Income Strategies

Question 1

Covered call writing is an appropriate strategy in a:

A. declining market
B. rising market
C. stable market
D. fluctuating market

Answer 1

The best answer is C.

A covered call writer owns the underlying stock position. The customer sells the call contract to generate extra income from the stock during periods when the market is expected to be stable. If the customer expects the market to rise, he or she would not write the call against the stock position because the stock will be “called away” in a rising market. If the customer expects the market to fall, he or she would sell the stock or buy a put as a hedge.

Question 2

On the same day in a cash account, a customer buys 100 shares of PDQ stock at $49 and sells 1 PDQ Jan 50 Call @ $2. The stock rises to $60 and the call is exercised. The customer has a(n):

A. $200 profit
B. $300 profit
C. $1,100 loss
D. $1,300 loss

Answer 2

The best answer is B.

The writer receives $2 per share for selling the call. If the short call is exercised, the stock which was purchased at $49 must be delivered for the $50 strike price, for a $1 gain per share. The total gain is $3 per share or $300. If the stock continues to rise, $300 remains the maximum potential gain because the call will be exercised, forcing delivery of the stock at $50 per share.

Question 3

A customer buys 200 shares of ABC at $68 and sells 2 ABC 70 Calls @ $3. The market rises to $80 and the calls are exercised. The customer has a:

A. $300 gain
B. $600 gain
C. $1,000 gain
D. $2,000 gain

Answer 3

The best answer is C.

If the calls are exercised, the stock (which cost $68 per share) must be sold at the $70 strike price for a $2 gain x 200 shares = $400. The customer also received $300 per contract for selling the calls, for a total of $600 in premiums received. Therefore, the total gain is $400 + $600 = $1,000.

Question 4

A customer buys 100 shares of ABC stock at $49 and sells 1 ABC Jan 50 Call @ $4. The market rises to $55 and the call is exercised. The customer has a:

A. $100 profit
B. $400 profit
C. $500 profit
D. $900 profit

Answer 4

The best answer is C.

If the market rises to $55, the short call is “in the money” and is exercised. The stock which was bought for $49 must be delivered for $50 per share (short call strike price) for a $100 profit. The writer also earns the $4 ($400) premium collected. The total gain is $500.

Question 5

A customer buys 100 shares of ABC stock at $51 and sells 1 ABC Jan 50 Call @ $4. The market rises to $55 and the call is exercised. The customer has a:

A. $300 profit
B. $400 profit
C. $500 profit
D. $900 profit

Answer 5

The best answer is A.

If the market rises to $55, the short call is exercised. The stock which was bought for $51 must be delivered for $50 per share (short call strike price) for a $100 loss. However, the writer earns the $4 ($400) premium collected. Thus, the net gain is $300.

Question 6

A customer buys 200 shares of GE at $72 and sells 2 GE 70 Calls @ $6. The market rises to $80 and the calls are exercised. The customer has a(n):

A. $400 gain
B. $800 gain
C. $1,200 gain
D. $2,800 gain

Answer 6

The best answer is B.

If the calls are exercised, the stock (which cost $72 per share) must be sold at the $70 strike price for a $200 loss per contract. Since $600 was collected in premiums per contract, the net gain per contract is $400. The gain for 2 contracts = $800.

Question 7

A customer buys 100 shares of ABC stock at $44 and sells 1 ABC Jan 45 Call at $5. Subsequently, the market price of ABC goes to $59 and the call contract is exercised. The customer has a:

A. $500 loss
B. $600 loss
C. $500 gain
D. $600 gain

Answer 7

The best answer is D.

The customer has created an income strategy. In this case the customer buys the stock and thinks that the market price of ABC will remain at or about the price for which he bought the stock. Thus, he sells a call against his long stock position. However, if the market goes up, he will not enjoy the market rise because the call goes “in the money” and is exercised. He will still make money - just not as much. He originally bought the stock at $44 and must deliver the stock at the strike price of the call - or $45, for a $1 point gain. He also gets $5 in premiums for selling the call. The total gain is $600.

