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

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 2

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 3

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 3

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 4

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 4

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 5

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 5

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 6

A customer buys 100 shares of ABC stock which is trading at $55. Subsequently, the market moves to $60. The customer thinks the market will remain at $60 in the following months, so he sells 1 ABC Sept 60 Call @ $3. ABC then goes to $58 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. $300 loss
B. $300 gain
C. $600 loss
D. $600 gain

Answer 6

The best answer is D.

The customer bought the stock at $55 and sells it at $58 for a $3 gain. However, he also sold the call at $3. The aggregate gain on both transactions is +$3 + $3 = $600 gain.

Question 7

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 7

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 8

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 8

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 9

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 9

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 B/E = Stock Cost - Premium

Question 10

A customer buys 200 shares of GE at $72 and sells 2 GE Feb 70 Calls @ $6. The breakeven point is:

A. $58
B. $60
C. $64
D. $66

Answer 10

The best answer is D.

The customer paid $72 per share for the stock and collected $6 per share in premiums for selling the call, resulting in a net cost of $66 per share. To breakeven, the stock must be sold for that amount. Note that breakeven is always computed on a per share basis - the fact that there are 2 contracts has no effect on the computation.

To summarize, the formula for breakeven for a long stock / short call position is:

Long Stock/Short Call B/E = Stock Cost - Premium

Question 11

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 breakeven point is:

A. $47
B. $48
C. $51
D. $52

Answer 11

The best answer is A.

The customer sold the call for a $2 premium per share and bought the stock for $49 per share, for a net outlay of $47 per share. If the stock is liquidated for this price, 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 $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 12

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 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 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 14

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 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 loss is:

A. $200
B. $3,700
C. $4,000
D. unlimited

Answer 15

The best answer is B.

If the stock drops, the call expires “out the money.” As the stock keeps dropping, the customer loses more and more on the stock position. Because the customer effectively paid $3,700 ($39 price - $2 premium collected) for the stock, this is the maximum potential loss.

Question 16

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 16

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 17

An options strategy where the maximum potential loss is equal to the difference between the value of the underlying long securities position and premiums received is a:

A. naked call writer
B. covered call writer
C. naked put writer
D. covered put writer

Answer 17

The best answer is B.

A covered call writer sells a call contract against the underlying stock that is owned by that customer. If the market drops, the call expires unexercised and the customer keeps the premium. However, as the market drops, the customer loses on the long stock position. Thus, the maximum potential loss is the full value of the stock position, net of collected premiums.

Question 18

A customer sells short 100 shares of ABC at $50 and sells 1 ABC Jan 50 Put @ $5. This strategy is:

A. bullish
B. bearish
C. bullish/neutral
D. bearish/neutral

Answer 18

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 or she sold the stock at $50, there is no further effect on the customer. The customer does earn the $500 of premiums from the sale of the put.

The, this strategy is profitable when the market is flat or falling - a bearish/neutral strategy.

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. The customer’s loss potential is unlimited on this short stock position.

Question 19

Which of the following option positions is used to generate additional income against a short stock position?

A. long call
B. short call
C. long put
D. short put

Answer 19

The best answer is D.

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 customer thinks that the market will remain flat, he or she can sell a covered put against his stock position to earn extra income during that time period.

If the stock is sold short and a put is sold with the same strike price, then if the market stays the same, the put expires “at the money” and the premium collected is retained.

If the stock falls, the short put is exercised, obligating the customer to buy the stock at the same price at which it was sold. In this case, only the premium is earned. If the put had not been sold, then the customer would have had an increasing gain on the short stock position as the market fell - so he or she does not make as much in a falling market.

On the other hand, if the market rises, the short put expires “out the money” and the customer is exposed to unlimited upside risk on the short stock position that remains.

Question 20

Selling a put against a stock position sold short is a suitable strategy when the market is expected to:

A. remain stable
B. rise sharply
C. fall sharply
D. fluctuate sharply

Answer 20

The best answer is A.

Selling stock short alone is a bearish position. Selling a put alone is neutral or bullish strategy. Selling a put against a short stock position is a neutral strategy (as is any income strategy).

If the stock is sold short and a put is sold with the same strike price, then if the market stays the same, the put expires “at the money” and the premium collected is retained.

