Hedging Strategies Flashcards
A customer owning 100 shares of stock could receive protection by:
A. buying another 100 shares of the stock
B. buying a call
C. buying a put
D. selling a put
The best answer is C.
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 (sell) the stock at the exercise price if the market falls - protecting the stock position from downside market risk.
Buying a put on a stock position held long is a suitable strategy when the market is expected to:
A. rise sharply
B. rise modestly
C. be stable
D. fall sharply
The best answer is D.
Buying a put allows the holder to sell a security at a fixed price. Thus, it protects the owner of the underlying stock position in a falling market.
A customer purchases 100 shares of MNO stock at $34.63 and buys 1 MNO Jan 30 Put @ $2.75 on the same day in a cash account. Subsequently, the stock goes to $43.50 and the customer’s put expires and the customer sells the stock in the market at the prevailing market price. The customer has a(n):
A. $275 loss
B. $346.30 loss
C. $612 gain
D. $887 gain
The best answer is C.
The customer buys the put for $2.75 and buys the stock at $34.63 per share. The customer purchases the Jan 30 Put as protection if the stock price falls below $30. If the stock does fall below $30 per share, then the customer would exercise the put, selling the stock at $30. This limits downside loss.
In this case, the stock price rises to $43.50 and the put expires “out the money.” The stock is sold at the prevailing market price. The stock that was purchased for $34.63, is sold for $43.50, for a profit of $8.87 per share. Since a premium of $2.75 was paid for the put, the net profit is $6.12 per share = $612 on the 100 shares owned.
A customer buys 100 shares of XYZ stock at $80 and buys 1 XYZ Oct 80 Put @ $3 on the same day in a cash account. The stock rises to $88. The put expires and the customer sells the stock in the market at the current price. The customer has a(n):
A. $300 loss
B. $300 gain
C. $500 gain
D. $800 gain
The best answer is C.
The customer buys the put for $3 and buys the stock at $80 for a total outlay of $83 per share. The put has been purchased as protection if the stock price should fall. In this case, the stock price rises to $88, so the customer lets the put expire “out the money” and sells the stock in the market at the current price. The net gain is $88 - $83 = $5 or $500 on 100 shares.
A customer buys 100 shares of ABC stock at $58 and buys 1 ABC Jul 55 Put @ $2.50 on the same day. If the stock falls to $50 and the put is exercised, the customer will have a:
A. $250 loss
B. $300 loss
C. $550 loss
D. $750 loss
The best answer is C.
If the stock price drops below $55, the customer will exercise the put and sell the stock (purchased at $58) at the $55 strike price. The customer will lose 3 points ($300) on the stock in addition to the $250 paid in premiums, for a total loss of $550.
A customer buys 100 shares of ABC stock at $40 and buys 1 ABC Oct 40 Put @ $4. ABC stock falls to $36 and just prior to expiration, the customer exercises the put, delivering the stock position. The customer:
A. breaks even
B. lost $400
C. gained $400
D. lost $3600
The best answer is B.
The customer bought the stock at $40 and sold at $40 by exercising the put. There is no gain or loss on the stock position. However, the customer did lose the $400 premium paid.
A customer buys 100 shares of ABC stock at $51 and buys 1 ABC Jan 50 Put @ $3. What is the breakeven point?
A. $47
B. $48
C. $53
D. $54
The best answer is D.
The customer bought the stock for $51 and paid a $3 premium for the put, for a total money outlay of $54 per share. If the stock rises to $54, the customer breaks even. If the stock continues to rise, the customer gains on the stock and the put expires worthless.
The put protects the customer if the stock should fall in price. If the stock price drops below $50, the customer can always exercise the put and sell the stock for $50, limiting the customer’s loss to 4 points ($400.)
A customer buys 100 shares of ABC stock at $40 and buys 1 ABC Oct 40 Put @ $4. The breakeven point is:
A. $36
B. $40
C. $44
D. $48
The best answer is C.
The customer paid $4 for the put and $40 for the stock, for a total of $44. To breakeven, she must sell the stock at $44.
To summarize, the formula for breakeven for a long stock / long put position is:
Long Stock/Long Put B/E= Stock cost + Premium
A customer buys 100 shares of XYZ at $51 and buys 1 XYZ Jan 50 Put @ $5. The breakeven point is:
A. $45
B. $46
C. $55
D. $56
The best answer is D.
The customer has paid $48 for the stock and $7 for the put, for a total outlay of $55. If the stock declines, the customer is hedged, since he or she has the right to sell for $50 with the long put; so only 5 points can be lost (bought at $55 total; sold at $50 upon exercise).
However, if the stock rises, the customer lets the put expire “out the money” and he or she can ride the price of the stock up, with theoretically unlimited gain potential.
A customer buys 100 shares of XYZ at $49 and buys 1 XYZ Jan 50 Put @ $5. The maximum potential gain is:
A. $500
B. $4,400
C. $5,500
D. unlimited
The best answer is D.
Since the customer has a long stock position, his potential gain is unlimited. If the market moves up, he or she lets the put expire “out the money” and sells the stock in the market at the higher price.
A customer buys 100 shares of ABC stock at $58 and buys 1 ABC Jul 55 Put @ $2.50 on the same day. The maximum potential loss is:
A. $250
B. $550
C. $5,550
D. unlimited
The best answer is B.
If the market should fall, the customer will exercise the put and sell the stock at the strike price, limiting potential loss. The put contract gives the customer the right to sell the stock at $55. Since the stock was purchased at $58, 3 points will be lost on the stock. In addition, 2.50 points were paid in premiums for a maximum potential loss of 5.50 points or $550.
A customer buys 100 shares of XYZ at $49 and buys 1 XYZ Jan 50 Put @ $5. The maximum potential loss is:
A. $400
B. $500
C. $4,400
D. unlimited
The best answer is A.
The long put gives the stock owner the right to sell at $50. Since he bought the stock at $49, exercising results in a 1 point stock profit. However, the premiums paid of $5 are lost, for a net loss of 4 points or $400 maximum.
A customer buys 100 shares of ABC at $65 and buys 1 ABC Jan 65 Put @ $3. At which market price is the position profitable?
A. $70
B. $68
C. $65
D. $62
The best answer is A.
To breakeven, the customer must recover the $3 paid in premiums and the $65 paid for the stock (total of $68). The customer must sell the stock in the market above $68 to have a profit. The only choice above $68 is Choice A, which is $70.
To summarize, the formula for breakeven for a long stock / long put position is:
Long Stock/Long Put B/E = Stock Cost + Premium
Which option position is used to hedge a short stock position?
A. long call
B. short call
C. long put
D. short put
The best answer is A.
When one has a short stock position, borrowed shares have been sold with the agreement that the customer will buy back the position at a later date. If the market rises, the loss potential is unlimited. The purchase of a call allows the stock to be bought in at a fixed price, limiting upside risk.
A customer who is short stock will buy a call to:
A. hedge the short stock position in a falling market
B. protect the short stock position from a falling market
C. protect the short stock position from a rising market
D. generate additional income in a stable market
The best answer is C.
A customer who has shorted stock is bearish on the market. However, the potential loss for a short seller of stock is unlimited if the market should rise, forcing the customer to replace the borrowed shares at a much higher price. To limit this risk, the purchase of a call allows the stock position to be bought at a fixed price (by exercising the call), if needed, in a rising market.