Question 8

A customer purchases 100 shares of MNO stock at $63.38 and sells 1 MNO Feb 65 Call @ $3.50 on the same day in a cash account. Subsequently the stock rises to $74.13 and the call is exercised. The customer has a(n):

A. $488 gain
B. $512 gain
C. $350 loss
D. unlimited loss

Answer 8

The best answer is B.

The writer receives $3.50 per share for selling the call. If the short call is exercised, the stock which was purchased at $63.38 must be delivered for the $65 strike price, for a $1.62 gain per share. The total gain is: $3.50 + $1.62 = $5.12 = $512 on 100 shares.

Question 9

A customer buys 100 shares of ABC stock which is now trading at $63. A month later the market goes to $65. The customer thinks the market will remain near $65 in the following months, so he decides to sell 1 ABC Sept 65 Call @ $3. ABC then goes to $60 and the customer’s call contract expires and the customer decides to liquidate his stock position at the current market price. The customer has:

A. no gain or loss
B. a $300 gain
C. a $300 loss
D. a $500 loss

Answer 9

The best answer is A.

The customer bought the stock at $63 and sells it at $60 for a $3 loss. However, he also sold the call at $3, collecting this amount in premiums. Thus, there is no net gain or loss on the transactions.

Question 10

A customer buys 100 shares of ABC stock which is trading at $65. The customer thinks the market will remain at $65 in the following months, so he decides to sell 1 ABC Sept 65 Call @ $3. ABC then goes to $60 and the customer’s call contract expires and the customer decides to liquidate his stock position at the current market price. The customer has a:

A. $200 loss
B. $300 gain
C. $500 loss
D. $500 gain

Answer 10

The best answer is A.

The customer bought the stock at $65 and sells it at $60 for a $5 loss. However, the customer collected $3 in premiums for selling the call. The net loss is $2 or $200 on 100 shares.

Question 11

A customer buys 100 shares of ABC stock at $39 and sells 1 ABC Jan 45 Call @ $2 on the same day in a cash account. The breakeven point is:

A. $37
B. $38
C. $40
D. $42

Answer 11

The best answer is A.

The customer’s effective cost for the stock is $37 per share ($39 stock cost - $2 premium collected). If the stock is sold for this amount, the customer breaks even. To summarize, the formula for breakeven for a long stock / short call position is:

Long Stock/Short Call Breakeven = Stock Cost - Premium

Question 12

A customer buys 100 shares of ABC stock at $49 and sells 1 ABC Jan 50 Call @ $4. The breakeven point is:

A. $45
B. $46
C. $53
D. $54

Answer 12

The best answer is A.

The customer paid $49 for the stock and received a $4 premium from the sale of the call, for a net cost of $45. To breakeven, the stock must be sold for this amount. To summarize, the formula for breakeven for a long stock / short call position is:

Long Stock/Short Call Breakeven = Stock Cost - Premium

Question 13

A customer buys 200 shares of ABC at $68 and sells 2 ABC Jan 70 Calls @ $3. The maximum potential gain is:

A. $500
B. $1,000
C. $6,800
D. unlimited

Answer 13

The best answer is B.

If the market rises, the calls are exercised. The stock (which cost $68) must be delivered at $70 for a gain of $2 per share. Since $3 was collected in premiums for selling each call, the net gain, if exercised, is 5 points or $500 per contract x 2 contracts = $1,000.

Question 14

A customer buys 200 shares of GE at 72 and sells 2 GE Jun 70 Calls @ $6. The maximum potential gain is:

A. $800
B. $1,200
C. $7,000
D. unlimited

Answer 14

The best answer is A.

If the market rises, the calls are exercised. The stock (which cost $72) must be delivered at $70 for a loss of $2 per share. Since $6 was collected in premiums for selling the call, the net gain, if exercised, is 4 points or $400 per contract x 2 contracts = $800.

Question 15

A customer buys 100 shares of ABC stock at $39 and sells 1 ABC Jan 45 Call @ $2 on the same day in a cash account. The customer’s maximum potential gain until the option expires is:

A. $200
B. $300
C. $700
D. $800

Answer 15

The best answer is D.