If the stock falls, the short put is exercised, obligating the customer to buy the stock at the same price at which it was sold. In this case, only the premium is earned. If the put had not been sold, then the customer would have had an increasing gain on the short stock position as the market fell - so he or she does not make as much in a falling market.

On the other hand, if the market rises, the short put expires “out the money” and the customer is exposed to unlimited upside risk on the short stock position that remains.

Question 21

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 21

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 22

A customer sells short 100 shares of PDQ stock at $59 and sells 1 PDQ 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. $300 loss
C. $600 gain
D. $900 loss

Answer 22

The best answer is B.

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 $59. There is a 9 point or $900 loss, that is partially offset by the $600 in premiums received. Thus, there is a net loss of $300.

Question 23

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 23

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 24

A customer sells short 100 shares of DEF stock at $82 per share. The stock falls to $71, at which point the customer writes 1 DEF 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 B.

The customer sold the stock short at $82 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 premiums 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: $82 sale proceeds - $66 cost basis = 16 points.

Question 25

An investor sells short 200 shares of ABC stock at $60 and sells 2 ABC Jan 60 Puts @ $4 on the same day in a margin account. The breakeven point is:

A. $52
B. $56
C. $64
D. $68

Answer 25

The best answer is C.

Since the customer received $4 per share in premiums, he or she can afford to lose $4 on the short stock position and still break even. The stock was sold short at $60. If the market rises to $64, the customer can buy back the stock and break even.

Note that breakeven point is always computed on a per share basis; the fact that there are 2 contracts does not affect the computation.

To summarize, the formula for breakeven for a short stock / short put position is:

Short Stock/Short Put B/E = Short Sale Price + Premium

Question 26

A customer sells short 100 shares of PDQ at $49 and sells 1 PDQ Sep 50 Put @ $6. The breakeven point is:

A. $43
B. $44
C. $55
D. $56

Answer 26

The best answer is C.

The customer sold the stock at $49 and received $6 in premiums for selling the put, collecting $55 in total. To breakeven, the stock must be bought at this price.

To summarize, the formula for breakeven for a short stock / short put position is:

Short Stock/Short Put B/E = Short Sale Price + Premium

Question 27

A customer sells short 100 shares of PDQ at $47 and sells 1 PDQ Sep 50 Put @ $6. The maximum potential gain while both positions are in place is:

A. 0
B. $300
C. $600
D. unlimited

Answer 27

The best answer is B.

If the market falls, the short put is exercised and the stock must be bought at $50. Since it was already “sold” at $47, there is a loss of $3 per share ($300 total). But the customer collected $600 in premiums; so the end result is a net gain or $300. 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 28

A customer sells short 100 shares of DEF stock at $62 and sells 1 DEF Oct 60 Put @ $6. The maximum potential gain while both positions are in place is:

A. $800
B. $4,400
C. $5,400
D. unlimited

Answer 28

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 $62, the customer gains 2 points, in addition to collecting 6 points of premiums. Thus, the maximum gain is $800. Conversely, if the market rises, the short put expires, leaving a short stock position that has potentially unlimited loss.

Question 29

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

A. $600
B. $5,600
C. $6,000
D. unlimited

Answer 29

The best answer is D.

If the market rises, the short put expires and the short stock position must be covered by making a purchase in the market. The loss potential is unlimited.

Question 30

An options strategy where the maximum potential loss is equal to the difference between the increase in value of the underlying short securities position and the premiums received is a:

A. naked call writer
B. covered call writer
C. naked put writer
D. covered put writer

Answer 30

The best answer is D.

A covered put writer sells a put contract against the underlying short physical security position. If the market rises, the put expires unexercised and the writer keeps the premium. However, as the market rises, the customer loses on the short security position. Thus, the maximum potential loss is the rise in value of the short security position, net of collected premiums

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 B/E = Short Sale Price + Premium

Question 32

A customer sells short 100 ABC @ $35 and sells 1 ABC Jan 35 Put @ $3. The customer would NOT make money if the market price for ABC was at:

A. $30
B. $35
C. $37
D. $40

Answer 32

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 $35 and collected $3 in premiums, for a total of $38. To break even, the stock must be bought for this amount. If the stock is bought for more than $38, the customer loses. Therefore, a loss is experienced at $40.

To summarize, the formula for breakeven for a short stock / short put position is:

Short Stock/Short Put B/E = Short Sale Price + Premium