A portfolio manager wants to hedge his long equity positions and increase the portfolio’s income. Which of the following strategies is appropriate?
A) Long index call
B) Long index put
C) Short index call
D) Short index put

Answer 26

Correct Answer:
C) Short index call

Answer Explanation
Income is achieved from writing options and receiving premiums. Short index calls provide some downside protection (the amount of premium received), and also increase the income to the portfolio.

Textbook Reference
Please see textbook section 6.4