If the market rises above $45 the short call will be exercised. The customer must deliver the stock that he bought at $39 for the $45 strike price, resulting in a $600 gain. Since $200 was collected in premiums as well, the total gain is $800. This is the maximum potential gain while both positions are in place.

Question 16

A customer buys 100 shares of ABC stock at $40 and sells 1 ABC Jan 45 Call @ $2 on the same day in a cash account. The customer’s maximum potential gain until the option expires is:

A. $200
B. $500
C. $700
D. unlimited

Answer 16

The best answer is C.

If the market rises above $45 the short call will be exercised. The customer must deliver the stock that he bought at $40 for the $45 strike price, resulting in a $500 gain. Since $200 was collected in premiums, the total gain is $700. This is the maximum potential gain while both positions are in place.

Question 17

What is the maximum potential loss for a customer who is long 100 ABC at $39 and short 1 ABC Jan 40 Call at $5?

A. $500
B. $600
C. $3,400
D. $3,900

Answer 17

The best answer is C.

This is a covered call writer. The maximum potential loss occurs when the market for ABC goes to zero. If it does, the customer loses $3,900 on the stock position, however, the customer received $5 in premiums for the now worthless call contract. The net maximum loss is $3,400. If the market rises, the call will be exercised and the customer will be obligated to sell stock at $40 that was purchased for $39. In addition to the $1 stock profit, the customer earns the premium of $5, for a total profit of $6 per share.

Question 18

A customer buys 100 shares of ABC stock at $62 and sells 1 ABC Jan 65 Call @ $3. Prior to expiration, the customer closes the short call position at $4. The customer retains the long stock position. The gain or loss on the option is:

A. $100 loss
B. $300 loss
C. $300 gain
D. $700 loss

Answer 18

The best answer is A.

The short call was opened at $3 and closed with a purchase at $4 for a net loss of 1 point or $100 for the contract.

Question 19

The sale of covered calls is used to:

A. hedge a long stock position in a falling market
B. protect a short stock position in a falling market
C. generate additional income in a stable market
D. profit if the market drops

Answer 19

The best answer is C.

Covered call writing is used to generate extra income from a long stock position in a stable market.

Question 20

A customer that owns stock and that is bullish on the market would sell covered calls on that stock above the market instead of buying calls on that stock for all of the following reasons EXCEPT to:

A. increase income from the stock position
B. maximize upside price appreciation
C. minimize the capital commitment
D. reduce loss potential on the stock position

Answer 20

The best answer is B.

If a customer sells a call against stock that he or she owns, a premium is collected. This reduces the cost of the stock position (hence reducing the potential loss on the stock position) and gives the call writer premium income. In return for this, the call writer gives up any “upside” gain potential on that stock (above the strike price of the call). Therefore, upside price appreciation is limited.

Question 21

A customer sells short 100 shares of ABC at $50 and sells 1 ABC Jan 50 Put @ $5. This position results in a profit when the market:

I rises
II falls
III is stable

A. I only
B. II only
C. I and III
D. II and III

Answer 21

The best answer is D.

If the market remains stable, the put expires “at the money” and the customer earns the $500 premium. The stock which was sold at $50 can be bought for $50, so there is no further effect on the customer. If the market falls, the short put is exercised and the customer must buy the stock at 50. Since he sold the stock at $50, there is no further effect on the customer. He does earn the $500 of premiums from the sale of the put. If the market rises, the short put expires “out the money.” The customer must cover the short sale at $50 by purchasing the stock in the market. His loss potential is unlimited on this short stock position.

Question 22

A customer sells short 100 shares of DEF stock at $63 and sells 1 DEF Oct 60 Put @ $6. The market rises to $68 and the put expires. The customer buys the stock in the market covering her short stock position. The gain or loss is:

A. $100 gain
B. $100 loss
C. $300 gain
D. $300 loss

Answer 22

The best answer is A.

If the market rises, the short put expires. Here, the customer buys the stock at $68 to cover her short stock position that was originally sold at $63. There is a 5 point or $500 loss, that is offset by the $600 in premiums received. Thus, there is a net gain of $100.

