Lesson 4.4: Benefits and Risks of Derivatives Flashcards
One of your clients purchases a European-style put option on a stock. The premium is $3 and the exercise price is $35. If the price of the underlying asset is $40 on the exercise date, the client has:
lost $300.
This option is out of the money and is therefore worthless. Remember, European-style options are exercisable only at expiration, and a $35 put is worth nothing unless the market price of the underlying asset is less than $35. As is the case with any long option position, the maximum loss is the premium paid.
All of the following positions expose a customer to unlimited risk except
A) short 200 shares of XYZ.
B) short 2 XYZ uncovered puts.
C) short 2 XYZ uncovered calls.
D) short 200 shares of XYZ and short 2 XYZ puts.
B) short 2 XYZ uncovered puts.
A put writer will lose money if the stock goes down, but the furthest it can drop is to zero. Therefore, the potential loss is not unlimited. All of the other positions expose the client to unlimited risk because a loss will occur if the stock price rises.
An investor buys five put contracts with a strike price of $55 per share. The current price of the underlying stock is $60 and the option premium is $7. The commission schedule is as follows:
Using the information provided, what is the total commission cost for this trade?
The cost per contract is $7 × 100 shares, or $700. That makes the total trade amount $700 × 5 contracts, or $3,500, which qualifies for the commission rate of $35 + 0.7% of the trade amount. The math is $35 + (0.7% of $3,500) = $35 + (0.7% × $3,500) = $35 + $24.50 = $59.50 total charge.
Derivatives can serve many purposes. However, investors should be aware that there are positions which can result in
unlimited loss.
Although all of these are true, the focus of the regulators is on clients being aware of the risks before they learn the benefits. There are some derivative positions, such as an uncovered call, where the potential for loss is unlimited.
One of your advisory clients indicates that he would like to sell forward contracts in soybeans. It would be wise to warn the client that he will be facing which of these risks?
I. Liquidity
II. Creditworthiness of the buyer
III. Lack of assurance that the delivery price will remain stable
IV. Location for the delivery may change
I & II
Because there is no standardization for forward contracts, they are considered to be illiquid. Because there is no entity backing up the contract (as the OCC does with listed options), a seller must always be concerned about the ability of the buyer to pay. Although the market price probably will change, the delivery price is always agreed upon at the time of the contract, as is the method, location, and time of delivery.
Which strategy would be considered most risky in a bull market?
Writing naked calls provides unlimited liability and the most risk. Buying a call would be an attractive strategy in a bull market with risk limited to calls paid. Writing naked puts risks only the difference between the strike price and zero, less any premium received. Buying a put is a bearish strategy with risk limited to the amount paid for the put.
An investor purchases two PMJ Dec 16 calls at $0.85. If the commission charge is $8, the total cost is?
A premium of 85 cents per share means each contract has a cost of $85. There are two of them, making that $170. Adding the $8 commission brings the total to $178.