Question 23

A customer sells short 100 shares of ABC stock at $63 per share. The stock falls to $47, at which point the customer writes 1 ABC Sept 45 Put at $2. The stock falls to $36 and the put is exercised. The customer has a gain per share of:

A. 18 points
B. 20 points
C. 27 points
D. 29 points

Answer 23

The best answer is B.

The customer sold the stock short at $63 per share (sale proceeds). Later, the customer sold a Sept 45 Put @ $2 on this stock. If the short put is exercised, the customer is obligated to buy the stock at $45 per share. Since the customer received $2 in premiums when the put was sold, the net cost to the customer is $43 per share for the stock (this is the cost basis in the stock for tax purposes). The stock that has been purchased is delivered to cover the short sale, closing the transaction. The customer’s gain is $63 sale proceeds - $43 cost basis = 20 points.

Question 24

A customer sells short 100 shares of ABC stock at $80 per share. The stock falls to $70, at which point the customer writes 1 ABC Sept 70 Put at $4. The stock falls to $62 and the put is exercised. The customer has a gain per share of:

A. 14 points
B. 16 points
C. 18 points
D. 24 points

Answer 24

The best answer is A.

The customer sold the stock short at $80 per share (sale proceeds). Later, the customer sold a Sept 70 Put @ $4 on this stock. If the short put is exercised, the customer is obligated to buy the stock at $70 per share. Since the customer received $4 in premium when the put was sold, the net cost to the customer is $66 per share for the stock (this is the cost basis in the stock for tax purposes). The stock that has been purchased is delivered to cover the short sale, closing the transaction. The customer’s gain is: $80 sale proceeds - $66 cost basis = 14 points.

Question 25

A customer sells short 100 shares of ABC stock at $62 and sells 1 ABC Oct 60 Put @ $6. The breakeven point is:

A. $56
B. $60
C. $66
D. $68

Answer 25

The best answer is D.

The stock was “sold” at $62 and $6 was collected in premiums for selling the put, for a total of $68 collected per share. To breakeven, the stock must be purchased at this price. To summarize, the formula for breakeven for a short stock / short put position is:

Short Stock/Short Put Breakeven = Short Sale Price + Premium

Question 26

A customer sells short 100 shares of ABC stock at $60 and sells 1 ABC Oct 60 Put @ $6. The maximum potential gain while both positions are in place is:

A. $600
B. $4,400
C. $5,000
D. unlimited

Answer 26

The best answer is A.

If the market drops, the short put is exercised and the customer must buy the stock at $60. Since the stock was sold at $60, the customer has no gain or loss on the stock - but he or she does keep the $600 of collected premiums. This is the maximum potential gain. Conversely, if the market rises, the short put expires, leaving a short stock position that has potentially unlimited loss.

Question 27

What is the maximum potential loss for a customer who is short 100 shares of ABC stock at $33 and short 1 ABC Jan 35 Put at $6?

A. $600
B. $900
C. $2,700
D. unlimited

Answer 27

The best answer is D.

If the market rises, the put contract expires, but the customer is responsible for covering the short stock position. The potential loss on the remaining short stock position is unlimited, since the market can rise an unlimited amount.

Question 28

A customer with an existing margin account believes that the market is headed for a long period of decline and wishes to speculate on this with PDQ stock and options. Because of the prevailing bearish sentiment, put premiums have reached new heights and call premiums are at new lows. PDQ stock is currently trading at $40 per share. PDQ Jun 40 Calls are trading at $4 and PDQ Jun 40 Puts are trading at $12. If the customer wishes to speculate on a market decline with the smallest capital commitment, the customer should:

A. Buy 1 PDQ Jun 40 Put in a margin account
B. Buy 1 PDQ Jun 40 Call in a margin account
C. Buy 100 shares of PDQ at $40 in a margin account and sell 1 PDQ Jun 40 Call
D. Sell short 100 shares of PDQ at $40 in a margin account and sell 1 PDQ Jun 40 Put

Answer 28

The best answer is D.

This customer wants to speculate on a market decline with the smallest capital commitment. If the customer buys a PDQ Jun 40 Put (a bear strategy), the customer must pay a premium of $12 = $1,200. If the customer shorts the stock at $40, a $2,000 margin deposit is required. By selling 1 PDQ Jun 40 Put, the customer collects $1,200 in premiums. This is a “covered” put writer and the premium received can be used to offset the $2,000 margin requirement for a net deposit of $800. This is a smaller capital commitment than buying the put.

In a falling market, the short put goes “in the money” and is exercised, forcing the customer to buy the stock at $40. Since the customer already sold the stock at $40, there is no gain or loss on the stock position. However, the $1,200 received in premiums is retained and is the gain. On the other hand, if the market rises, the customer can lose an unlimited amount on the short stock position (the short put expires “out the money”). The customer would not buy a call, since this is a bullish strategy. The customer would not buy the stock and sell a call (a neutral strategy), since in a down market, the customer would lose the value of the stock (net of the collected premium).

Question 29

customer would NOT make money if the market price for ABC was at:

A. $42
B. $40
C. $37
D. $35

Answer 29

The best answer is A.

A customer with a short stock / short put position loses if the market rises. The customer sold the stock at $37 and collected $4 in premiums, for a total of $41. To break even, the stock must be bought for this amount. If the stock is bought for more than $41, the customer loses. Therefore, a loss is experienced at $42. To summarize, the formula for breakeven for a short stock / short put position is:

Short Stock/Short Put Breakeven = Short Sale Price + Premium

Question 30

A customer sells short 100 shares of PDQ at $47 and sells 1 PDQ Sep 50 Put @ $6. The customer will have a loss at which of the following market prices for PDQ?

A. $55
B. $53
C. $47
D. $41

Answer 30

The best answer is A.

A customer with a short stock / short put position loses if the market rises. The customer sold the stock at $47 and collected $6 in premiums, for a total of $53. To break even, the stock must be bought for this amount. If the stock is bought for more than $53, the customer loses. Therefore, a loss is experienced at $55. To summarize, the formula for breakeven for a short stock / short put position is:

Short Stock/Short Put Breakeven = Short Sale Price + Premium

Question 31

A customer sells short 100 shares of PDQ at $49 and sells 1 PDQ Sep 50 Put @ $6. The customer will have a loss at which of the following market prices for PDQ?

A. $42
B. $43
C. $55
D. $56

Answer 31

The best answer is D.

A customer with a short stock / short put position loses if the market rises. The customer sold the stock at $49 and collected $6 in premiums, for a total of $55. To break even, the stock must be bought for this amount. If the stock is bought for more than $55, the customer loses. Therefore, a loss is experienced at $56. To summarize, the formula for breakeven for a short stock / short put position is:

Short Stock/Short Put Breakeven = Short Sale Price + Premium

Question 32

A customer bought 100 shares of DEF stock at $23 per share. The stock has appreciated to $41 per share, and the customer would like to protect the gain at minimal cost. Which of the following options positions would “collar” the position at the lowest cost?

A. Buy 1 DEF Jan 40 Call and Sell 1 DEF Jan 45 Put
B. Buy 1 DEF Jan 40 Put and Sell 1 DEF Jan 45 Call
C. Sell 1 DEF Jan 40 Call and Buy 1 DEF Jan 45 Put
D. Sell 1 DEF Jan 40 Put and Buy 1 DEF Jan 45 Call

Answer 32

The best answer is B.

To protect the stock position from a downside move, a put must be purchased. To keep the cost of the put low, the put should be “out of the money.” Since the stock is currently worth $41, the purchase of a 40 put, which is 1 point “out of the money,” would be the cheapest. To further reduce the cost of protection, the customer would sell an “out of the money” call to collect a premium that could be used to offset the cost of the put premium. Since the stock is at $41, the sale of a 45 call would give the customer 4 points of additional upside gain if the market should rise. If the market rises above this, the call will be exercised, and the customer would deliver the stock at $45 per share. In exchange for giving up any further upside gain above $45 per share, the customer collects the premium income from the sale of the call (and this offsets the cost of buying the put). Thus, the customer has “collared” the stock position, either selling the stock at $40 by exercising the long put if the stock price should fall below $40; or by selling the stock at $45 if the market should rise above this, since the short call will be exercised.